On Monday, August 10, Barron’s ran a story “Does the IPO Market Shun Smaller Companies?”, written by Mark Veverka, asserting that “venture capitalists want to widen the playing field for the underwriters.” The story includes quotes from former National Venture Capital Association (NVCA) chairman Dixon Doll of DCM and investment banker Paul Deninger, who is the vice-chairman of Jefferies & Co. It accurately points out that, when it comes to IPOs, many venture capitalists have mistakenly defaulted to choosing the large investment banks (such as Goldman Sachs, Morgan Stanley, and Credit Suisse) as lead underwriters for their portfolio companies.  This practice has created “a near oligopolistic hold on tech IPOs” by these large investment banks.  Such market power allows bankers to shapes the profile of those companies worthy of going public to favor the natural demand from their largest clients: short-term trading focused hedge funds and large institutional investors that demand highly liquid public securities.

The collateral effect of this market reality is that the vast majority of emerging VC-backed companies are effectively barred from going public.  To be clear, there are plenty of strong venture-backed companies today that should be public but that do not meet the valuation or liquidity criteria of the three large remaining investment banks (more on this below).  Unfortunately, outside of the IPO-syndicate-bias and the much-maligned Sarbanes Oxley, the article does not address far more serious systemic regulatory consequences that further exacerbate the problem– such as the combined impact of decimalization and the Spitzer decree (taking trading commissions down from $0.125 per share to $0.01 or $0.02 per share and requiring that equity research be paid for by commissions ) which have effectively gutted both the after-market trading and research support that emerging company IPO’s need.

While the article notes that “the objective is to get back to late-80s, mid-90s practices, allowing more start-ups access to capital so they can remain indepenedne tand create more opportunities for venture capitalists to cash out”, the emphasis on who is cashing out is misplaced.  More accurately stated, the institutional investors who fund the venture capital partnerships need more opportunities to cash out– and these institutions are largely public pension plans, college endowments, and other true long-term investing financial institutions.  Why do they need to cash out?  Because they are also the main players who have historically reinvested in the next generation of innovation.

Sadly, the article completely ignores the implications of this systemic liquidity crisis.  If we look at the historic record, the most important point overlooked by this story is that smaller companies need to go public because they are the engines of growth that drive the U.S. economy– both in terms of job creation and GDP growth.  The IPO chasm that exists today is the result of the death of the sub $50 million IPO.  For a clear example, see the following list of 17 companies that went public and raised $50 million or less between 1971 and 1996:

These companies only raised $367 million in the public markets and they account for 470, 000 U.S. jobs today. Adjusted for inflation andmeasured in 2009 dollars, the $367mm in total dollars raised by this group equals$670mm, and only 2 of these 17 companies’ IPOs (EMC $80mm; and Oracle $70mm) exceed $55mm in 2009 dollars.  While today these companies are household names, when they went publicthey were largely unknown. How many companies are unable to go public today  because they aren’t big enough to merit the attention of the large investment banks who cater to short-term traders?  How many future engines of U.S. GDP growth and job creation will be still-born and be forced in to a merger?  Should they be starved of liquidity because they need to cash out investors, build working capital, but it is unavailable to them because they need less than $50 million?

Deninger points out in the article that “In recent years, VC firms have become too dependent on mergers and acquisitions as the exit strategy of choice. . .. In fact, most tech-start-ups are ‘built for acquisition’, as opposed to being built to become the next publicly held Microsoft or Oracle.” An addendum to his quote should be that merger synergy is code for firing people.  Mergers trigger job losses; IPO’s create jobs.

In my view, it is wholly inconsistent with the Obama administration’s economic growth objectives for the current systemic liquidity crisis in our equity capital markets to be strangling our emerging technology growth companies while they are still in their venture capital cribs.  We need to raise awareness of this severe problem because it threatens an entire generation of American innovation.  Venture capitalists only make money if their investors make money, and many of their investors are the stewards of America’s pension plans.  VC’s need to build companies that are cash flow positive as private companies, not only so that they can improve their negotiating leverage in the event of an acquisition but, more importantly, so that they can wait to go public until the regulatory constraints that have killed the sub $50 million IPO are lifted.

In closing, the article incorrectly asserts that “ironically, the tech IPO market is re-awakeining just as the NVCA prepares to roll out its initiative.“  The few IPOs so far this year are drops of water in the desert, and those that are in the queue, while they represent outstanding companies, do not represent a sufficient number of companies to make a material difference for the institutional investors and the many entrepreneurs who have the most at stake.  Let’s not misinterpret false positives at the expense of the future of the American economy.

