Why “Flight To Quality” Is The New IPO: An Interview With David Blumberg

By Murray Newlands for Forbes

Veteran investor David Blumberg, Founder and Managing Partner of Blumberg Capital, has seen over 25 years of exits and acquisitions. Blumberg’s early-stage venture capital firm just had a win in the IPO of Nutanix, a cloud-based data center technology company that combines computing, storage and networking. Nutanix enables companies — Best Buy, eBay, Honda and Toyota among them — to utilize “private clouds,” keeping chosen data in-house and sourcing other pieces to the cloud.

Blumberg was kind enough to speak to me about the trends surrounding IPOs and acquisitions, and what he’s seen change in the years that he has had his finger on the investing pulse.

You recently had a successful exit with Nutanix reaching IPO. Congratulations are in order. But what happens to the other 90%?

Thank you. Well, what happens to the 90% has changed over time. A little bit of history first. In the old days when I was just getting into the industry, it was much easier, faster and cheaper to go  public. It was not such an awesome endeavor, it was much lower cost, and people could go public at a much lower revenue level. When I was at T. Rowe Price in the ’80s as a buy-side analyst, many companies with modest revenues went public and they benefitted from good coverage by the securities analyst community. The public markets offered a low cost source of stable equity capital for growth. All that changed after a number of regulatory and structural changes, including Sarbanes-Oxley, raised the costs of an IPO and decimated the Wall Street analyst community.   The exchange of securities research for trading commissions, known as “soft dollars” became more difficult.  Sarbanes Oxley regulations dramatically increased the burden and cost of accounting,  legal reviews, all of that. Then came the tort lawsuits against public companies after share prices fell from their opening.  Whether or not there was misdoing, they still were sued, and a lot of the managers and directors became fearful of such potential civil and criminal liabilities.

There was a whole group of people — Mark Zuckerberg and some other great successes are in that category — started to say, “Wait a minute. What’s the benefit of going public so early? If we can raise money in the private markets, let’s just keep growing and growing and defer that decision.”  In the 1960’s through ‘80s by comparison, companies went public earlier which benefitted public shareholders and the mutual funds throughout the growth cycles and those stakeholders enjoyed a huge, long upturn. It was called “Growth Stock Investing.”  At T. Rowe Price, we were particularly known for it. We had bought and held Xerox for years in its heyday, and IBM in its glory days. Now that’s flipped, and the benefits are being enjoyed by the entrepreneurs, early employees of the fast growing companies, and the VCs because we’re holding onto the equity during this incredible growth spurt and then selling it into the public market.

Now, Nutanix happily seems to be enjoying the best of both worlds. They seem to be on a tear, and although I can’t predict the future, I feel like they’re in the right vein of history, riding a trend.

What do you mean by those glory days of going public flipped?

When I said it flipped, I meant that in recent years, more than 90% of companies with positive exits are acquired, and only a very small percent go public.  Since most VC backed companies are acquired, the question becomes: do they get acquired for a great multiple and provide great returns for investors? Or are they acquired merely for return of capital? That may sound okay if you’re just an average retail investor, but for a VC that’s disastrous. Venture Capital is a very expensive asset class. It is expensive because it’s very hands-on and time-consuming, so it doesn’t scale very well. We cannot take $200 billion like Vanguard and put it in ETFs using automated trading and have everything be efficient. Our asset class requires people meeting people, going to conferences, serving on Boards of Directors, taking a lot of equity risk, and building a portfolio over time. That’s expensive.

Again, a tiny minority of companies go public, and a much larger majority are acquired. There are a few new dynamics in the market. One is secondary share selling. This can be good for the entrepreneur, employees, and for the early stage investor, angel or VC.

The reason this midpoint liquidity via secondary share selling is important is because IPOs have shifted later, causing cash flow delays for founders, early employees and early investors.  Some LPs want some midpoint returns — we’ve got to show once in awhile we can return cash — and then there’s also market risk and volatility, so you never know if the market is going to let you get liquidity even if the company is doing well. Also, entrepreneurs in Silicon Valley want to afford a home, and it costs a lot of money, so if they’re only making an average Silicon Valley salary, they don’t have the wherewithal for a down payment and need to do some secondary selling. That’s a new phenomenon that historically hasn’t had a precedent.

