Venture capital is a great investment category if there is a good way for capital providers to get their money out of startups at a profit. And VC did the best in the 1990s when the IPO market was booming.

These days, the IPO market is in the doldrums and that means many VCs hope for a profit hinges on their ability to find a deep-pocketed acquirer willing to pay more for the company than its valuation when it raised its most recent round of private capital.

Indeed in 2016, M&A activity in technology was far more significant than IPO exits. "In 2016, of the 513 VC-backed tech exits in the United States, 499 were M&A events. These M&A exits represent $56.7 billion, versus the mere $9.6 billion exit value from the year's 14 tech IPOs," according to TechCrunch.

Sadly M&As are often priced at a discount -- for example, Hyperconvergence infrastructure supplier, SimpliVity, was bought by HP Enterprise earlier this year for $650 million in cash -- a $350 million discount from its value in 2015 when it last raised private capital.

While 2016 was a bad year for IPOs, 2017 is looking pretty discouraging as well. According to Techcrunch, "2016 suffered a 65% decline in the number of U.S. IPOs from a recent high of 363 in 2014; a 37% decline in the number of U.S.-listed companies as companies disappeared, were taken private or simply decided to operate privately longer."

The first half of 2017 looks a bit worse. Fenwick & West reported that there were "12 tech and 15 life sciences offerings, or 27 offerings altogether. That's very close to the 31 IPOs that were executed in the second half of last year (14 in tech, another 17 for life sciences companies)," noted TechCrunch.

There are two big changes that are keeping the IPO market in the doldrums. First, a few of the biggest startups -- like Uber -- are still growing -- though unprofitable -- and they have attracted huge amount of capital without going public. Thanks to secondary markets, early employees can sell their shares and thus gain the diversification and liquidity that they would have gotten through an IPO.

Secondly, institutional investors are in big trouble. For decades, academic research indicated that the average investor would be better off buying low-expense, low-fee index funds rather than investing in individual stocks. But it has only been in the last few years that people have started to shun active management in favor of such index funds.

The fund flow data are compelling on this front. "Flows out of actively managed U.S. equity mutual funds leaped to $264.5 billion in 2016, while flows into passive index funds and ETFs were $236.1 billion, according to data provided by the Vanguard Group and Morningstar," according to CNBC.

This shift means that the active managers have less money to invest and if they want to generate market-beating returns, they have to try to pick only stocks that are likely to go up more than the averages. Such active managers are investing in so-called FANG stocks -- fast-growing companies such as Facebook, Amazon, Netflix, and Google which I analyzed in my recently-published book, Disciplined Growth Strategies.

Active managers are probably reluctant to invest in heavily hyped -- but poorly performing IPOs such as that of Snap which has plunged 51% since its first day of trading on May 15. Though Snap's shares shot from $17 to $27 a share after it started trading in March 2017, on August 1, they were valued at just $13.25 apiece. This terrible performance makes it harder for other companies to go public -- especially ones that like Snap are growing quickly but lack a path to profitability.

What makes things worse for Snap is that its cofounders have complete voting control which makes the company unfriendly to public shareholders -- a move which has caused index-fund operators to ban it from being included in stock indexes. This limits the amount of capital that will flow into the stock.

Boston early-stage venture capitalist Jeff Fagnan of Accomplice told me in a July 31 interview that the IPO market's problem must be solved -- though he did not offer ideas on how. As he said, "Will the IPO market become more vibrant? The data on that are murky. The companies being brought to market must be growing quickly and have profitable unit economics [meaning they are priced above their variable costs]. The institutional investors are out there and the IPO market's problem needs to be solved. Otherwise, we will be left with oligopolies."

VCs are thirsty for big returns on their investment but the IPO market is drying up with little hope for revival. To do that, company founders should deliver -- as Facebook does with its 42% revenue growth and 45% net profit margin -- fast growth with profitability.

Published on: Aug 1, 2017