I will be the keynote speaker at the America Midwest Regional Final competition of the Global Security Challenge (GSC) on September 22nd in Chicago.  This event is part of a global competition to deliver innovative solutions to pressing cybersecurity problems.  The GSC Security Summit 2009, which will be held November 13 in London, will see the culmination of the six regional finals held around the world in September and October.  The Summit will include the final pitches from each regional finalist in the SME and Start-up categories, as well as the ‘Dragon’s Den’ style closed-door Q&A with the expert Judging Committees. The award categories are:

• Best Security SME
• Most Promising Security Start-up
• Most Promising Security Idea

Top contenders from previous Global Security Challenge competitions have subsequently raised over $55 million in new capital.  The current open competition is for the “Most Promising Security Idea”:

The GSC committee recognizes that there are many potentially disruptive innovations that have yet to reach commercialization. Through the Most Promising Security Idea category, the GSC encourages innovators to continue to pursue their ideas and efforts. The award is designed to support and promote researchers, infant companies (with no revenue), and any other inventors who just have an idea for a security solution.

The winners of this category will receive:

• $10,000 cash grant, sponsored by Accenture.
• Mentorship from Mark Shaheen, managing director of Civitas Group.
• Unparalleled networking opportunity with government officials and industry leaders.
• Invaluable publicity.
• Examples of our areas of interest are (but are not limited to): biometrics, detection sensors, cyber security, video surveillance, RFID, personnel protection, encryption software, data-mining, biotechnologies, and explosive trace detection. Who can Apply?: Eligible entrants must be a company, or one or more individuals, whose idea did not generate revenue in 2008.Deadline for Submissions: September 1, 2009 at 11.59 GMT.

For more information on the GSC CLICK HERE.  I am proud to be involved with this competition as it represents the type of innovation challenge that drives entrepreneurs to develop breakthrough ideas into real companies.

The Wall Street Journal published a combined version of  my letter to the editor in response to the Washington vs. Silicon Valley editorial of August 7 with letters from Harry Edelson (another First Boston alumnus from the ’80’s), and Ryan Phillips (whom I do not know).  My blog post of yesterday is a longer version of the letter that I sent to the editor.  Scott Austin has written a lively column today on this topic in Venture Capital Dispatch.  The opinion piece elicited 60 comments as of the date of this post covering a wide range of opinions on this important topic.

I think it’s very important that readers separate their personal feelings about venture capitalists from the capital markets issue.  Small cap IPO’s are necessary to restore job growth in America, regardless of whether they are venture backed or not.  If we don’t restore a robust market for initial public offerings of companies raising less than $50 million, America loses, and that has everything to do with promoting entrepreneurs.

I liked the Friday, August 7 Wall Street Journal editorial, Washington vs. Silicon Valley, but it does not go far enough.  In Silicon Valley, Boston, Austin, and other innovation centers across the country, entrepreneurs and their backers (who are not limited to venture capitalists) are all keenly aware that Washington’s addiction to enacting hasty, one-size-fits–all financial regulation will continue to have far-reaching unintended negative consequences for the U.S. economy:

“… Sarbanes-Oxley compliance costs, Eliot-Spitzer’s stock analyst settlement and the economic downturn have created an historic drought in venture-backed companies going public.  . . .  It boggles the mind that Washington would enact new policies sure to prolong this (IPO) drought and strike at the heart of American innovation.” (from the WSJ editorial)

The U.S. IPO drought testifies to a systemic liquidity crisis for emerging growth companies that is putting at risk an entire generation of innovative American companies.  IPO’s are essential to job growth in America and to maintaining a balanced innovation ecosystem for two important reasons.  First, the National Venture Capital Association has published data revealing that over 90% of the jobs created by venture-backed companies occur AFTER they go public—and this relationship holds over the past 40 years.  Second, emerging growth companies lose negotiating leverage in acquisitions when they have no other viable liquidity alternatives.  Between 2001 and 2008 mergers and acquisitions (M&A) accounted for 87% of venture-backed company exits, up from an average of 44% in between 1992 and 2000.

