But the US IPO torrent has turned into to a trickle.
Today only the largest of companies can go public, generally only those with over $500 million dollars of market capitalizations. In the 80s there were IPOs where the net proceeds were less than $900K. Veteran Venture Capitalist Alan Patricof told me about a $10 million IPO he did in the seventies. When I asked him about this, months later, he corrected me, pointing out it was not a $10 million IPO, it was a $1 million IPO on a $10 million pre money valuation! Mighty Intel Corporation went public in 1971 with an $8 million IPO and a mere $53 million valuation. My concern is that we are not graduating the “Intels” of tomorrow.
AT&T, Disney, General Electric, Genentech, Cisco, Intel, Microsoft, Google and E-bay all had a public offering. Since going public, they have all benefited from the credibility, profile and prestige associated with being publicly traded companies. And of course the access to capital, both as IPOs, and perhaps even more importantly, with secondary offerings. The ability to do a short lead time secondary offering gives a company enormous flexibility.
But that flexibility is unavailable to most growth companies today.
Would the phone, talking movie, television, personal computer, and internet industry have been as innovative if these leading companies were instead acquired as a division of Western Union? I think not, but that is the future of most venture-backed companies today. M&A has become the only available exit for growth investors and Founders. Long term this presents a problem.
Large companies have a track record of wasting innovation opportunities. Western Union had an opportunity to buy AT&T for one million dollars, but refrained because they figured voice would never travel adequate distances. Xerox discovered the technology behind Apple, Microsoft and Cisco but only as independent companies could theses “start-ups” attract the talent, capital and customers to create new industries. More recently, watchers of the New York tech scene will recall Google’s purchase and shutdown of Dodge Ball.
New, well-funded, stand-alone leadership is needed to drive innovation, but that is NOT the future we are building.
How many jobs were created by these innovative companies? How many lives were changed for the better?
It is estimated that 5% of America’s productivity improvements have come from the logistical excellence of Wal-Mart…. Do you think this would have been achieved if Sam Walton sold to Sears?
There is a long-term problem with the innovation engine of capitalism. So how did we get in this situation?
There is no one event, but instead a culmination and interaction of many factors.
1. Death of the mid-market investment firms. Remember Alex. Brown & Sons, Hambrecht & Quist, Robertson Stephens, Legg Mason and Montgomery Securities? These firms played a critical role in connecting investors with innovators, and often profited in the process. Today these firms have had to evolve or go out of business due to changes in the regulatory and market landscape. Other firms have attempted to fill the void and found that the economic model supported by equity research, equity sales and equity trading no longer works.
2. Decimalization. When equities were traded in eighths not hundredths, trading volume could support market making specialists, and even research. Financial Intuitions have lost the incentive to bring new equities to market, and then trade those equities in small volumes with other humans. The profit is in high volume algorithmic trading among hedge funds.
3. Rise of the Internet Brokerages. E*trade, Schwab, TD Waterhouse and Datek are great for the self-service day trader, but they eliminated the phone sales so critical to retail stock brokerage. There is a saying, small cap stocks are sold not bought, and the US sales infrastructure has been decimated by internet brokers.
4. Growth of Prop Trading. – In the 90s rule changes drastically reduced the risk for the owners of financial institutions. Many of the big firms went from partnerships to corporations. For Wall Street, capital-raising is now a sideshow. At Goldman, trading and investing for the firm’s account produced 76 percent of revenue last year. Investment banking, which raises capital for productive enterprise, accounted for a mere 11 percent of total revenue. While Goldman is at the extreme, it is clear that the needle can be moved more effectively by successful prop desk bets than by the hard, slogging work of identifying promising companies and underwriting their IPOs. Because investment banking fees for IPOs are based on the size of the transaction (the underwriters’ spread), bigger deals are, not surprisingly, favored over small ones. This results in an over-representation of big transactions, including, in particular, deals for portfolio companies of LBO sponsors.
5. End of Research. – Decimalization did not help, but I am not sure that Eliot Spitzer’s efforts were at least as bad. Eliot Spitzer disconnected the economic incentive for brokers to generate investment research on companies with which they may have banking relationships. You would think Eliot would understand bankers whoring their clients is a good thing. In many countries, companies literally pay to publish research. Why is it a shock that research is designed to sell stocks? Guess what --- if anyone tells you anything about a stock, you should be skeptical of his/her motivation. Memo to world, use your own judgment and don’t rely solely on third party research. That said, some level of research is critical to understanding perspectives on a company.
6. Increased Litigation Risk. - Guess what, not all IPOs go up. In the 90s there was a wave of shareholder lawsuits, resulting in massive wealth transfer to class action lawyers. I don’t know if any of these suits reduced malfeasance, but I am sure they dampened managers’ efforts to grow companies. Note: The massive IPO litigation against 310 companies and 55 underwriters relating to 309 IPOs completed from 1998 to 2002 finally settled in late 2009 for an aggregate of $586 million. Worth noting since the case was solely about IPOs (not all public offerings) and related to allocation of perceived “hot issues.
