Put in more current perspective, if Morgan’s tech banking group was a college football team, it would have about tied the University of Texas for the top spot on the 2011 revenue chart.  Those bankers can take some comfort that the “Deutsche Bank Goffers” would have ranked 11^th – just ahead of the Oklahoma Sooners – and the lowly “Goldman Sachs 49ers” would have come in at 16^th barely tied with the Hawkeyes of the University of Iowa.  Tech IPO banks and NCAA football teams have much in common – they both use cheerleaders to distract and arouse the crowd and they both rely on a passionate fan base whose enthusiasm often belies reason.  However, the real point of this comparison is to comment on relative relevance to the economy.

Like football, innovation is the lifeblood of the American way of life.  In recent times, the pinnacle for innovative enterprises is completing a wildly successful initial public offering, which has the dual benefit of commercial credibility and marking the company at its “true” valuation.  So, what does it mean when our kings of IPO underwriting have shrunk to the size of college football programs?  If the IPO market was still the real source of capital and liquidity and reputational swagger for tech companies, this would be a sign of real concern.  But this is no longer the case.

In 2011, US IPOs provided about $9 billion to tech companies.  The bulk of growth capital investment – over $30 billion – came through the private transactions you read about in places like PE Hub.  These private deals were larger, provided better shareholder liquidity and were often at higher values (Groupon or Zynga ring a bell?)  So, shrinkage in the IPO market is no cause for alarm as the capital is still flowing to companies that drive our economy.  It’s just not via the path that requires a company to increase its D&O insurance, watch its audit fees triple and run consecutive 90 day sprints.

Of course, IPOs for larger established companies continues to thrive and for larger tech companies like Facebook, there is always a window.  But for those companies who haven’t found their way to the private capital markets and find themselves stuck in the long-term IPO pipeline – perhaps an application for Title IX funding?

Then, IBM saw that its CEO/CIO clients had lost interest in employee machines and quit the business.  DEC focused billions on a single chip inside their machine and then folded.  Compaq fired some engineers and hired a few extra finance executives and consolidated.  And Henry Ford was reincarnated in the person of Michael Dell who understood that winning this phase of the “PC” industry would happen on the factory (and call center) floor.

Of course, nobody needs to go to a store just shop for a commodity – toilet paper is toilet paper – a PC is a PC – and you don’t need to consult an salesperson to decide what color cover to put on you Dell notebook.   So CompUSA and the other PC stores were no longer needed and they died of natural causes.

Meanwhile in Redmond, they were celebrating the safety of their position safe above the fray of the hardware guys and had their “leadership” focused on defending their cash flows against innovative disruption.  People start flocking to browsers – they gave one away – people start flocking to search engines – same – people start playing computer games on dedicated machines – they built one.  Follow and imitate to protect the rent money.

The foregoing history is an over-simplification – but it is accurate.   100′s of billions of dollars were being spent by America’s technology companies on R&D, product marketing and strategic planning all while embracing the absolute truth that PC’s were a commodity with no possibility of achieving competitive advantage by providing the customer with a better experience.  The world’s leading tech companies were focused on CEO’s/CIO’s or faster chips or more efficient factories or protecting monopolies or anything but the Persons using the machines.  They were all wrong.  As it turns out, in the mid 90′s the PC was just beginning its innovation phase.

The PC revolution had just begun and if you gave the customer a better experience, you could still create the most valuable company in the world.  Steve Jobs knew it.  Apple has always been about the user and the computer.  Make no mistake – the iPod is a computer – a PERSONAL computer with hardware and software totally optimized for listening to music.   The iPhone and iPad are PERSONAL computers as well.

Ironic that as it turns out, the Mac was the only PC because Steve knew “it was Personal.”

RIP

Don’t believe me? Well consider a few facts. While it is true that the high organic growth rates that fueled the IPO’s of the 90s have permanently disappeared – it is also true that we dramatically under estimated the lifetime value of a customer. If you were there in the 90s, then you remember telling software CEOs that public investors would place ZERO value on their maintenance streams. Growth investors wanted growth and it was all about elephant hunting for the next big license sale.