Large corporations are generally not known for being innovative and even less for creating new jobs after acquiring other companies (merger “synergy” is code for firing people). In the current liquidity starved environment, some acquirers are able to drive draconian acquisition terms, including features such as two-year contingent calls on up to 100% the cash proceeds to selling investors.

Venture capital partnerships are typically ten-year partnerships with historically proven expectations that significant liquidity will be delivered from successful partnerships to investors by year 6. The median age of a venture-backed company at the time of its IPO has increased from 4.5 years in 1998 to 9.6 years as of year-end 2008.  The median company age at the time of an M&A exit has increased from 3 years to 6.5 years over the same time frame.

What makes this combination untenable is that the IPO drought, combined with lengthy “tails” on lower-value merger payouts, pushes liquidity out much closer to the end of life of the partnerships themselves, making it impossible for investors to re-cycle their prior risk capital to fund the next generation of innovative companies based on previously valid asset allocation models.  The massive institutional investor losses incurred from investments in asset classes unrelated to venture capital due to the global financial crisis have only fanned the wildfire fire burning in the American innovation forest.

We must solve the IPO problem, and a review of historic IPO data pre-technology bubble suggests that we need to achieve an average of 130 IPO’s per year to restore equilibrium to the venture-backed company liquidity cycle.   While Sarbanes Oxley compliance costs and the stock analyst settlement are part of the problem, the root causes include the decimalization of stock trading commissions and the death of the sub $50 million IPO.

Investors take risk in order to reap rewards.  Washington needs to recognize, first and foremost, that entrepreneurs, venture capitalists, institutional investors, market markers, and underwriters all seek to be rewarded for committing risk capital (which includes sweat equity) to making these highly risky ventures successful.  If the upside is taken away by regulations that make the risk/reward equation unattractive, risk capital and entrepreneurs will leave the U.S.  That exodus has already begun, and it is evident in many statistics that testify to America’s slipping global competitiveness since 1999.

Sadly, risk aversion is the order of the day in Washington at a time when we need risk takers to lead America to a new cycle of sustainable economic growth through new job creation.  It’s past time for our policymakers to unwind the unintended consequences of a decade of ill-conceived securities regulations that have already weakened our innovation ecosystem.  Let’s start by advocating policies that will bring risk-taking entrepreneurs and technology innovators back to the table before the American cupboard is bare.

On June 25th I moderated a panel on the implications of America’s
Innovation Crisis for Cybersecurity at the National Press Club in
Washington, D.C.  The full transcript of the slides integrated with my
prepared remarks is now posted at www.levp.com .  This event was sponsored by the non-profit Security Innovation Network.

At the end of the panel I asked each of the panelists, Bob Ackerman of Allegis Capital, Professor Randy Katz of Berkeley, and Dave Robbins of BigFix, to answer the following question:

“In closing, I would like each of our panelists to comment on the most
important change that they would like to see implemented in order to
promote the protection of our nation’s critical infrastructure.”

Bob Ackerman’s answer follows:

“The solution to the critical needs of our country  – whether it is in reinventing our economy or the innovation that is essential to protecting our nation’s critical infrastructure – will depend on the creativity and drive of entrepreneurs. At precisely the same time that political leaders are calling for expanded innovation to meet our national needs, there appears to be an almost all out assault on entrepreneurship in America – by deed if not by word.  Capital and talent are the two most valued and at the same time portable assets in the global economy.  For more than three decades, the United States was the destination for the best and brightest minds from around the world.  In the US, brilliant entrepreneurial risk takers found the resources they required to implement their dreams and an environment that rewarded those that took the risks associated with innovation – and succeeded.  Today, we are making it increasingly difficult for the best and brightest to come the US and stay to contribute to our economy. For those that are here, we are increasing the regulatory hurdles associated with building successful businesses while increasing the taxes associated investments make in long term innovation.  Stock options – once the great wealth builder for employees in start-up companies – have had much of their value striped by regulatory changes.  When combined with the current political overtones that suggest people who have achieved wealth must have somehow “cheated”  – we have created an environment where the risk/reward associated with high risk entrepreneurial innovation is seriously out of balance.  At precisely the same time where we are more dependent than ever on an innovation-driven economy and our competitors have borrowed our historical playbook – we are effectively erecting barriers to innovation in America.”