7. The Internationalization of Wealth. – in the 70s and 80s the US was the place to be, as much of the world’s investable risk capital was connected to the US household. Unlike years ago, today the bulk of the world’s investable wealth sits outside the US borders. Brazil, Dubai, Russia, China, India, and dozens other countries have amassed significant investable wealth. In 2009 more IPO funds were raised in China than the US. Today the largest retail broker in the world is in India.
8. Larger Funds. – Globally there is a proliferation of wealth looking for investments, the result has been larger investment funds. The problem is, these large funds can’t make small IPO investments because if they buy more than 10% of the IPO float they may get deemed a “statutory underwriter” and take unwanted potential liability. But at the same time, if a fund is going to make the effort to understand an IPO, they want to buy enough that the purchase can impact fund performance. It just does not make sense for Institutional Investors to buy IPO shares for companies under $500 million market cap.
9. Increased Regulatory Expense including Sarbanes-Oxley. – On my last trip to the London Stock Exchange, they showed me a picture of Sarbanes and Oxley, their two favorite Americans. The LSE professionals estimated that the US SOX legislation had driven dozens of companies to file abroad. The added accounting expense is almost always hundreds of thousands of dollars a year. This is time and resources going into accounting, which instead could be going into product innovation. The increased imposition of personal liability on officers by SOX
reporting is another factor that deters companies from listing in the
From 12-15-10 WSJ - "Section 404 is still consuming more than $2.3 million each year in direct compliance costs at the average company. The SEC's survey shows the long-term burden on small companies is more than seven times that imposed on large firms relative to their assets. Are the internal controls audits helpful? Among companies of all sizes, only 19% say that the benefits of Section 404 outweigh the costs. More respondents say that it has reduced the efficiency of their operations than say it has improved them. More say that Section 404 has negatively affected the timeliness of their financial reporting than say it has enhanced it."
In the years since SOX passage, the country has experienced an historic drought of initial public offerings. Is Sarbox to blame? Many financial pundits say no, but the SEC survey results point in the other direction. When public companies are asked whether Section 404 has motivated them to consider going private, a full 70% of smaller firms say yes, and 44% of all public companies also say yes.
So what happens next? A US exodus?
Some would argue promising start-ups won’t get funded at all. They would argue the lack of an active IPO takes away the incentive for Angel and Venture investing. I disagree. At that seed stage the constraining factor is the number of capable entrepreneurs, not capital. Capable entrepreneurs will find a way get going (and a way to exit). The problem lies later, when a company starts to get traction, really starts to create jobs, wealth, and intellectual property.
Furthermore, with the proliferation of derivatives the seed stage asset class is one of the few uncorrelated asset classes. I see an ever more active angel community stepping in at the very early stage. The problem is as a company grows.
For decades the preferred path for technology commercialization was simple; A US company, incorporated in Delaware, backed by US investors, went public on the Nasdaq. But that system is broken.
Investors still like Delaware, but today, Delaware no-longer has a monopoly on predictable governance and favorable tax treatment. Dozens of jurisdictions are vying to host the Intels of tomorrow. New Zealand will even let you use Delaware law for a New Zealand company. Ireland, Iceland, Belgium, Hong Kong, Cayman, Singapore, Dubai, Chile, Canada and England all have aggressive incentive programs to attract start-ups. Today’s star-ups are often international at inception, so why default to Delaware, especially if it is going to have negative impact on capital access and exit strategy.
I predict that the U.S. and Delaware will lose its preeminent start-up position if we don’t fix the IPO system.
Already some of the best venture deals of this decade bypassed the traditional Delaware holding company structure; Baidu and Skype
And the Nasdaq has lost its lead also. Market makers no longer exchange information over the phone scrambling to match buyers with sellers on the other side of a trade. Today the Nasdaq is digital, and this lowers the barrier for competitors. Competitors include SecondMarket, SharesPost the PORTAL Alliance, and of course EVERY exchange outside the U.S.
There is strong incentive to move away from Nasdaq.
- China (and other countries with rapidly expanding economies) is eager to support local capital markets. Obtaining a domestic listing will become much easier, since China has ambitious plans to float hundreds of companies on the new market each year. Maintenance fees are lower and disclosure requirements are less stringent when listing at home.
- U.S. investment banking firms charge fees that are significantly higher than those charged by firms in other countries. As an example, the average fee charged for U.S. IPOs was about twice that charged for firms going public on London exchanges.
- U.S. IPOs have greater first-day underpricing than those in other countries. While big first-day return is good for purchasers of IPO stocks, it amounts to money left on the table for the issuing company.
- While not specifically measured, the perception is that non-IB fees (for lawyers, accountants, printers, etc.) are much higher for US IPOs.
- A decreased value placed on the prestige of an American exchange listing.
America needs leadership in fixing this financing gap, or the companies that shape our future won’t be American.