Measuring companies strictly by their new license sales was OK – there were plenty of customers ready to throw money at more software – as Tom Seibel proved. Of course all good things must come to an end – and so it was that the seemingly endless corporate appetite for purchasing software came to an abrupt end on about December 2000.

Now like any herd, the enterprise software industry was hard to divert (as were the sellside and buyside research analyst).  They had enjoyed had too much success building new products, hiring expensive sales people, and hunting big bucks – that long after the customer had said “no mas” – 100s of software companies (many VC funded) continued to burn money with this business model.

But there are always the practical visionaries who can recognize a paradigm shift. Those who could see that no matter how many salesmen were hired – that the customer has enough software already. These visionaries understood that it was time to stop wasting shareholder money on chasing revenue that wasn’t there.

These same visionaries recognized that all was not lost because there was great value in an existing customer who relies on your software to run his business, who never wants to buy new software again and is willing to mail you a big check every year. This is particularly good news when the customer is OK with you making over 25% EBITDA margins on maintenance.

Here’s to switching costs!

Quietly over the last six years, leading private investors such as Francisco Partners, Golden Gate, Silver Lake, Hellman and others have put together portfolios of these 90’s darlings. Companies like Attachmate, Infor, Kronos and SunGuard. There are literally dozens of these companies that have been reconfigured to capture modest new customer growth while vigorously defending existing customers with an improved focus on service and product enhancement. The typical financial profile would be over $100M in revenue over 80% of which coming from exiting customers – over 60% is contracted – delivering 25% EBITDA margins. Growth is only between 5-10%, but very predictable.

“So what?” you say, how can these slow growing boring companies be attractive public investments? General Atlantic tried it three years ago with SSA 3.0 and investors weren’t too enthusiastic. Old patterns die hard – often for good reason. But lots of things died in the meltdown. As I look around I see “low risk” investments like T-Bills exposed to negative yields with even modest inflation, I see high potential but risky companies that seem….well RISKY, I see real estate and I run, and I see established “safe” companies priced high because safety is in short supply and high demand.

Sounds like a good opportunity to sell 10% rock solid growth, steady 25% EBITDA margins and very clean balance sheets.

P.S., check the LBO bankruptcy list for any software companies. Despite deals that went down well above 15x EBITDA – you won’t find any.

Coming first quarter 2010 to a broker near you…….Return of the Enterprise Software IPO in 3D!

I completely agree that our IPO market needs fixing. But the venture community needs to get out of its Aeron chair and pitch in before calling the “Obama Phone.”

Benchmark, Integral and Impact threw another shovel of dirt on the IPO market with OpenTable, when they paid 70% of the deal fees to Merrill Lynch – a firm that is too big to care about small cap IPO’s. Does anyone with half a brain think that the OpenTable deal fees will have any effect on Merrill’s allocation of resources?  Big banks like Merrill, Goldman, JP Morgan, Morgan Stanley can not afford to focus on the small-cap IPO market. You don’t need a calculator to do this math!

Investment banks should use IPO deal fees to cover the long term costs of research analysts, market makers, institutional sales, non-deal roadshows, investor conferences. All of these services are required to have a sustainable IPO market.

Benchmark Capital, Integral Capital Partners and Impact Venture Partners followed the VC herd that has prioritized brand over service since the Internet bubble. “Why pay IPO fees to a small growth focused firm like Thomas Weisel when I can get a cool helicopter ride to Merrill’s palatial headquarters?” The venture herd has turned its back on the firms that have committed 100% of their talent and capital to the real IPO market – firms like TWP, JMP, Cowen, Needham, and Piper Jaffrey. That is what has killed the IPO market.

When the IPO market worked, prospectus covers were dominated by firms that were totally dedicated to small cap offerings. Firms that provided all the required services because that was their #1 line-of-business. It was common to see three underwriters splitting fees 40%-30%-30% because each firm was going to dedicate the needed resources to support the new public company for years!

