How Wall Street's mess will hurt high tech

Troubles at two major Wall Street securities firms Monday will have ripple effects that could stifle mergers and acquisitions in the technology industry and further dampen the market for initial public offerings.

Or so say financial pundits who are examining the potential fallout of Lehman Brothers' bankruptcy and the $50 billion sale of Merrill Lynch to Bank of America in order to avoid its own financial crisis. Venture capital and finance experts compared the news to the late 1990s when the Big Eight accounting firms shrunk to the Big Four. Consolidation and financial uncertainty at the nation's largest securities firms will close some doors to tech companies aiming to go public, slow the process for M&A deals, and generally add more worry lines to tech investing.

"There's just a lot more uncertainty around getting mergers and acquisitions done that are really the life blood of tech financing," said Colin Blaydon, director of the Tuck Private Equity and Entrepreneurship Center at Dartmouth University.

The changes on Wall Street caused the worst investor sell-off in seven years. On Monday, the Dow Jones industrial average dropped by more than 500 points (a 4.4 percent drop), its biggest decline since the terrorist attacks of September 11. The Nasdaq composite index fell by more than 80 points for a 3.6 percent decline.

2008 has already been a tumultuous year in the securities market because of ongoing effects from the mortgage credit crisis. But specific to the tech industry, investors say the market is being squeezed by fewer opportunities for exits from public offerings and buyout deals. Large tech companies are also taking a more cautious approach to M&A, and that's causing valuations to fall. Now, with fewer healthy investment banks, which handle about three quarters of the country's venture-backed exits, it will be harder to ink a deal.

"An oligopoly is not the best thing for the American capital system. When you have so few investment firms out there, it makes it difficult to get a deal at the end of the day," said Mark Heesen, president of the trade group National Venture Capital Association.

Heeson said he's particularly concerned about the likelihood of fewer quality acquisitions. In the last eight years of acquisitions, he said, there have been about 350 acquisitions every year. (Right after the tech bubble, those numbers held up mostly because of fire sales.) But now, those figures are dropping. In 2007, the NVCA reported 355 venture-backed mergers and acquisitions. In the first half of this year, however, it has counted 120.

"Cisco, Intel, let's say they bought 15 companies last year. This year, they may only buy eight. That's impacted by the stock market because they have less money to invest," Heeson said. "When a VC invests in a tech the ultimate goal is for that company to go public or get acquired. What happened today in a very unsettled market is it will now be even harder to go public than it has been. That will affect small tech companies for at least the next six months."

Early stage venture deals shouldn't be altered by Monday's events, however. There are still a lot of growth-industry investors with a large amount of capital, and they will find it appealing to invest in smaller companies because valuations will be lower.

Early stage investing also doesn't typically require investment banking or M&A support. But for later-stage financing or mid-cap buyouts, when deals get more complicated, that's when tech M&A bankers show up. With deals that require multiple bankers, all parties involved will likely exercise more caution.

"M&A transactions take a period of time to get done, and if anyone at all is concerned about the financial strength of any of the parties, those transactions will be harder to get done," Blaydon said. In the last three weeks, Lehman Brothers was pushed out of several transactions it was selected to be a part of, for example.

Short term, venture experts don't expect much fallout to venture investing, which typically hits between $7 billion and $8 billion each quarter. Despite the IPO market, investment dollars have held steady. But analysts say that over time, as these companies can't go public or get acquired, early stage companies could suffer because venture firms must put extra dollars into late stage companies.

The U.S. is already in the midst of an IPO crisis, and Monday's events added to the problem. According to the NVCA, only six venture-backed companies have gone public so far this year; and for the first time in 30 years, no VC-funded company went public in the second quarter. In a good year, about 100 venture funded companies go public.

"What would have happened if Dell or Google or Amazon or eBay didn't go public? Think of all the jobs that would have been lost. From an economic standpoint, we'd like to see many more IPOs and fewer acquisitions," said Emily Mendell, vice president of strategic affairs at the NVCA.

As a result, the NVCA wants to encourage the growth of small boutique firms like Jeffries or Piper to help save the tech IPO. The trade group is meeting this fall with industry leaders to discuss options.

Geoff Yang, a partner at venture firm Redpoint Ventures, said problems at the investment banks will affect capital markets and investor confidence. He said he's already seen some buyers put buyout deals on hold because their company stock prices are down, causing some of the more capital-intensive deals to seize up.

"For a lot of these Internet businesses that don't take much capital, they're less affected," said Yang. "But for anything that is capital-hungry like the energy market, they're definitely going to feel the effect. For those companies to succeed, we need a vibrant capital market."