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Rethinking exit strategies 14/11/2007. Source: IVCJ (Israel Venture Capital & Private Equity Journal).
 The exit landscape has changed in recent years. In this IVCJ article, Eddy Shalev, Founder and Managing Partner of Genesis Partners, urges venture capitalists to help their portfolio companies increase their valuation in preparation for acquisition as well as to consider an IPO on an alternative market.
The centrality of exits to the effectiveness of the venture capital model is constant and axiomatic. In recent years, however, several trends have converged, forcing venture capitalists around the world – and particularly in Israel – to re-evaluate their approach to exits.
Exits are a cornerstone of the venture capital industry. Unlike other institutional investors or corporate investors, venture capitalists are constrained by a fairly rigid model according to which they must return capital to their limited partners within the life of their fund. For a typical VC fund, this means that within five to 10 years an investment must reach an exit in order to be considered a success. Another peculiarity of the venture business is that in the big picture only the large exits really matter. For an early stage fund, 75 percent or more of the capital returned by the fund will usually be generated by one investment. This is the essence of the venture model – multiple high-risk investments, a small percentage of which provide outsized returns.
Historically, the Israeli venture capital industry has relied on NASDAQ IPOs as the best avenue for significant exits that impact fund returns. Traditionally, IPOs – especially US IPOs – have been associated with extensive press coverage, sell-side analyst coverage, trading support from market makers, and highly liquid capital markets. Publicly traded companies have benefited from access to capital markets for secondary offerings, the ability to use equity as acquisition currency, and the patina of success and potential that accrues to public companies. NASDAQ, which was particularly hospitable to early stage technology companies, quickly became the exchange of choice for Israeli high-tech companies and their VC backers. Today, there are over 110 publicly traded Israeli companies on NASDAQ, more than any foreign country.
Since 2001, however, the exits that are required in order to generate venture capital returns have become increasingly harder to achieve. There are two principal factors that explain this. First, overall revenue growth rates have been slowing in the technology, software, and communications markets, leading investors to be far more selective. Gone are the days when the phrase “technology IPO” was automatically associated with extremely high growth rates. With the telecom bubble and the Internet bubble behind us, investor appetites for technology offerings have become more subdued. Despite the recent buzz in the popular press suggesting that technology IPOs are making a significant comeback, there has been a fundamental long-term shift in the IPO markets that will make it harder for young companies to go public. In the mid-1990s, a technology company needed a revenue run rate of $30 million and a slight profit (if at all) in order to go public. Today, the bar has been raised, and companies seeking to go public must demonstrate significantly higher revenue run rates and high profit levels. In addition, they must offer investors the credible promise of high profit growth rates of up to 25-30 percent annually in the years following the IPO.
Second, with the advent of Sarbanes-Oxley legislation in 2002 as well as other accounting and securities regulations, the costs and risks of being a public company in the US have risen significantly. According to some studies, the cost of being a public company has risen to between $1 million and $5 million annually (depending on the size of the company) as a result of Sarbanes-Oxley. The ultimate impact of Sarbanes-Oxley on the IPO market is hard to calculate, but it certainly has had a cooling effect on the willingness of young technology companies to go public.
Facing the increasing challenges associated with IPOs, venture-backed technology companies have turned to other avenues to achieve exits. Exits through acquisitions – a staple of venture investing – have become increasingly popular recently. Many large companies, such as Cisco and Oracle, have built their growth strategies around aggressive acquisition policies. Others, such as Google and Microsoft, are increasingly focused on acquisitions. In general, however, acquisition valuations are less than IPO valuations. As acquisitions become an increasingly important source of exits, the venture capital industry will have to focus on helping start-ups generate enough value and staying power that they can achieve higher acquisition prices. Acquisitions of unprofitable companies or of companies with hesitant investors tend to be underpriced – and venture capitalists must learn the rules of the M&A game in order to drive higher returns.
Another possible avenue for exits is alternative markets such as the NYSE's Euronext, the LSE's Alternative International Market (AIM) and the Toronto Stock Exchange's TSX Venture. These markets offer more lenient conditions for young companies and have attracted investors that are willing to place a bet on technology IPOs. These exchanges, however, have limited track records, and it may be some time before their impact on the venture exit landscape is understood. The exit outlook has undoubtedly changed, and venture capitalists must learn to change with it. To be successful, technology venture capital funds must continue to invest in early stage companies with the potential to generate tremendous value in large markets. Extracting that value, however, has become a more complicated proposition. IPOs will continue to be available for the best start-ups, but acquisitions are likely to continue to increase in importance – and even to account for many of the very large exits that drive the venture model.
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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