IPOs, M&As, Liquidity, & You. (the entrepreneur)

Bill Payne , Angel Investor , Frontier Angel Fund

28 Dec 2011

In the “good old days,” angels invested in seed-stage startups and teed up promising companies for subsequent venture capital financing. If the company was successful, this quickly led to an IPO – a very happy ending for the entrepreneur, the angels, and the venture capitalists. My, my…how the world has changed. The two major differences in the exit environment in the past decade are (1) the disappearance of the IPO market and (2) the rapidly increasing size of the average VC fund.

The NASDAQ IPO marketplace was changed radically by the Sarbanes Oxley (SOX) legislation, which was Congress’ unsuccessful attempt a decade ago to preclude future ENRON financial disasters. SOX and radically higher NASDAQ fees have limited those new ventures going public to much more mature and highly visible companies.

As you may know, startups can go public on active foreign exchanges – such as Toronto’s TSXV and the London AIM market – but there’s a catch. The TSXV and the AIM markets are thinly traded and can provide only limited liquidity for investors, which is one of two main reasons for startups to offer an IPO (the other is to raise capital). Consequently, the fraction of venture funded companies that have used the IPO to define the exit for investors has been reduced from 90% twenty years ago to less than 10% today.

Without explaining why the average venture capital firm is managing larger funds today than a decade ago, let me describe how this change has impacted the startup funding landscape. With more money to invest per principal, venture capital has chosen to invest more money per round of investment. The average VC round has moved up from $2-3 million twenty years ago to $7-8 million today. Angel investors, however, have continued to fund round sizes between $150,000 and $1 million, just as they did twenty years ago. This has created a gap between angels and VCs with little funding available between $1.5 million and $4 million. I described this Funding Gap in an earlier post.

Larger VC rounds and the lack of early IPOs have also resulted in substantially longer pre-exit waiting periods for venture capitalists. Companies that might have provided VCs with exits in 2-3 years a decade ago, may now require eight or even ten years to exit. Angels and entrepreneurs who invest ahead of VCs are required to have much more patience than in the past.

These changes suggest three messages for entrepreneurs:

• Don’t try to raise $3 million (in the gap between angels and VCs). There are simply very few investors doing gap funding. Design your milestones around the capital sources available.
• Raising venture capital may lead to a huge exit. But, it will take much longer than in the past. And, extending the time to exit also increases the risk of failure – perhaps by being blind-sided by technology or a large competitor.
• Consider an “angel only” deal, raising only a million or two in multiple rounds from angels. Plan to prove your business model and get to positive cash flow with angel money and without VC investment. Then, plan an early M&A exit to a much larger player who is deliberating a “make versus buy” decision on your business proposition.

The scarcity of IPOs and the increase in VC fund size has led to several changes in capital markets. VCs are investing more per company and waiting longer to divest via a M&A transaction. Plus, there is an emerging trend of angels doing more angel-only deals, and then looking for an early exit to an interested large player.

All opinions expressed are those of the author,  and do not necessarily represent those of Gust.

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