Then, there’s a third new aspect with regard to exits, and that’s called acqui-hires. Acqui-hires typically occur when an engineering team is acquired even though the company may not have been successful. It may still make financial sense to the acquirer because it’s hard to find engineers. If you build a 20 or 50-person engineering team you can often sell that and get your money back, sometimes for a premium.

Then there’s a fourth new dynamic: the new phenomenon of technology sales. We enjoyed one of those with a company called Cyvera two years ago. Cyvera is an innovative, end-point cybersecurity company that had just begun its sales when they were bought for $200 million by Palo Alto Networks. Now what does that say? Obviously, they weren’t being bought for their then current revenue. They were being acquired for their technology and potential future revenue. I think Palo Alto Networks made a bet, and Founder and CTO Nir Zuk confirmed it to me two days ago at a conference, that his sales force could take the Cyvera technology under his brand name and sell the hell out of it. It was something that our start-up couldn’t have done so quickly at scale. We would have had to grow a whole new sales infrastructure, expand marketing, build the brand, and then build revenue. So, that’s another reason why companies can be acquired for relatively high valuation multiples – it’s the technology acceleration factor.

Now let’s look at the problems. What about the companies that just don’t work out? Obviously, that’s life and life happens. An interesting statistic from the U.S. Chamber of Commerce is that historically over the last 20 to 30 years about 400,000 companies were created every year and 300,000 died. That’s the risky nature of business, and especially small business. Whether you open a restaurant, or a hair salon, or a high tech start-up, the odds are, frankly, it’s going to fail. Venture-capital-backed companies less so, because we tend to serve as a quality filter; we invest more capital than a typical entrepreneur. Let’s then look at what happened after 2009. I would argue that chiefly due to burdensome regulation and high taxation the ratio has flipped. We have more companies dying in America than being born, which is a shocker. Doesn’t that surprise you?  We need to fix this and encourage entrepreneurship.

Absolutely. But are you also talking about venture-backed companies? Do those fail as often?

No, I’m not really focusing on those.  The statistics I cited include all the startup companies in America. Hair salons, restaurants, taco stands, whatever. Sadly, since 2009, more small businesses are dying than are being born. Now, I heard that it flipped positive last year, but for too long, it’s been a negative trend. That’s bad. It’s particularly bad for women, which is interesting, because women are more likely to become entrepreneurs now than men. And I think that’s partly because the flexibility of entrepreneurial work offers a great benefit compared to the standard, “Commute  downtown, work in a big office building, commute all the way home, and don’t have a life.”

Again, there’s been a dramatic cultural change. It is especially apparent in cultures where shame is enormously important, like in Eastern Asian cultures, Japan, Korea, Taiwan, then in Germany, Scandinavia and other countries in Europe. Historically, if you lost or failed at anything, it was such a black mark, you couldn’t recover.  You were marked as a loser. In sharp contrast, here in Silicon Valley we have the attitude “Hey, you can fail once, but just get up again, learn from it, and move forward.” And that bravado is starting to move and spread across the globe.

Some of the cultural change is being spurred by technological change. The product cycle has shortened to a matter of months from years – increasing the need for innovation and decreasing the cost. Also, new platforms such as cloud infrastructure, social media and smartphones have reduced cost structure and the sales friction for entrepreneurs to sell, and enabled them to reach whole new markets. The tide is coming in for early stage entrepreneurs. It is cheaper than ever to start a company, and faster to scale.

Look at Nutanix. They did a lot of this by choosing to go to market with channel partners, which is a way that you can go from one to many customers instantly. The old days were dominated by enterprise sale models, and those sales guys had to go through the CIO, plus you were competing against Cisco, HP, IBM, Oracle and the other big guys. It was so difficult because you were a tiny little start-up saying, “Oh we have a better ratchet or a wrench.” And they would say, “I don’t care, you might not be around next month.” Now it has been flipped around. Nutanix and many other startups are bringing this radical innovation that’s absolutely necessary and easier to sell, especially using the SaaS model. Try before you buy, scale as needed, and why buy, when you can rent?

