Venture Capital Industry Has Too Much Money for IPOs

On the surface, the annual Deloitte and National Venture Capital Association report finds that initial public offering activity is too low for 80 percent of VCs. More IPOs would mean more money for venture firms when they and institutional investor limited partners exit an investment.

There's just one problem. One of the big reasons there aren't more IPOs is that the limited partners have too much money to invest. Because of a twisted combination of mechanics and big numbers, everyone focuses on a few big deals and can't afford to invest in smaller companies that used to have a better shot at going public. And there's no easy fix.

What's wrong with acquisitions?
The VC need for IPOs makes sense. The two major alternatives for investors to recoup their money from start-ups are going public and acquisition. And clearly there are times when an acquisition could be a very big deal. Look at the $6 billion Google (GOOG) offered for Groupon late last year.

If an IPO isn't a realistic option, acquisitions become the only alternative. "You only have a certain number of buyers when it comes to acquisitions, and there are fewer and fewer of buyers out there because the number of public companies is shrinking," says NVCA president Mark Heesen. The few potential buyers know that interest is limited, so they needn't bid as high as they otherwise would.

IPOs are harder to arrange
If IPOs are so important, why don't venture firms push harder in that direction? Because it's not a process they can control and the current conditions don't leave them jumping for joy, for 3 reasons:

• It currently takes companies about ten years to go public, according to Heesen. That's too long for VCs, who prefer the 5 to 7 year range. The longer before exiting, the bigger the payoff has to be.
• The big institutional investors -- pension funds and university endowments, for example â€" have less interest than they used to in equity investments. They have enormous piles of money to invest, and it takes as much work to invest a small amount as a large sum. But there are limitations to how much of a company they can buy without additional regulation kicking in. As Heesen says, it's easier to buy bonds. If they don't buy into an IPO, then it takes too much work for the investment bankers to move shares to smaller individual investors.
• The same institutional investors also tend to be the VC limited partners that provide the bulk of the money for investing, according to Mark Jensen, managing partner of the venture capital services group for Deloitte. "They're looking for a return of about 25 percent annually," he says. So the initial funding deals have to be large.

This driving need for big deals to make the financial returns and investing conditions acceptable for the institutional investors is why so many VC firms will combine to put $2.34 billion into Facebook, $1.14 billion into Groupon, or even the relatively small amount of $103 million into LinkedIn. Even Pandora (P) had $56.3 million in investment. The money goes into greatly expanding a business over years so that it hits an IPO with a big return for the investors.

"All anyone reads about is the successes, not the failures," says Jensen. "The few that do make it have to return a significant amount of capital to cover losers and provide a significant return for the limited partners." But relatively few companies need that level of funding or are candidates for the size of returns necessary to justify the investment. Until the dynamics of the market change, IPOs will remain rarer than VCs, their limited partners, and entrepreneurs would hope.

Related:

• Pandora Jukebox Collects a Lot of Coin for Some Investors
• Groupon Vs. LinkedIn: The IPO Bad Boy Smackdown
• Bubble Time Makes Silicon Valley VCs Smile -- Everyone Else, Beware
• SEC Considers Changes That Could Hammer VCs and Angel Investors
• Goldman-Facebook Deal May Smell, but How About the Rest of Business?

Image: morgueFile user cohdra, site standard license. Erik Sherman

Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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