Ok, ok – I get why VC’s turned to the bulge bracket in the bubble. The four horsemen got sloppy and VCs needed bulge bracket financial advisors to manage the personal fortunes they were pulling out of IPOs. Plus – during the bubble – IPOs were kinda automatic thanks to Daytraders et al. But that was a moment in time that ended in 2000. The real IPO economics were back by 2001 and, while it will come as a shock to the venture community, you can’t maintain a full-service, growth-focused investment bank without revenues.

Seventy percent of the deal fees to Merrill – Really???? Another 10% to Allen & Company for no research or trading – Really????? You want to call Obama to fix the IPO market – REALLY???????

Issue 1 is paying for liquidity. You can’t rebuild the IPO market without reliable liquidity. Reliable liquidity was provided in the 80’s and 90’s by growth focused investment banking boutiques and they were compensated through trading revenues based on spreads. Unfortunately, no one understands how to put a price on liquidity in growth focused equity markets – not the NVCA, not the SEC, not Fidelity, not the collective finance faculty of Wharton, Chicago and Harvard. During the internet bubble, the supply of public liquidity appeared infinite and the price inevitably moved to zero as spreads collapsed. Not only did spreads collapse, but it became criminal for the Putnam’s of the world to pay $0.25 per share to trade with a full-service rain-or-shine I-bank when they could pay $0.05 per share to a no-service fair-weather ECN. Without significant trading revenues, the 4 Horseman packed up their research analysts and market makers and rode off into the sunset. I believe the sentiment at the time was “good riddance.” For a while, it seemed that there was enough liquidity to get by from day traders, ecn’s, and dark pools. But when the economic environment turned choppy, we saw the impact of losing substantial institutions whose business model was dedicated to smooth functioning markets. Institutions who had been trusted to the bridge the gaps in liquidity that can cause a run a stock (bank).

For a functioning IPO market that supports growth companies with all their natural volatility we need trusted institutions that provide liquidity both directly (market making) and indirectly (trusted research). No one can arithmetically answer the question “what is the right NASDAQ spread to compensate a full service I-Bank for nurturing young volatile public companies?” But the dialog around a healthy IPO market has to start with a recognition of the need for liquidity providers and a willingness to foot the bill. Who needs to be in the room to address this fundamental issue – the SEC, NASD, NASDAQ, NYSE, Bill Donaldson, Sandy Robertson, Ken Pasternak and Tom Weisel would be a good start.

Issue 2 is rebuilding the trust that attracts investors. – You can’t rebuild the IPO market for young rapidly changing growth companies without more trust in the system and the IPO product. Sustainability requires trust and trust requires quality standards. We “blew it” in the internet bubble – just as a new universe of individual investors was entering and expanding the IPO market, diligence and research standards fell apart. This is an old story, but an important one to embrace.

Rebuilding the IPO market to help VC’s exit an oversupply of weak companies is a recipe for failure – again. As a former Robertson Stephens partner, it is ironically pleasant to hear VC’s extol the virtues of I-banking boutiques and healthy collaboration between research and banking. The fact that the growth focused banks got fat and sloppy during the internet bubble is well documented – the 4 Horseman went from being the best source for new investment ideas to the target of litigation. Of course, growth focused banks were not the only ones who got fat and sloppy during the internet bubble. VC’s enjoyed the same tailwind and used it to grow their capital under management over 1000%. But, the VC business has one characteristic that dramatically separates it from I-banking – they have “10 year” funds that guarantee their revenues. The 4 Horsemen got fat and sloppy in the bubble – and were history by 2002. In contrast, the VC industry has been able to invest like it was 1999 for 10 years – which brings us to 2009. Pushing open the IPO market is not the solution for a surplus of mediocre VC backed tech and biotech companies.

We should applaud the NVCA for taking initiative and all Americans should fully support policies that rebuild the IPO machine. But, any policy discussion must embrace the need for high quality standards and recognize the potential negative implications of the current overhang Venture backed companies two blind spots.