Getting back to your question: what about the losers? I think that they have a new trampoline to bounce them back, because if they fail with their company, there’s not a lot of unemployment in Silicon Valley. You’re not too worried about being on the dole for a long time. Folks are generally hired quickly if they’re worth their salt as an engineer or product manager. Plus, we are seeing acqui-hires that effectively hire the whole company. Finally, there’s not much shame in failing. The worst thing you can do when you fail is to have done something really unethical: you really screwed your employees, or you really screwed your customers. That reputation is hard to restore.  For the average case, “Hey we tried and it didn’t work,” is not seen as so bad, particularly for the engineers. Engineers generally build what they’re told and it generally works. There aren’t too many companies that have failed due to product failure. It’s pretty rare.

What happens to the companies that raise their round, get a product, and get to break even, but they don’t raise a later round? I’ve had a lot of VCs tell me it’s harder and harder to raise later rounds.

I disagree. Here’s what I think happened. In 2014, almost every company could raise money most of the time. Towards the end of 2015, the public market companies started saying, “We’re having earning reversals. We thought we were going to have this much profit, now we’re going to have lower profits or we’re going to have a loss.” That sent shock waves through the public markets that had started to move into private investing. Companies like Fidelity, Wellington, and T. Rowe Price had started to buy into companies like Nutanix and HootSuite, for example, along with many others. They were paying relatively high multiples, thinking that this is like pre-public equity, ready to IPO within 6-18 months.

Then when the public stocks fell, even though some of these private companies like Nutanix were still doing well, the multiples started tanking. It moved from “anybody can raise” to “nobody can raise.” By now, I would say, good companies can still raise, and this is especially true at the later stage. Look at the bigger, stronger companies; they’re still able to raise on good terms. The stronger companies are raising big amounts of capital at good evaluations, and they’re socking away a ton of cash.

I think that is valid across the industry. It’s what I would call a flight to quality. Now, I know you’re going to say, “What about the ones who don’t have the quality?” And I would say, “Well, quality today certainly means traction. If you don’t have traction, it’s really hard to just sell a story.” That’s the problem; you can’t just keep selling a story. You can’t be the little boy who cries wolf. You’ve got to deliver the goods. That’s when companies will fail: when they run out of money before they can deliver anything, yet they keep selling the same story.

Okay, what happens to the companies that are generating revenue and are sustainable but aren’t going to make it to that dot showing growth? As an investor how do you cope with those? There’s got to be a fair amount of those.

Yes, there is — uncharitably called “the living dead.” Some of them are doing okay, but they’re not on the growth path that obviously could go IPO, and they’re not necessarily attractive to buy. They get acquired, but generally for a weaker multiple, and that’s where VCs get in trouble. If we’ve put too much money in, or keep following on and doing bridges and small rounds, eventually the return on our capital will not be great.

That later stage is where some companies and growth stage VCs can take on risk – if the growth doesn’t show up.  They’re expecting a relatively short time frame to exit.  In contrast, as early stage investors, we can take a longer perspective and we generally pay low prices for the risk we’re taking. But if you come in at a $100 million valuation and you’re looking for a 3X or 5X and then a few years down the road, the company is only growing at five or 10 percent a year, you’re probably not going to make that required return without a highly structured preferred share class.

What percentage from A stage companies become “the living dead?” I’ve seen quite a few companies that raise $20 million on a $50 million valuation and were heading up, and now they seem to be laying off a few people, and struggling for that B round or C round. There seems to be a lot of companies in an interesting space right now.   

Let’s take Twitter, for example. Twitter is facing deceleration of growth. I was just watching CNBC,  waiting for Deeraj Pandey, CEO of Nutanix to be interviewed, and there were a couple of analysts saying Twitter is a company that’s going to have to sell itself from a weak hand now. This is amazing because it’s a unique asset, and somebody should want it and make it good, but the business model may not be fully baked. They’re certainly not going to sell at the highs they enjoyed when they were just selling the story. Now investors are looking more for the delivery. There’s definitely space for growth because growth implies a bright rosy future.  Now if growth goes away, for most tech companies, that scenario would really drop the multiple dramatically. That’s a very big difference between what venture capitalists look for and what buy out investors look for.  We look for growth; they look for predictability.

First appeared at Forbes