Editor’s note: Jim Verdonik is a longtime veteran of the high tech sector, having acted as a lawyer in numerous venture capital and entrepreneurial startup deals in the Triangle. He is a member of the Local Tech Wire asked Verdonik to offer his analysis of the plan announced by the National Venture Capital Association on Wednesday. Verdonik’s thoughts:
First, the Ecosystem proposal mentions four investment banks (the "Four Horseman").
I echo the proposal’s statement about the importance the Four Horsemen played in IPOs. As a securities lawyer in New York in the 1970s and 1980s, I worked on IPOs and other transactions with these four firms all the time. IN fact, I did legal work to establish one of them (the Robertson Stephenson firm when founder Sandy Robertson left another firm. These four firms literally dominated the IPO industry for venture capital backed companies.
They dominated even though they were smaller than many other firms because they specialized in tech based deals.
This dominance prevailed until the late 1990s when big banks paid the owners of these four firms a lot of money to buy the firms. Like others who were able to sell before the Dot Com bubble burst, these people made enormous amounts of money by selling when market values were inflated.
The problem for the rest of the economy was that when the big banks bought these firms, the big banks insisted that they stop underwriting smaller IPOs. Instead of deals where companies raised $20 million or $40 million, the standard became to raise $100 million. The primary reason was that bigger investment banks wanted more fees and that can only be done with bigger sized transactions. This change had several effects. Most tech companies were priced out of the IPO market, because your value has to be a lot higher to raise more capital. The other primary effect was that most tech companies that did go public had to raise greater amounts of venture capital when they were still private to fund their growth to a point where they qualified to do a higher IPO. That created greater risk and greater dilution, which lowered returns for early round investors. The reaction to that change was that many early stage investors changed their strategy to become later round investor. When that happened fewer companies were able to raise early stage capital. That failure to raise early stage capital means that ten years later there are fewer companies qualified to do IPOs.
So, you see, the sale of the Four Horsemen to the big banks set off a chain reaction that adversely affected all the economic development and capita; raising at lower levels of the ladder below the IPO market.
What was disappointing in the VC Proposal was any sense of responsibility by the VC industry for essentially abandoning the lower levels of the capital raising ladder in reaction to events at the top of the ladder. Likewise the proposal doesn’t address how VCs should be playing a role in better preparing companies to be public companies.
I also want to note another effect of the sale of the Four Horsemen. As the IPO markets shrunk, Wall Street still had to make a living. In their new homes inside big banks, investment bankers turned to selling debt and securitization deals. The old saying is that "Nature abhors a vacuum." As the equity markets receded, investment bankers turned to debt markets to make a living. Other factors were involved, but our current real estate/debt crisis has roots in the restructuring of Wall Street from boutique investment banks that specialized in limited areas to big investment banking factories.
There is good news, however. As the big Wall Street firms imploded, talented people will find other types of deals to do. Some of them will start smaller boutique firms. Its already happening. Every layoff has a silver lining. Government restriction on bonuses at the big surviving banks will accelerate the process of boutique formation as the best people leave the big banks. Of course, this isn’t an overnight process. It may take decades to rebuild boutiques that had the talent and capabilities that the Four Horsemen who dominated the 1970s, 80s and 90s had.
The fundamental lesson for the tech world, however, is that small is healthy.
Small investment banks do small sized deals
Small VC firms invest in small early stage deals.
When more money is needed the small players form a syndicate to do a big deal by bringing in lots of small firms.
When the big deal is over, the syndicate members go back to doing small deals separately or in smaller syndicates.
That’s the system that built U.S. tech industries and it’s what is required to bring them back.
