- Among startups that don't fail, most are acquired instead of going public.
- Although most startups that are acquired are still purchased by other independent companies, a growing number and proportion are being snatched up by private equity firms.
- In the past, private equity firms were largely considered bottom feeders, buying up companies on the cheap for their cash flow, but increasingly, they're buying companies with the intent to help them grow or to combine them with other startups to reach a larger scale - and they're more willing to pay up for them, industry experts say.
- The trend is being driven by a surge of cash into private equity firms and the growing number of companies that are avoiding the public markets, they say.
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It used to be that the goal of every startup founder was to take their company public.
That may still be the goal for most, but in the last several decades, a much more realistic option for startups that managed to stay afloat was to be acquired by another company in the same sector.
In recent years, though, a third option has emerged for startups - being purchased by a private equity fund or by a company owned by one. Those kinds of buyouts now far outnumber IPOs and account for one out of every five so-called exits for venture capital-backed companies in the US, according to data PitchBook compiled for Business Insider.
The growing influence of private equity on the startup market has "really reshaped the industry," said Wylie Fernyhough, a senior private equity analyst at PitchBook.
The kinds of startups being targeted by private-equity firms likely would have gone public 20 years ago, industry experts told Business Insider. But today, they're generally considered too small or don't have bright enough prospects to hit the public markets.
For such companies, private equity has become "an attractive exit opportunity," said Pete Flint, a managing partner at venture capital firm NFX.
The vast majority of startups that don't fail are acquired
Venture capitalists back startups with the intent of cashing out those investments at some point in the future, either by being able to sell their shares to public investors when or after the companies go public or by selling the startups to other companies.
While initial public offerings get lots of attention, they've become relatively rare. In part that's because many startups never make it to the exit stage at all, because they go out of business first. But also it's because the vast majority of startups that don't go out of business are acquired instead of going public.
Last year, for example, of the 934 startups that had some kind of exit event, 853 - about 91% - were acquired either by another company or as part of a private equity-related deal, according to PitchBook. That rate has been relatively steady over the last 18 years.
"The vast majority of exits that all of us are thinking about are things that are not the public markets," said Sean Foote, a member of the professional faculty at the Haas School of Business at the University of California, Berkeley. Acquisitions, he continued, are "the major way in which companies find their home."
While such deals have long been important, what's changed over the last 20 years is the growing influence of private equity. In that time period, private equity firms have gone from bit players in the startup ecosystem to major actors in it.
In 2003, just 17 startups were acquired by private equity firms or companies owned by them, according to PitchBook's data. That amounted to just 5% of total exits that year. By 2012, 88 startups were snatched up in private equity-related deals, accounting for 10% of all exits. Last year, 186 were acquired in private-equity deals, amounting to 20% of all exits.
Private equity firms are big players in the acquisition market
In 2004, IPOs outnumbered private-equity buyouts by a ratio of 3-to-1, according to PitchBook. But private equity acquisitions have outnumbered IPOs every year since 2008, and for the last three years, there have been more than twice as many of those kinds of deals as public offerings.
What's more, even as startup acquisitions of all kinds have skyrocketed - jumping from 279 in 2002 to 853 last year - private equity-related ones have accounted for a growing portion. They accounted for 22% of all startup acquisitions last year after making up less than 7% in 2002, according to PitchBook.
"I think it's a trend that's going to keep growing," said Lanham Napier, the cofounder of startup investment firm BuildGroup.
The amount of money startups are seeing from selling to private equity firms is still a small portion of the total value of all exits, varying from less than 1% to about 8% annually over the last 10 years. But it's grown significantly, going from just $690 million in 2012 to $6.3 billion last year. And some individual deals have become quite large.
In 2017, for example, private equity-backed PetSmart bought online pet supply retailer Chewy for $3.35 billion. And last year, PE firm Thomas Bravo acquired ConnectWise, a maker of mobile device management software, for $1.5 billion.
Generally, the private-equity firms are snatching up more mature startups. On average, the companies they're acquiring are around 10 years old, according to PitchBook's Fernyhough. By contrast, startups that went public were about 9 years old at the time of their IPO and those that were acquired by other companies were about 7 years old, he said.
But increasingly, private equity firms are backing more mature companies and using them to buy younger startups, creating larger companies or "platforms" that potentially offer better growth or market prospects, the industry experts said.
"You can sell early stage companies to PE-backed platforms," said Dan Malven, a managing director at 4490 Ventures. "I think we're going to see more and more of that."
Fewer companies are going public
Part of what's driven the surge of private-equity buyouts - and acquisitions overall - is that fewer and fewer venture-backed companies are going public. That's a trend that dates back to the 1990s and one that's linked to the growing dominance of small numbers of firms over large sectors of the tech industry, according to research by Jay Ritter, a professor of finance at the University of Florida who has been studying the public offering market since the 1980s.
