Innovation in Silicon Valley: Finance as Well as Technology

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“We don’t care what the entry level valuation is,” says a parter in venture capital firm DCM at the 9th Silicon Valley Innovation Summit. “We only care about the exit valuation.”

I always love the Silicon Valley Innovation Summit for the same reason many people don’t. It’s not the same Web 2.0 people I see all the time in the Valley. It’s an older, more experienced crowd of VCs who are a bit more focused on enterprise solutions and the cloud than social platforms — although they will invest there, too, they assure the audience. They have more of a long term perspective on their industry, too, and generally lower profiles.

All the VCs I have heard so far agree that valuations in some segments are getting frothy, but they aren’t sure that’s even relevant to them.Mobile, communications, health care, and e-commerce are really just beginning to develop for them as investment segments. So they are looking for experience and past track record, as well as openness in the CEO and founding team, and they don’t care if they are in a bubble. Besides, Brian Ascher from Venrock pointed out, “raising money may look and sound easy right now, but the bubblicious valuations are only given to experienced entrepreneurs looking for growth money, and not to hard-working seed stage companies that are still getting turned down and told ‘come back when you have traction.'”

Unfortunately, there’s no magic number that defines the value of traction. Most investors are looking for sustained engagement with little churn. Engagement can mean number of sessions per month, length of time on the site, or anything that proves you have a viable company.

The best speaker of the morning was Paul Deninger of investment banker Evercore, talking about IPOs. He began talking about this year’s IPOs, and educated me: there is no such thing as a successful IPO. If your stock price goes up after issue, if will probably go right down again. 55% of IPO companies “break issue” within the first year (which means trade below their offering price). Although newbie investors think that’s awful, fully 50% of largest market cap companies you know in tech today broke issue. That’s because young companies miss their numbers all the time during the first year of being public, and Wall Street punishes them. So a maniacal focus on the price at IPO is misplaced; the highest IPO prices mean the company is more likely to break issue.

He used LinkedIn as an example. LinkedIn sold only 8.3% of itself in the IPO, which created huge demand for scarce shares and drove the price up. But that didn’t set the company up for success later. You should sell 25-30% of the company, so you have a more realistic market price. You want a realistic price because you can’t hire without options that have the potential to go up.

Deninger, who is an incredible speaker, assured us that there’s no tech bubble, just a microbubble in a small segment of Web 2.0 companies.

Companies have been waiting longer to go public, and that has created both a pent up demand for IPO shares and the growth of secondary markets. There are now at least three ways for founders to achieve liquidity: sale or merger, IPO, or sell shares on the secondary market. If you can sell your own founder’s shares on the secondary market, why not wait until the last possible moment to go public?

To go public, you need a passionate CEO, an awesome management team, a great committed board, financial controls in place, and a good business model. Companies should not go out before they are ready with all those things in place.. And there’s no such thing as the right size to go public either, Deninger said. “Asking an investment banker what you should do for your company is like asking an Oracle salesman how much software you should buy.”

But if you are seven years old and still haven’t gone public, your team probably would like some liquidity. That’s why the secondary markets arose. Secondary markets allow companies to create customized managed liquidity solutions, through which companies can decide who can sell and when, using an automated solution that prevents companies from getting shareholders they don’t want, or selling too much of the company.

One signal of the quick prominence of secondary markets was the presence of two representatives of this liquidity vehicle on the panel this afternoon. However, that investment banker said 90% of liquidity in the tech market actually comes from mergers and acquisition, but we have only half as many buyers as formerly — because of the dearth of recent IPOS. This represents a real problem for venture-backed companies.