Entrepreneur

Startups: Welcome to the lost decade

(Editor’s note: Serial entrepreneur Steve Blank is the author of Four Steps to the Epiphany. This column originally appeared on his blog.)

If you take funding from a venture capital firm or angel investor and want to build a large, enduring company (rather than sell it to the highest bidder), this isn’t the decade to do it. The collapse of the IPO market and dysfunctional math in the venture capital community has stacked the odds against you.

Here’s why.

The two decades from 1979 (when pension funds fueled the expansion of venture capital) to 2000 (when the dot-com bubble burst) were the Golden Age for entrepreneurs and venture capital firms. VC’s were making investments every other financially prudent institution wouldn’t touch – and they were printing money.

The system worked in predictable and profitable ways. VCs invested their limited partners’ “risk capital” in a portfolio of startups in exchange for illiquid stock. Most of the startups they invested in either died by running out of money before they found a scalable business model or ended up in the “land of the living dead” by never growing (or failing to pivot.)

But a few startups succeeded and grew into profitable companies. Their venture investors made money by selling their share of these successful companies at a large multiple over what they originally paid for it. One of the most predictable ways for an investor to sell these shares was to take a company “public.” (Until 1995 startups going public typically had a track record of revenue and profits. Netscape’s 1995 IPO changed the rules. Suddenly there was a public market for companies with limited revenue and no profit. This was the beginning of the five-year dotcom bubble.)

During the decade between 1991 and 2000, nearly 2000 venture-backed companies went public. Take a look at the chart below. (It includes venture-funded startups in all industries, from software to biotech. Source: NVCA.)

The size of the red bars (IPOs) versus blue (mergers and acquisitions) illustrates that while venture-backed startups did get acquired, the IPO market was booming.

Going public did two things for your company. You finally had money in the bank to expand your business, scaling it from the “build” stage into the “grow” stage. But more importantly, your VC’s could sell off their ownership stake. This changed their interest from managing your board for their liquidity to managing the board for all shareholders.  Most VC’s would get off of boards of companies that went public.

The public markets for venture-backed technology stocks never really recovered after the collapse of the dot-com boom. Fast forward to today and take a look at the last ten years of IPOs and M&As in the chart below, and you’ll see why life is different for entrepreneurs.

Depending on your industry, in this decade it’s 5 to 10x less likely that your company will have an IPO as an exit. And what the chart doesn’t show is that the dollar amounts of the deals are significantly smaller than the last decade.

Since there’s no public market for the shares your venture investor has bought in your startup, the most reasonable way for a venture firm to make money is to have you sell your company to another company. But unlike an IPO — where you sold stock to the public and got to run your company — in an acquisition, your company is gone. And odds are you will be too in a year or so.

None of this has gone unnoticed by the venture community. Some of the old-line venture firms have changed their strategy, but some are still locked into last decade’s model while the partners are living off of their management fees and go through cargo cult-like rituals. You can tell who they are by how often they remind you “this is the year the IPO market will come back.” (If the limited partners of these VC’s acted like real fiduciaries rather than waiting for the end of life of the fund, more than half of old-line venture firms would have shut themselves down today.)

New, agile and adroit venture firms with new business models have emerged to deal with the reality that Web 2.0 startups require significantly less capital to start, exits for venture firms are predominately acquisitions and a venture firm with a smaller fund (less than $150 million) matches these exits.

Floodgate, Greycroft, Union Square Ventures, and True Ventures are example of this class of firm. (Raising a VC fund in this environment has it’s own perils.) And the explosion of private Angel firms continues to fuel this new ecosystem.

Other VC’s who invest in Information Technology have taken a different approach. They’ve created virtual IPOs for founders and employees via late-stage private financing. It has put a per user dollar value on these sites and these few startups will be the next likely IPO candidates. In their short time as a fund, Andreessen Horowitz seems to be on top of this game with their investments in Facebook, Skype and Zynga.

But not all industries are as capital efficient as the Web or information technology. Biotech, medical devices, semiconductors, communications and cleantech require significantly more capital to build and scale before they can generate profits. It’s in these industries that the lack of a public market has taken the heaviest toll on entrepreneurs and their startups. Great companies with innovative ideas have simply died not having the cash to scale. Venture capitalists who would have normally kept writing checks were faced with no public exits and cut them off.

Some of these industries have turned to the U.S government for funding. Elon Musk has not only tapped the feds for his electric car startup Tesla, but also received hundreds of millions for his space launch company, SpaceX. Other cleantech companies have tried this approach as well. Yet while the U.S. government doles out funds to connected entrepreneurs, it lacks an integrated strategy to deal with the lack of public market financing for critical growth industries.

It may be that these entrepreneurial industries suffer the same fate as manufacturing in the U.S. — they die out of benign neglect and a lack of a coherent understanding of the role of risk capital in our national interest.

If you’re starting a software company, your exit is most likely a sale to a larger company. This decade has been a Darwinian filter – only the very best companies will survive as standalone companies.

If you’re starting a company in other, capital-intensive industries, it’s no longer just about having great technology. You need a plan for partnership and long term funding from day one.


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