How should we respond?  We need to attract and retain the talent and capital necessary to fuel the engine of innovation.  We need to attract capital and encourage focused, systematic innovation through modifications in our tax code.  Lower tax rates for long term innovation is an excellent place to start.  We need to rethink our approach to regulation with a more constructive understanding of the levels of risk associated with (and appropriate regulation) companies as they grow and prosper.  A successful start-up company and a multi-billion dollar global player should not be subjected to the same level of regulatory oversight – in most cases. Further, our immigration policies need to focus on encouraging the world’s best and brightest to come to the United States, benefit from our educational system and remain here to contribute to our economy.  Today, our policy in this area can almost be described as “Here’s your PhD. – now go home!”.  Rest assured – the capital will follow the talent.

In parallel with the above, we need to take concrete steps to encourage companies to grow in the U.S.  This is a combination of the steps I have previously mentioned while making it easier for young companies to go public – tapping the capital they need to continue growing and adding high paying jobs to our economy.  Regulatory reform can address some of these issues but the venture industry also needs to take responsibility for re-invigorating the investment banking environment upon which a vibrant IPO market is dependent. This is an area where experience will matter.  For example, venture professionals who have lived successfully through these challenges in the past – have an invaluable historical perspective that can contribute to this revitalization.  Unfortunately, many have left or are leaving the industry.  Why – it’s become harder and harder to be successful while the rewards are being diminished.  They either retire – or they follow the entrepreneurs who are voting with their feet and talent and moving to greener pastures – in other countries.

Last Thursday I moderated a panel on the implications of America’s Innovation Crisis for Cybersecurity at the National Press Club in Washington, D.C.  The full transcript of the slides integrated with my prepared remarks is now posted at www.levp.com .  This event was sponsored by the non-profit Security Innovation Network.

At the end of the panel I asked each of the panelists, Bob Ackerman of Allegis Capital, Professor Randy Katz of Berkeley, and Dave Robbins of BigFix, to answer the following question:

“In closing, I would like each of our panelists to comment on the most important change that they would like to see implemented in order to promote the protection of our nation’s critical infrastructure.”

Dave Robbins’ answer follows:

“First, I would like to see all federal IT groups focus on building a stronger foundation within their core network.  Often, an IT organization gets caught up in the purchase and implementation of a myriad of tools that don’t really solve key and basic problems.  In order to be more secure, you have to have better real time situational awareness: how many assets do we have; where are the assets located; where in the world are those assets now; what applications are running on the asset; what non-approved applications are on the asset; what is the patch level; is AV running.  Secure your core configuration and the rest of the task of security becomes much easier.

Second, make the entire process of selling to the U.S. government easier.  I find it sad and ironic that it is easier to sell governments throughout the world compared to my own. Far too many complicated buying processes and far to many acronyms and archaic terms (skivvy-skree is actually patch management!?!) create an impenetrable wall between young innovative companies and selling to the government.   Dealing direct with the government would make it easier instead of being forced to work through resellers and integrators that have little real knowledge of what makes an innovative company special.

You have to remember, if you want access to new innovative technology, you must find ways to work with smaller companies. Large companies don’t innovate, they increment, which is the antithesis of innovation.   Patents don’t equal innovation…products equal innovation.”

I am at an early morning session where Jason Calacanis, CEO of mahalo.com, Nick Denton of Gawker, and Jeff Jarvis of BuzzMachine and the New York Daily News, discuss the challenges of printed media’s transition to online digital media. This topic and Twitter are big themes at this year’s Ideas Festival, with everyone from Steve Brill to Michael Kinsley, Norman Pearlstine and Katharine Weymouth discussing the former and Peter Hirshberg driving an army of Tweeters at #AIF09 to develop a use case for the latter.

What amazes me is that the discussion on the demise of the traditional media model amounts to a collective shrugging of the shoulders by these experts.  Given that the business model for traditional newspapers is so broken, the disagreements as to the way forward run very deep.

Some of the suggestions in this morning’s breakfast discussion include that every print article should disclose  metrics as to how many people have read it in order to establish popularity benchmarks—this becomes a way of judging market reach as well.  Risk: ‘The New York Times could become the Paris Hilton Times’.  This tension between the eroding credibility and gravitas of the “traditional press” and the “deep but unverified assertions” of many blogs is at the heart of the problem.  Building a business model that scales to capture the high ground of credibility at a large scale online is in the process of evolving.  100-journalist strong online media news organizations are now thriving (meaning profitable), per the panelists.

Chaos currently reigns. Jeff Jarvis recommends reading Clay Shirky’s Thinking the Unthinkable.