I was fortunate to do my vocational training in New Haven with some great luminaries in the field of valuation – Steve Ross, Roger Ibbotson, Bob Shiller among the more famous.  I came away with a wonderful set of sophisticated tools and two fairly simple rules.  Rule #1 – the best measure of “today’s” value is the price that a “willing buyer” pays to a “willing seller.”  (please note that “willing” is not synonymous with smart but is frequently synonymous with amorous)  Rule #2 – the only scientific measure of any assets value is the discounted value of the cash flows that asset can produce in the future.  It doesn’t matter if the asset is a T-bill, a tech company or a first growth Bordeaux – each asset can be reduced to a black box that generates cash flow in the future.  In a world populated by unemotional math majors with a common view of the future, Rule #1 and Rule #2 should produce similar results.

In the world we actually live in people make decisions from their heart, or their gut or often from one of two regions slightly below their gut.  In our emotional world there are times when Rule #2 becomes irrelevant – eventually these periods are called bubbles and crashes.  I remember a time in early 2000 when public technology consulting companies were trading a value that equated to over $2 million dollars per employee.  Anyone with a calculator would know that even if each employee worked productively for 1000 years they could never produce the cash flow to justify the valuation.

Of course many fortunes are made by both the brilliant and the dumb playing on Rule #1.  If willing buyers are paying over $2 million per employee for a tech consulting firm, then it can be smart to buy one for $1.5 million per – AS LONG AS YOU GET AN EXIT BEFORE RULE #2 COMES BACK INTO PLAY.  We all know entrepreneurs who sold at the right time and those who didn’t. We also know hedge fund managers who seem smart enough to know when Rule #2 is suspended and then recognize the signs that Rule #2 is coming back into play and exit the market with their bubble gains intact.  Some hedgies are even smart enough to short the market at these times.  (If you run a hedge fund – it seems pretty key to understand the current valuation fashion  – or to have access to CNBC so you can create a bubble or a run on the bank.)

But if you run and/or own a company – then you run a serious risk if you try to play the market and ignore Rule #2 when making tactical or strategic decisions.  Maximizing value for shareholders is about maximizing the long term positive cash flows coming out of your business – period.  If an acquirer comes along who is driven by fashion (or synergy) and is inclined to pay you a lot more than your expected cash flows, then the only economic answer is to sell (are you listening Mr. Yang?).

So what is your business worth today?  Unless your company is a T-bill, then there is a distinct shortage of “willing buyers.”  During crashes, like bubbles, Rule #1 tends to separate from Rule #2.  During a crash, few people are buying and those that do tend to pay less than the expected value of future cash flows.  Just last week we saw the BOD of UK based Macro4 endorse a bid at a little better than 3x annual cash flow. Here in Massachusetts we see Soapstone trading at a 60% discount to cash.  Hence the advice from Eric Upin at Sequoia to hoard enough cash to survive until we see the mood swing back towards Rule #2  – if not all the way to another bubble.

Theoretically – Rule #2 says your business is worth more or less what is was worth last year.  Of course we have to adjust for recent growth and any decline that the recession might bring.  In practice, if you must sell now then all valuation is relative and the comparable companies – be it Merck, Google, or JPMorgan – have been crushed since last year.  If you need to sell now, then you need to find a “willing buyer” (2 or more would help) and we are afraid to state the obvious – but your value has declined dramatically since last year.

Yet another lesson for entrepreneurs that you can not control the heart, gut, or other body parts of investors.  But you can do your best to control future cash flows and with adequate capital Rule #2 will set the floor on your exit value.

To provide some foundation for this assertion, allow me to put forward my qualifications. As mentioned above, I am and engineer, a bona fide techie who started his career building stuff like fusion reactors. I’m also an MBA and former senior partner at Robertson Stephens – the leading global technology and Internet investment bank in its day. I was a 100% enthusiast as we brought public such firms as E*trade, TeleBank, Insweb, Knight Trading, MeVC, Multex, Omega Research and PayPal – all financial services firms that used the internet to change the industry. The final highlight on my abbreviated qualifications is that I am married to a PhD who has published several books on financial markets.