But that trend has arguably been accelerated over the last 20 years by regulations that added to the costs and burdens of being a public company and, conversely, made it much easier for companies to remain private for far longer periods.
"The public market has evolved to a point where it's not that you couldn't have these companies go public, but there are significant regulatory costs that you can avoid if you stay private," said Robert Hendershott, an associate finance professor at Santa Clara University's Leavey School of Business. "Private equity is a natural way to give someone an exit."
The kinds of startups generally favored by the public markets these days are those that are growing quickly, operate in a large market, and are either profitable or have a clear path to profits, NFX's Flint said. Unfortunately, there are lots of good companies that don't meet all three of those criteria. But they can be a good fit for private equity firms, because such firms can invest in their long-term growth or combine them with other startups to give them the scale they need to be more attractive to public investors, he said.
"They are perfect opportunities for private equity rollup or acquisition," Flint said.
Private equity firms are swimming in cash
The surge in private equity buyouts has also been stoked by a huge gust of money into the industry, particularly in the last 10 years. In 2010, US-based private equity firms raised $59.2 billion, according to PitchBook. Last year, that amount had swelled to $301.3 billion.
While only a portion of those amounts are going to tech-focused funds, that portion has been growing. Tech-focused private equity funds based in North America and Europe raised just $3.7 billion in 2010, according to PitchBook. By last year, that amount was up to $68.3 billion. By contrast, the US venture capital industry raised $46.3 billion in new funds last year, according to PitchBook.Private equity funds have access to "a staggering amount of capital," said Mike Smerklo, a managing director at Next Coast Ventures.
But another reason why private-equity acquisitions have become increasingly popular for startups and their venture backers is because the deals can be more attractive than either going public or being acquired by another operating company, industry experts said.
It used to be that private equity firms acted kind of like bottom feeders in the startup market, paying relatively small amounts for firms that had few other options and focusing on the cash flow those companies could generate for them. But that's no longer the case. Private equity firms - particularly the tech-focused ones - are increasingly looking at companies that can offer revenue growth and they're often willing to pay top dollar for them, the experts said.
Startups used to see the biggest exits by going public or by being acquired by an operating company, said BuildGroup's Napier.
Now, though, "some of these private equity firms have gotten so good at [buying startups], some of their valuations are just as big as those other things," he said.
PE firms can move quickly and offer fewer restrictions
Private equity firms also tend to be far less bureaucratic than corporate merger-and-acquisition departments, they said. Such firms also can often throw far more resources to bear on analyzing potential deals than corporations can. And the deals they strike typically don't have to go through the kinds of shareholder votes or board approvals that corporate deals often require.
"They're able to move a lot more quickly," said PitchBook's Fernyhough.
What's more, venture investors and founders often confront more obstacles to accessing their promised returns when they sell to corporations or take their companies public than when they sell to private equity firms. Typically in an IPO, there's a lock-up period of up to six months during which early investors are barred from selling the company's stock. Meanwhile, in corporate acquisitions, there often are conditions put in place that allow founders or early investors to see the full value of the buyout only if the startup hits certain financial or performance targets after the acquisition.
"When I sell a company to a private equity firm, it's clean," said Foote, who in addition to his role at Berkeley is a managing director at venture capital firm Transform Capital. "There's often very few strings attached."
It's not unusual for acquirers, whether they are large, independent enterprises, other startups or private equity-backed conglomerates, to pay for their purchases with shares of their own stock. But the private equity-backed roll-ups often are perceived to have greater prospects for growth than big, established corporations, potentially making their shares more desirable.
"We try and analyze that growth potential," said 4490's Malven. They try to figure out if "we want to ride on their equity."
The fast pace can also cut against startup founders and VCs
To be sure, the growing influence of private equity does have some drawbacks for venture capitalists and startups. The fast pace of those firms and their large research teams can go against founders and their backers, Malven said. The private equity firms can have their teams analyzing multiple companies and potential deals at once, he said. If a startup doesn't act on an offer quickly, the firm can threaten to move on to doing a deal with a rival company, he said.
"They can put you in a squeeze," said Malven.
And the firms can have their shortcomings when it comes to evaluating startups, industry experts said. Because they're typically focused on analyzing the financial health of companies, they can be very good at evaluating companies that already have established a market for their products and have a revenue stream, they said. But they're not as good at sizing up companies based on the potential of their technology or their intellectual property or their unproven ideas, they said.
"They're much at better looking in the rear-view mirror than they are in through the windshield," Malven said.
Still, by and large the venture capitalists and other industry experts said the venture ecosystem has benefitted from private equity firms providing more exit options for startups.
Venture capitalists are often looking for home runs with their investments - companies that have the potential to deliver huge returns on their investments. That remains the primary focus of firms like his, said NFX's Flint. But not every startup is going to be a home-run investment, and having the ability to get a modest return on those kinds of companies is a good thing, he said.
"More options for more capital is great for the ecosystem," Flint said. "It's great for founders, it's great for early stage VCs, it's great for customers."
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