Barbell Issue #1: Viable Exits Moving Forward

To briefly re-state the “Barbell problem:” Early stage start-ups are starting to be sorted into two ends of a barbell with no middle ground:  one that has light capital requirements (software, web applications, SaaS apps) and one that has larger capital requirements (hardware, semiconductors, etc.).  There is no opportunity for start-ups in the middle or in the “capital intensive” end of the barbell in today’s market.   Non-capital intensive companies need to be run lean and mean until they have achieved some scale; capital intensive companies have little choice when it comes to starting and scaling:  they use other people’s money and therefore have larger outcome requirements; they must be certain to hit financeable milestones with current funding.

Jeff Bussgang over at peHUB writes about VC “right sizing” but describes a really interesting set of data points from JPM regarding business/revenue criteria where IPO is a theoretically possible exit:

I attended a breakfast last week where JP Morgan’s vice chairman, David Topper, gave his review of the macroeconomic picture, including the IPO market. Although he was too polite to say it outright, his data clearly showed will be irrelevant to VCs for the foreseeable future. He laid out the four criteria that are required for an IPO candidate:

  1. IPO size of $200 million (implying a market capitalization north of $700 million). Without this level of float, there isn’t enough liquidity in the stock to attrack investors.
  2. Profitable, established business (i.e., not “approaching profitable” but proven profitable over many quarters if not years).
  3. Minimal leverage.

Of these three, #1 is the real killer for venture-backed start-ups. When I was an executive at Open Market and did our IPO in 1996, we executed an $80 million IPO – at the time, that was considered mid-sized. In today’s environment, where Google is trading at a 6-8x EBITDA multiple and typical revenue multiples are 2-3x, an IPO candidate would need to be throwing off $100 million in cash flow and/or generating north of $200-300 million in revenue while still growing fast. These are incredible numbers for venture-backed start-ups less than 10 years old.

Of course, the point here is that businesses meeting these criteria are exceedingly rare; more rare to be venture backed; and more rare still in this macro-economic climate.  There is a public market window open right now — who knows for how long — and we’ll see a couple of companies beyond Rosetta Stone ($200m revenue run rate today; ~$27m EBITDA with good growth; = ~$40m market cap) try to get out in the next few months. They each are able to play in the “outcome ball park” described by Jeff.  If the IPO market maintains such criteria (seems likely), the current M&A market is focused on distressed assets (only question is how long is this true), then the only other outcome possibility is getting to profitability (and perhaps considering dividends earlier than typical) and staying there.

In a barbell-related note, Fred Wilson concludes that the most dramatic decrease in VC investment is happening on the West coast compared to the North East (Boston & NYC). Nonetheless, the notion of the funding level dropping, capital costs (to start-ups) increasing and capital efficiency remains a requirement:

There is money out there for good ideas, particularly ones that are capital efficient and located somewhere other than Silicon Valley.