So, how can it be a bad thing to have computers to run advanced financial valuation models? How can it be a bad thing to have stock trades be executed immediately on the net and only cost $5 instead of $100? How can it be a bad thing for mutual funds and individuals to be able to trade directly and anonymously for pennies on the net? How can it be a bad thing to have all public company information available for free to everyone? Of course the answer to any one of these question taken independently is: “All of these innovations were beneficial adding efficiency and leveling the playing field.”

It is when we examine the combined impact of all of this innovation on our financial markets over the last decade that we see the result was massive collective stupidity. (For those of you who would like to suggest that greed is the culprit – I will assert that that function has been constant since the beginning of time and is irrelevant in explaining the source of this crisis)

Here’s how it went down. Step 1: Introduce the computer for financial modeling. This OK at first as the models can be understood by experienced financial professionals and add real efficiency. BUT – over time the models grow in complexity as do the financial securities so the math PhD’s running the model are the only one’s who really have a clue and the experienced bankers who have judgment and broad training (Dick Fuld?) are relegated to either being silent or pretending they understand. Sounds a little like “The Terminator” – but you know it happened. The greed at Lehman was a constant – but the stupidity went off the charts.

Now let’s add the Internet. Step 2: “Free” retail stock trading via the net. The good news was added efficiency and a leveling of the playing field. This also welcomed every one of P.T. Barnum’s widows and orphans into the market regardless of training or qualifications. What a surprise that we had a bubble in 1999 – good year for casinos too. One side effect of “free” trading is that Investment Banks could no longer afford to pay brokers or analysts top dollar to provide expertise and advice – but who cared because these guys were just greedy overpaid middlemen and besides all the information an investor needed was available for free.  So out goes experienced professionals who had reputations to rely on and in comes 100% access for all to company info and analysis via EDGAR, Yahoo, Raging Bull. Great –we could all get GAAP statements on companies like Enron, Bear Stearns, Tyco, Lehman – so who needs advice.

Of course it wasn’t just the little guy who changed trading behavior – some hedge funds and mutual funds figured out that they could trade directly and cut out the middleman too. Those that didn’t figure it out were told by regulators to cut out the middleman because having a long term relationship with a broker that includes dinners and even fancy wine was clearly criminal when you could trade thru a blackbox for pennies.

My argument is simply that we embraced the sophistication, efficiency and anonymity of computers and the Internet and disposed of the judgment, experience, training and long term relationships. We did this in true American fashion without debate or consideration on the impact on markets which had been built on social contracts and trust.

As we see treasuries sold with negative yields – I hope no one would debate that we have a total collapse of trust in our financial markets. I would never argue that the solution is to abandon innovation.  However, the hands that help rebuild our capital markets will need a better understanding of the role of technology and the role of relationships in capital markets if we are to cure our historic stupidity.

The traditional Wall Street model was providing advice to companies, providing ideas to investors and liquidity to both. This was done via Sales, Trading, Research and Investment Banking. These services were lucrative for Wall Street firms, but they were also critical to the formation of growth capital in the economy. Some would argue that this was our country’s greatest competitive advantage!

This traditional business model was severely wounded by the Internet, which created both a huge speculative bubble and the impression that the best transactions were free and anonymous. When the dotcom bubble burst, investors were reasonably pissed at the Wall Street firms and convinced that transactions should be free.

So it’s the autumn of 2001, you are CEO of a traditional Wall Street firm and here’s the situation: Investors are still pissed, don’t want to read your research and don’t want to pay you more than $1 per trade. The government wants you to go directly to jail for buying your client an obnoxiously expensive bottle of wine. Companies know you can’t raise capital for them so they go see Bob Greenhill for advice.

In other words – the traditional business won’t pay the rent. So what can you do when no one else will take your investment advice? Either you can just go away like Roberston Stephens, H&Q, Alex. Brown, etc. — or maybe you can become a hedge fund!

Check out the post-bubble P&L’s of the ”traditional” Wall Street firms and you’ll see that they have moving away from their “traditional” businesses and turned themselves into highly leveraged hedge funds over the last 8 years. And why not? It worked for Long Term Capital.

So much information – so little understanding…