[Dave Heal's] Observations & Reports

The IPO is dead! Long live the IPO!

Sarbanes-Oxley: The IPO Maven’s MacGuffin?

About a month ago the Wall Street Journal ran an editorial that blamed the dearth of IPOs on Sarbanes-Oxley, the 2002 law enacted in response to the accounting tomfoolery of Tyco, Enron, WorldCom, etc.

The elephant in the room is the 2002 Sarbanes-Oxley law, which triggered billions of dollars in new compliance costs for public companies. But the accountants who profit from Sarbox and the Treasury maintain that the law is merely one of many factors discouraging new public companies. This view is shared by most in Washington because Sarbox was a bipartisan overreaction to the accounting scandals at Enron and WorldCom and was signed by George W. Bush.

The implication here becomes clear in the rest of the piece: those blaming the Death of the IPO on everything besides Sarbanes-Oxley are making a cynical, politically expedient argument.

The coalition that wants to change the subject whenever Sarbox is mentioned fingers other problems, some of which are real. Limits on immigration dull our competitive edge. Hyper-litigation is always a costly drag on U.S. GDP. Eliot Spitzer’s settlement over stock research on Wall Street reduced the analyst coverage for small companies and thus made it harder to get their story out to investors. A decade ago, “decimalization” at the stock exchanges delivered small savings for investors on each transaction but reduced the profits for brokerages, especially when trading small-cap stocks.

Valid points all, but when a young company rockets past $100 million in revenues and decides to remain private—a common occurrence lately—it’s not because the founders are waiting for a change in immigration policy. When Facebook, already one of the most famous brand names in America, decides to hold off on an IPO, it’s not because its executives fear a lack of analyst coverage.

Before we dive into the arguments, let’s understand a few of the reasons why companies have historically gone public. Among the many reasons are the following (admittedly interrelated) ones:

  1. Raise money: This is obvious. IPOs were (are?) the easiest and most cost-effective way for a large company to raise a bunch of money and then have a currency with which to pay new employees or do M&A deals.
  2. Provide liquidity for existing shareholders: Allow founders to sell some stock, diversify, get rich/stop being so damn poor and wean the kids off of hand-me-down crayons, etc.
  3. Increase public profile/get brand exposure/enjoy momentary frisson of power: Go public and you get a lot of press. Some stodgy corporations may also prefer to do business with a public company because of all the supposed hijinks-quashing regulation that goes with the listing. Going public also seems to reduce the cost of getting credit from banks. You also get to go on a road show and drop a giant prospectus in people’s laps.

Dan Primack responded to the WSJ post and sensibly noted that the IPO market was declining long before Sarbanes-Oxley was passed in 2002. Although I would quibble with his title, which I imagine he didn’t choose. Regulation, broadly conceived, did indeed kill the IPO. To the extent that it’s been killed, that is, which leaves it probably somewhere right around Zombie; it used to be real dead but is now out and about trying to make a comeback.

And but sure, you can, as the WSJ did, find lots of surveys of company heads, both private and public, that will lament the bill’s passing and the absurd amounts of expensive red-tape bushwhacking that compliance involves. But to heap the majority of the blame on any one thing that happened as late in the game as 2002 strikes me as wrong.

The graph below shows the number of IPOs per year in the US (not just the venture-backed IPOs that the WSJ piece focused on). Obviously, there’s a definitional problem at play here as well: what counts as an IPO? FYI: this chart included IPOs only by operating companies, excluded those below $5/share, and those offerings that issued ADRs (non-US companies listing on American exchanges).

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The data for 2009 and 2010 that I’ve seen have IPO levels steadily rising back up just shy of the levels of the mid-2000s. And in fact just yesterday Paul Kedrosky, in his Field Notes (link round-up), highlighted a RenCap post that says IPOs are “surging” in April, with a total of 31 companies filing with the SEC so far. It should be noted, however, that even if the number of total IPOs isn’t shockingly low, many of these companies are larger and the proportion of small to large cap companies issuing IPOs has changed drastically in the past decade or two. The WSJ definitely got that piece right.

So, I think there are two separate threads worth exploring here. What killed the IPO market/How dead is it? And if it’s dead or at least permanently depressed from mid-90s levels, should we care? My admittedly arm-chair answers are: Yeah, it’s pretty dead, especially for small cap companies. And yes, we should care, but maybe not as much as people would have you believe.

Historical Perspective on the Death of the IPO Market


To put it bluntly, the reasons that the WSJ article pooh-poohs (the rise of online brokerages, decimalization, Eliot Spitzer’s moderately successful crusade to turn Wall Street into a giant smoking crater), in conjunction with the reason it holds on a pedestal (Sarbanes-Oxley), do a pretty good job of describing why the IPO market looks the way it looks.

