The significant increase in sales of venture-backed companies in the second half of 2010 and early 2011 should signal an improved fundraising environment as well as increased returns for venture capital firms for the balance of the year and beyond. This is especially welcome news for startup companies, which are likely to benefit from greater funding opportunities resulting from reignited interest in investing in the venture sector among limited partners.
As the credit crisis and Great Recession began to unfold in 2008, exits for venture-backed companies plummeted. According to PricewaterhouseCoopers LLP, sales of venture-backed companies totaled 380 in 2007 and fell to 348 in 2008 and 273 in 2009. During the same period, according to PwC, initial public offerings of venture-backed companies declined from 86 in 2007 to six in 2008 and 12 in 2009. As the economy recovered in late 2009 and throughout 2010, the number of exits dramatically increased. In 2010, according to PwC, sales of venture-backed companies totaled 420, and there were 72 IPOs of venture-backed companies. While the increase in IPOs in 2010 was impressive, the vast majority of venture-backed companies generated returns for their investors through a sale and not from an IPO.
What has caused this dramatic recovery in the number of sales of venture-backed companies? Many believe the increase is due to the general pick-up in economic activity and the resulting increased liquidity of larger corporations due to improved profits and increased issuances of debt at low interest rates. This increase in liquidity coupled with reasonable valuations for acquisition targets as a result of the lingering recession is likely the reason that the larger companies have increasingly pursued acquisitions. This upswing in purchases by larger companies is great news for technology companies and other fast-growing venture-backed companies and the venture capital funds that have funded them.
The increase in sales of venture-backed companies should free up fresh capital for new investments. Entrepreneurs who founded the companies are getting cashed out or receiving publicly traded shares that can be readily converted into cash. This gives the founders fresh capital to start companies or provide much needed angel financing to other budding entrepreneurs. In addition, the sales provide increased capital for the venture funds that backed the sold companies. This fresh cash can be held back by the venture funds to finance startups or to provide additional capital to existing portfolio companies. Alternatively, the venture funds can distribute the proceeds from the sale to the fund's limited partners who have been patiently waiting for return of (and returns on) their capital.
Increased returns to the limited partners should ultimately result in more cash available to finance new startups. The paltry returns to investors in venture capital funds over the past decade have been well reported. According to Cambridge Associates LLC, the average venture fund posted a negative return of -4.6% over the past 10 years. This dismal performance resulted in dramatic declines in the dollars invested in venture capital funds.
At the height of the dot-com bubble in 2000, $107 billion was raised by venture capital funds. This declined to $36 billion in 2007 before the Great Recession and declined again in 2008, 2009 and 2010. With the increase in M&A activity, the returns to investors in venture capital funds should improve, and investing in venture capital funds should once again become attractive to the endowments, pension funds, family offices and wealthy individuals that typically invest in venture funds.
As fresh capital finds its way into the venture funds, we should see an increase in funding of startup companies. This increase in funding will provide much needed relief to entrepreneurs who have been capital starved over the past three years and should result in an increase in the growth and hiring by these startups, which have long been a traditional engine of growth for the U.S. economy.
Jeremy Glaser is a member in the corporate section of the San Diego office of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC.