The other day, I had an interesting conversation with Colin Wallace as the result of an introduction by Steve Roberts at RockRidge Capital.  Colin and his partners at Publex Ventures are launching a new, $40 million fund that will make investments in early stage private companies and micro-cap public companies with the intention of facilitating value-creating mergers.  Colin calls the process "liquidity by design."  In true entrepreneurial fashion, the investment thesis emerged from the recognition of the pain of three groups: angels, orphans, and infants.

Pick Your Pain

An entrepreneur by background, Colin is now a professional angel.  That is, he's invested enough of his personal net worth that liquidity matters.  (Most of us have a tolerance for a certain amount of illiquidity, but that doesn't mean that we want 90% of our portfolio tied up in a 401(k), for example.)  When the IPO window closed, the expected liquidity cycle for angels was stretched out to  5 to 7 years or more.  It's the kind of change that can take the fun out of being an angel.

Meanwhile, the dot bomb, the decline in the stock market, and sputtering IPO market have created two groups of orphaned companies.  On the one hand are companies that got public on the premise that they would be able to access the capital markets on an ongoing basis, attract and retain analyst coverage and institutional investor support, and grow to a few hundred million in revenue and healthy profitability.  Things haven't worked out according to plan for a remarkable number of such companies.  Revenue has flat-lined below $50 million; analysts have lost interest; the institutions have stayed away in droves; and access to the capital markets is purely theoretical.  Colin estimates that some 6,500 companies in the U.S. fit the general category of orphaned micro-cap public company.

The second group of orphans are those VC-backed companies that didn't quite make it through the IPO window before it closed.  Many companies that received VC funding back in the day had cost structures that couldn't be ratcheted back fast enough to adapt to the new reality of scarce capital (may they rest in peace).  Some that did survive have fallen out of favor and have found it difficult to raise follow-on rounds from their existing investors.  They are in portfolio limbo - a constant, throbbing pain, I imagine.

The last group to feel the burn are companies in their infancy.  Angels have discovered that the duration of their existing portfolio is a few years longer than they had anticipated, so they aren't eager to write checks for new companies.  Notwithstanding the realities of a cool IPO market, institutional VCs must still respond to the liquidity demands of the 10-year limited partnership.  Consequently, VCs have shifted to later stage investments or to specific niches that feed the M&A appetitives of a narrow range of acquisitive public companies.  That means that roughly 99% of young, promising ventures find fund-raising to be a pretty challenging proposition.

The Market Responds

It's not like thousands of investors, bankers, lawyers, and consultants have failed to notice.  One response has been an uptick in the number of private investments in public equities, or PIPEs.  There is little new under the sun, and PIPEs are no exception.  What is new is the increase in the volume of deals and the market credibility of the players.  The old "reverse merger" of a viable private company into a "shell" public company is a familiar game with a shady history.  Per Colin, the new generation of PIPE players have done a lot to legitimize the micro-cap market.  However, the track record of mergers arranged by financial engineers is spotty.  (How many of us cringe when somebody says "roll-up?")

Publex Ventures believes it knows a better way.

As entrepreneurs, Colin and his partners have been through mergers and have lived to tell the tale.  Having identified more than a dozen micro-cap "platforms," Publex is seeking to identify investment opportunities in complementary private companies.  If the personalities fit and there is a shared value creation vision - and the valuation is right - Publex will make investments on both sides of a series of mergers.

If all works according to plan, everybody's pain goes away:

• Orphaned micro-cap companies get to grow, address strategic weaknesses, and improve their effective access to the capital markets.
• Private companies - orphans and infants - get access to investment capital and the public markets in one fell swoop.  Huzzah!
• Participating investors - including the angels who are expected to provide $10 million of the first Publex fund - see their time-to-liquidity (that is, the ability, but not obligation, to sell their shares) reduced to 9 to 18 months, per Colin's estimates.

Sounds great, but will it work?

As one of those recovering financial engineers who has scars from past experiences with PIPEs and roll-ups, you'll forgive me if I'm naturally skeptical.  On the other hand, the Publex vision is intriguing.  I was dumbfounded to hear Colin say there are 6,500 micro-cap and small-cap public companies in the U.S.  There have to be some good companies in that crowd - even if, as Colin acknowledges, they are bound to "have issues."  Second, I suspect that there are more reputable, experienced angels, VCs, and institutional investors hanging around the micro-cap playing field these days.  It's not unreasonable to suppose that the less-than-credible players have been pushed to the sidelines.  Last, but certainly not least, disciplined mergers based upon a clear-eyed assessment of operational and human realities offer a real chance of creating the sustainable value that is going to be required to help lift micro-caps into the realm of "real" public companies.

It's not an easy play, and there are lots of moving (human) parts.  On the other hand, VCs shouldn't get paid a 20% carried interest for easy money.  For what it's worth, I think the Publex strategy can work.  It sure beats the hell out of waiting for the IPO market to heat up.