That unignorable history (unless you’re the Wall Street Journal) looks roughly like this:

  1. 1996-1997, the rise of DIY online brokerages: Starting with Charles Schwab in 1996 and moving on to E*Trade and others, online brokerages began undercutting the traditional brokerage house fees by an order of magnitude. Trades could be had for ~$20 instead of ~$200. And with the decline of the traditional brokerage model came the end of competition between firms to have the best stock picks based on the best (or least the most well-funded) research. The Bubble did a good job of masking this, but as the traditional brokers disappeared, so did some of the money going into small cap stocks.
  2. 2001, SEC introduces decimalization: Stocks used to be traded in fractions, so there was a spread between the bid and the offer. SEC shifted to decimals (pennies) in order to lower the pricing and make trading easier to understand for consumers. It certainly did this, but it also disincentivized the brokers and defunded research.
  3. 2002, Sarbanes Oxley: As we discussed above, this made it a lot more expensive and time-consuming to take your company public.
  4. 2003, The Global Research Settlement: Eliot Spitzer imposes his phallus on Wall Street! As part of the Settlement, 10 of the largest securities firms “agreed”, in conjunction with the exchanges, to insulate their banking sections from their research sections. This ended the tradition of investment banks paying their research analysts from investment banking fees. Once again, this helped kill support for small cap stocks.

These are the main landmarks, but there’s a whole host of other factors that helped contribute to the trend. How the WSJ can look at this history and claim that Sarbanes-Oxley was the precipitating event in this trajectory, or that it can somehow be divorced from its regulatory antecedents and blamed for the lame IPO market is beyond me.

And, if you think that the stuff that happened before Sarbanes-Oxley has contributed as much or more to the lack of IPOs, your outlook on the likelihood of a mid-90s-style revival should be pretty grim. This graph does a good job of showing the decline of small cap IPOs well in advance of Sarbanes-Oxley.

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Does it matter?/What to do?

I pose “does it matter?” as a question, but it’s one with a pretty obvious answer. Yes, it matters, especially to entrepreneurs, but also to VCs, who have seen the length of time from incorporation to IPO creep steadily upward. The average used to be around 5 years. We’re nearly at the point that the average period is nearly the same as the duration of most VC funds. It should be self-evident that this is bad for everybody involved, although I would argue (maybe in another post) that the rise of secondary markets should cushion the blow both to companies and VCs.

The NVCA released a report 2 years ago that described the rather dire state of affairs and recommended a 4-Pillar Plan To Restore Liquidity in the US VC Industry. The 4 Pillars (one wonders whether there was a 5th that was scuttled after an NVCA intern discovered the 5 Pillars of Islam and was worried about the SEO implications) are:

  • Ecosystem Partners:

Within the last decade, venture-backed companies have been faced with fewer choices as it relates to investment banks and accounting firms that will assist in the IPO process. While the major investment banks continue to operate, the “four horsemen” boutique investment banks of the 1990’s (Alex Brown, Hambrecht & Quist, Montgomery Securities, and Robertson Stephens), which specialized in IPOs of venture-backed companies, no longer exist. Further, the fall of Arthur Andersen and the resulting pressure placed on the Big Four accounting firms has, in many markets, left a void in terms of quality auditing services available for these smaller companies.

Against this backdrop, the NVCA believes that the venture capital industry must do more to promote alternative ecosystem partners while engaging with existing members to identify ways to better serve the needs of emerging growth companies. The Association has begun to engage in talks with boutique and major investment banks as well as the Big Four and other public accounting firms about how they can also better serve the needs of small cap companies. The NVCA also intends to encourage the use of a broader array of service providers such as the “Global Six” including Deloitte LLP, Ernst & Young LLP, Grant Thornton LLP, KPMG LLP, PricewaterhouseCoopers LLP and BDO Seidman LLP.

  • Enhanced Liquidity Paths:

There is consensus among many within the capital markets ecosystem that the distribution system that connects sellers and buyers of venture-backed company new issues is broken. There are many drivers behind this disconnect including mismatched expectations in terms of issue size, the lack of sell side analysts, and the propensity of hedge funds to buy and sell stock quickly. All of these factors contribute to a lack of an adequate distribution channel and considerable post-IPO market volatility.

To offer small venture-backed companies an enhanced distribution system for the sale of initial stock, the NVCA endorses concepts such as Inside Venture which is a private market platform that connects qualified companies that intend to IPO within 18 months with pre-screened cross-over investors. These buyers commit to buy and hold these stocks for the long term. Other providers with similar models include Portal Alliance (NASDAQ), SecondMarket and Xchange. Additionally, the NVCA will help raise awareness about pro-active M&A roll up strategies of smaller portfolio companies to achieve IPO critical mass and global alternatives to the U.S. public markets.

