Dude, where's my IPO?


(MoneyWatch) COMMENTARY Facebook may be the biggest technology IPO ever, but the number of companies going public is a fraction of what it used to be. Here's why -- and why that's not going to change anytime soon.

For 20 years leading up to 2000, an average of 311 companies went public every year. Since then, the number has plunged to 102. Obviously, the dot-com bust changed things, but there good reasons why, more than a decade later, the IPO market hasn't returned to normal.

Interestingly, popular explanations for the decline in IPOs, like Sarbanes-Oxley and reduced analyst coverage for public companies, are almost certainly wrong. A more likely theory is detailed in a recent paper published by the Harvard Business School called "Where Have All the IPOs Gone?"

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While I agree with the hypothesis of the report -- that legislation is neither the cause nor the solution to the problem of the disappearing IPOs -- I have a somewhat different take on the market dynamics that got us here.

The venture capital bubble

First off, the tech bubble was also a venture capital bubble. When it burst, so did private company valuations. Companies were acquired for pennies on the dollar and the IPO market collapsed. Without successful exits, the venture capital industry imploded, shrinking to about half its former size.

While venture funding has slowly clawed its way back to somewhat respectable levels, that contraction brought about changes to the way VCs look at funding companies and their exit strategies.

For example, since there are just as many startups chasing far less money, VCs can afford to be far more selective. While they're always on the lookout for the next Google (GOOG), Twitter, or Facebook, those deals are few and far between.

Selling out is better than striking out

Swinging for the fences isn't what it used to be. Sure, if a startup is gaining traction and growing at a torrid pace, VCs are certainly willing to keep funding a company in the hope of a big IPO payday. It's worth the risk.

But once it becomes evident that a startup is a single or a double as opposed to a home run (let alone a grand slam like Facebook) and its valuation begins to flatten out, it makes more sense to sell the company and take some profit rather than continue throwing money at it and end up striking out.

Another factor is that, since the public markets have contracted and the valuations of technology companies aren't what they used to be, it's harder for small companies to put together a successful IPO because the "comps" -- public companies investment banks use as valuation comparisons -- are significantly lower.

In other words, the financial threshold companies must reach to consider an IPO, such as revenue growth and profitability, is much higher than during tech bubble (good thing, too, since we know how that irrationally exuberant era ended). That means far fewer companies can reach required valuation to go public. Simple math.

When is an exit not an exit

To make things worse, here's another factor that nobody talks about. Even when a company does go public, VCs don't get to just cash out, not even when the three or six month lock-up period is over. They simply own too much of the company. Instead, they have to realize their profits slowly over time. As a result, a 5- to 10-year investment in a private company becomes a much longer investment in a public company. So it better be a good one.

Put all that together and you can see why the vast majority of startups that grow to a reasonable size are sold, and far more than before the dot-com crash. It simply makes a lot more financial sense than continuing to fund startups in the hope they'll someday reach that higher IPO threshold, not to mention live with the risk of a post-IPO collapse.

The rise of private equity

Lastly, it used to be fairly common for big companies to spin off discrete businesses as IPOs, but that generated a lot of post-IPO flops. The problem was that the spinoffs were usually saddled with too much debt, among other things.

These days, it's more common to sell a big chunk of the divested corporate assets to a group of private equity firms, let them trim the company into fighting shape, then take it public if and when that makes sense. That longer gestation period, coupled with the higher bar to go public, has had a chilling effect on divestiture IPOs, as well.

Bottom line: This isn't your father's IPO market, and that's not going to change anytime soon.

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