Commenting on Twitter– the speakers highlighted the asymmetry of Twitter between The Followed and Followers. Finally the discussion has turned to the fact that Twitter makes no money.  The speakers believe that the Twitter business model will turn into search-based advertising and feel that Twitter is so revolutionary that the successful business model for Twitter is at hand.

I’ve been a Twitter skeptic but am starting to see it as a useful public utility for crisis situations and spontaneous viral group eruptions (from the incipient Iranian revolution to the Aspen Ideas Festival).

Follow me on Twitter @plevensohn and check out #AIF09 in the Twitter stream to see what is going on at the Aspen Ideas Festival in real time.

Today’s Security Innovation Network (SINET) event drew 300 people to the standing-room-only main ballroom at the National Press Club in Washington, D.C.  CNN filmed the entire event, and we will keep all interested parties informed as to when the video of the three panel sessions will be available.

The content was very powerful, and many eyes were opened to the interconnected nature of the crisis in America’s innovation ecosystem and the negative implications for cybersecurity. As one questioner said, “when are you going to stop talking about the problem and start taking actions, and what are you going to do?”

The question was meant more constructively than it reads on paper, and the answer is, “hopefully, a lot, but we need influential change agents to volunteer to get involved with the SINET to get things done.”  Much more to follow…

Scott Draughon, Anyck Turgeon, Robert Rodriguez, Pascal Levensohn

At 4 pm EDT on June 17 Robert Rodriguez, chairman of the Security Innovation Network, and I will discuss the recession’s implications on the continuing pace of American innovation on MyTechnologyLawyer, a live radio show.

The title of the hour-long show is “The Innovation Crisis in America.” The format for the show will be conversational, and I expect that our hosts, Anyck Turgeon of Crossroads Systems and Scott Draughon, originator and the main host of the show, will elicit some provocative answers through their questions.

Among the questions that we will discuss:

What is Innovation?
What supports the argument that there is an innovation crisis in America?
How does Silicon Valley fit into the innovation ecosystem?
How has global competitiveness changed over the past decade, how do observers measure changes in competition, and what does this mean for America?

Listeners can tune into the show live by going to this link: CLICK HERE

The show will be recorded and accessible for downloads at your convenience at www.mytechnologylawyer.com/crossroads .

There is plenty of ink flowing with speculation on the future of the venture capital industry.  Phil Wickham, CEO of the Kauffman Fellows Program, has a constructive perspective on this topic, which he expressed in his CEO recap in the Kauffman Fellows Program eBulletin that was published on June 2.

Below, I’ve quoted his key observations from the newsletter, with which I agree:

“… I [have] found two camps regarding venture capital: the majority believes venture is the answer to all our needs (mostly entrepreneurs) and the minority seems to think that the entire industry couldn’t fall of the edge of a cliff fast enough (mostly policy and academia). I have to say that the whole thing alarmed me, since we so strongly believe that the answer is nuanced and solidly in the middle of these two extremes. The CVE’s [Center for Venture Education] DNA is that of an “entrepreneur-first” organization, growing out of the culture and values of Mr. K [Ewing Marion Kauffman] and his Marion Labs team that put together and operated the Kauffman Foundation.

Since our full independence from the [Ewing Marion Kauffman]Foundation in 2001, our focus has been to anticipate as much as possible the evolution of the entrepreneur’s needs and opportunities, since we are management’s primary service provider. As a result, we have included the unique expertise of tech transfer funds, angel groups, corporate venture funds, international government seed funds and even foundation investors in the Kauffman Fellows Program as we strive to build a curriculum with maximum value for our customers.

… We’ve concluded a few simple things. First, that entrepreneurial capital is about enabling scale, and the value we deliver as an industry is much the same at any stage or in any environment. Second, that the CVE’s intellectual capital built up over the past 15 years is broadly applicable across all forms of entrepreneurial capital. Third, within that body of knowledge, our evolving expertise in leadership and managing the human dynamic has far more long-term impact than anything else we do. Finally, we are starting to discover that there is a much broader opportunity to spread this leadership know-how to all of the players in the eco-system: university researchers, entrepreneurs, LPs, government policy experts and service providers. We think that if – across the globe – each positional player can come to understand their own and each other’s roles and put their collaborative talents and energies behind the entrepreneur’s imagination, the world will be a better place for our children to inherit.”