Exit Here, Mind the Gap: Part I

The second quarter sucked. For a lot of reasons. If you were a VC, it’s more than likely you woke up once or twice in a cold sweat wondering if those lignin-to-hydrogen and supercapacitor companies you funded were really the best place to put $80 million. And maybe for a brief moment this Saturday morning, you cracked open the The New York Times business section, your eyes wandering past the picture of the fat lady with the milk jug, until you settle on a story that made you mix tears of pain with your Wheaties.

The second quarter was the first time since 1978 that there were no venture-backed IPOs. The first quarter was no picnic either, with only five VC-backed companies making their debut on the public markets. So there are a few well-trod reasons why this is probably the case: the markets continue to death spiral as big investors sells off and small investors either hold tight or move money into safer harbors, like commodities; the Fed has made some noise about uncertainty over inflation, halting the orderly retreat in the Federal Funds Rate to two percent, with rate hikes possible in the future; tightening credit markets and lots of distrust has moved money out the banks and under the mattress; and, generally, with the economy at its worst point in recent memory, who’s got time to pop open a bottle of Perrier-Jouet and go bang the hell out of the NASDAQ bell. Come to think of it, if you haven’t moved all of your money out of the NASDAQ and into oil exploration equipment manufacturers and defense contractors, you might as well just give up right now.

Just kidding.

Kind of.

But macroeconomic problems aside - because, really, when was the last time you talked to a VC who cared about macroeconomic problems? - it’s probably important to think about whether the absolute lack of exits has endogenous origins. Are VCs more focused on investing in companies that can grow or companies that can be sold? Or, as Gary wonders, are the companies VCs are investing in truly disruptive game-changers, or are they merely incremental innovators? The former being companies that could come into their own as real competitors on the public markets, the latter likely relegated to acquisition and roll-up into Dow Corning, Bosch, or another similarly situated industrial conglomerate.

But I say that like it’s a bad thing. It’s not. But it may be sign of a larger problem. VCs, especially greentech VCs, are investing in companies that are “fun and appealing to them but Wall Street doesn’t care,” says Paul Kedrosky. Those companies include the n+1 solar company with the highly-efficient solar cell and the other other company working on fast-charging technology for Li-Ion EV batteries. The VC herd mentality may end up doing them in in the end. When one firm invests in a cell company, so do the next nine. Same with cellulosic ethanol, same with fuel cells, and on and on. Of the 426,718 solar companies funded in 2007, maybe four represent real value based on a marketable innovation. There’s also the problem that greentech companies take a long time to build. I suspect a lot of investors came into this market in late 2006, dropped $5 million in an A round, and thought they were on their way to success. Five months later they get a call asking if they want to follow on with another $65 million to fund the design of the production process.

Excuse me? What? Oh, yeah. We’ve Got To Build A Factory To Build Our Product. While you were busy downing your favorite aspirin and Lipitor cocktail, the nature of VC investing changed. And with it, the timelines to exit. Some VCs worry that the end of exit opportunities through the public markets will mark the end of the VC industry. I disagree. I think some VCs have started, ever so subtly, to craft companies in ways that exploit the value of their product, and not necessarily the value of their company as a whole. In our next installment, we look at how those product-centric companies are fairing in the frothy M&A market. And by frothy, I mean 1/frothy.

Oh, and just to make sure we’re all on the same page. Does anyone remember the last venture-backed greentech IPO? I think it was Orion Energy Systems, which debuted on the NASDAQ around Christmas 2007 and raised around $80 million. Before that were the dueling IPOs of EnerNOC and Comverge in May and April 2007, respectively. Before that? First Solar in 2006.