  • Tax Incentives

The NVCA has long asserted that the government must support a tax structure that fosters capital formation and rewards long term measured risk taking. To support a more vibrant IPO market, the U.S. must maintain tax policies that have been proven to encourage venture capital investment so that the pipeline of promising IPOs is as robust as possible. Further, Congress should consider adopting new tax incentives which would stimulate IPOs, at least in the short term.

The NVCA will continue to advocate strongly for a capital gains tax rate that is globally competitive and preserves a meaningful differential from the ordinary income rate. The Association asserts that venture capitalists who are successful in building new companies should continue to be taxed at a capital gains rate for any carried interest that is earned over the long term. The Association also intends to explore the possibility of a one time tax incentive for buyers and holders of IPOs as well as increasing the holding rate for capital gains status to two or more years.

  • Regulatory Review

From a regulatory perspective, the last decade has been characterized by a series of broad sweeping regulations aimed at curbing serious abuses within the financial system but fraught with unintended consequences for small pre-public and public companies. From Sarbanes Oxley (SOX) to the Global Settlement to Reg FD, small venture-backed companies have been faced with costly compliance and increasing obstacles to enter the public markets as a result of regulations intended for larger multi-national corporations. The NVCA strongly supports regulation and protecting investors where necessary but does not support a uot;one-size-fits-all” regulatory approach.

To wit, the NVCA will advocate for a full systematic review by the Securities and Exchange Commission of recent regulations which impact small cap companies. This review would include interpretations of SOX, pre-IPO financial reporting requirements, the separation of analyst and investment banking functions, and private placement requirements. There are opportunities within existing regulations to tier compliance so as not to overburden emerging growth pre-public and public companies at a time when they need support from the government, their auditors, and the markets.

[-ed: Sorry about the excessive C&P, but I thought that full, in-line descriptions of the Pillars might be preferable to a link. This is what my vast readership has told me in the past.]

The most interesting part of the NVCA prescription for me is Pillar #2 and the mention of secondary markets. Private trading on secondary markets, it seems to me, provides a pretty compelling remedy, especially for entrepreneurs looking for funding to bridge that period between the old school 5-year IPO timeline and the new world order of 7 -10 years. This may even prevent companies from going public before they’re ready or from selling to a larger company with unsatisfactory conditions (valuation, earn outs, etc.). All the while, these secondary markets should allow companies to reap many of the benefits of going public referenced at the beginning of the post without many of the drawbacks. Secondary markets often allow companies to reveal far less information than they would have to if they were issuing an IPO and they’re far less costly. I’ve seen estimates of the cost of going public that range from 10-20% of the total valuation for legal, accounting, underwriting services.

I don’t have enough experience or knowledge of the VC industry to know whether secondary markets in conjunction with non-IPO exits are going to be enough to keep the industry funded at levels that will promote growth and innovation. I suspect that the answer is no, and that industries that are traditionally more reliant on IPOs, or industries in which the universe of potential strategic buyers is smaller or less obvious, may suffer from narrowed funding options and more skeptical investors. And in the comments section of Primack’s piece, VC Jeff Bussgang makes a few observations about the relationship between the M&A and IPO markets that should make us worry about the health of the ecosystem without a robust IPO market:

Dan – I rarely disagree with you (and I almost always disagree with the WSJ editorial pages) but I think you’re wrong on this one.

First, VCs need a strong IPO market to generate strong exits alongside the M&A market. If the IPO market is strong, then it’s a credible threat that provides leverage when negotiating with acquirors. I have seen many situations where a company will file to go public and then get bought at a healthy price because it’s such a strong financing and liquidity path (e.g., Gomez – Compuware).

2) Lean start-ups are great for the initial days when searching for product-market fit, but once a company gets north of $10-20 million in revenue, there comes a time to abandon lean and begin to invest in growth – a broader product footprint, global distribution and world domination. Having a high potential path to an IPO generates M&A interest for everyone in the ecosystem. Many scale revenue companies (say, $50-100 million) are hunting around to bulk up to build up enough critical mass to go public. Online video leader Tremor’s acquisition of ScanScout and Transpera is an example here.

3) Yes, the IPO market has gotten better, thankfully, but the barriers are still high. Many of these companies are very large entities or foreign companies (e.g., Chinese-based IPOs have been very fashionable lately). Talk to medium-scale company CEOs and investment bankers and you’ll hear the same thing – it’s hard, expensive and daunting to take a company public.

We should all be fighting to make it easier. Even if that means (gulp) agreeing with the WSJ editorial pages..