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A Case Study in the Unintended Consequences of Financial Market Regulation: The Death of the Small Cap U.S. IPO?

The first 100 days of the Obama administration are widely expected to usher in a new era of U.S. capital markets regulation designed to restore the public’s trust in the decimated institutions that provide much of the liquidity infrastructure for the global capitalist system.  It is imperative that improved financial oversight be achieved swiftly through the enactment of effective regulation so that the markets can re-equilibrate and resume their normal function.  Without these necessary changes, global economic growth will continue to falter.

At the same time, we must recognize that regulations enacted in haste can have severe, negative unintended consequences.  The current moribund state of the American IPO market is a real-time case study in such unintended regulatory consequences.  Of equal import is the fact that the IPO drought is structural, not cyclical, and this has far reaching implications for the future of innovation in America. 

On November 19^th, Grant Thornton released a white paper, “Why Are IPO’s in the ICU?” written by David Weild, former Vice Chairman of the NASDAQ, and Edward Kim, former head of NASDAQ product development, both now principals at Capital Markets Advisory Partners. 

To download the white paper click Download Why are IPOs in the ICU_11_19 :  

The paper was presented to the NYSE and National Venture Capital Association’s Blue Ribbon Regional Task Force, which has been convened to make specific recommendations to the Obama administration in January regarding changes that must occur if America is to restore the small cap IPO as a compelling and differentiated positive feature of our capital markets.

The paper is concise and makes a cogent case as to how we got here.  If you want to understand why the IPO market has died and why the middle market for public emerging growth companies has effectively ceased functioning, you must read this paper.

 I agree with the paper’s overall thesis and with a number of its important assertions, including:   

* While conventional wisdom may say the U.S. IPO market is going through a cyclical downturn, exacerbated by the recent credit crisis, many are beginning to share a view of a new and much darker reality: The market for underwritten IPOs, given its current structure, is closed to most (80 percent) of the companies that need it. 

* The lack of an IPO market has caused venture capitalists to avoid financing some of the more far-reaching and risky ideas that have no obvious Fortune 500 buyer. Gone are the days when most venture capitalists would so willingly pioneer new industries and technologies (e.g., semiconductors, computers and biotechnology) that have no obvious outlet other than the IPO market.

* Regulators may have unwittingly done a real disservice to mom and pop investors by enabling traders to hijack the markets for speculation. This phenomenon can be seen by the large Wall Street firms who have witnessed their top 10 (by revenue) institutional investors — which only a decade ago were “long- only” mutual funds such as Fidelity and Alliance — be displaced by hyper-trading long-short hedge funds.

* The U.S. will lose its competitive advantage in developing, incubating and applying new technologies. Technologists are already returning to foreign jurisdictions like China and India where government has devised an increasing array of economic and capital markets incentives to compete.

The lack of IPO’s in the U.S. has broad, negative implications for continued risk taking by U.S. venture capitalists. If we have no public market liquidity for emerging growth companies, there will be no next generation of American technology giants. The demise of the technology IPO has also contributed to the structural breakdown in the broader cycle of research and development that underlies the American innovation crisis heralded by Silicon Valley thought leaders such as Judy Estrin.

 

If you have constructive recommendations for reforms that you believe should be enacted to support a renewed IPO market, please contact me at pascal@levp.com, and I will forward your suggestions to the NVCA.

"Bailing Out Wall Street" Commonwealth Club Panel Broadcast on KALW 91.7 November 11 at 7PM PST

KALW 91.7 FM, the local San Francisco National Public Radio station, will be broadcasting "Bailing Out Wall Street", the lively election-eveCommonwealth Club INFORUM panel on which I participated, tomorrow at 7 PM PDT.   In front of a live audience of over 200 people, we shared differing views on the wisdom of the Federal Government's emergency relief and assistance program to the banking and finance industries-- commonly tarred as the "Wall Street Bailout".  Our vigorous discussion was fueled by the nature of the panelists, as I joined Dave Callaway, Editor-in-Chief, MarketWatch, Jonathan Berk, Professor, Graduate School of Business, Stanford University, and Maggie Mui, San Francisco Market Regional President, Wells Fargo.  The panel was expertly moderated by Kathleen Pender, Net Worth Columnist, San Francisco Chronicle.

 

Dave Callaway, Maggie Mui, Jonathan Berk, Pascal Levensohn, and Kathleen Pender

Some of the thorny questions we addressed: 

• Will the bailout work and is it really a bailout?
• Did the Treasury's decision to throw Lehman Brothers under the proverbial bus on September 13 light the match for the panic that subsequently routed financial markets?
• What are the current prospects for entrepreneurs and for continuing innovation in Silicon Valley during these recessionary times?
• Are we going to drown in new securities regulations with unintended negative consequences?

Why Entrepreneurs Can Thrive During a Recession

Vivek Wadhwa, currently a Wertheim Fellow at the Harvard Law School and a successful tech entrepreneur, wrote a constructive article in Business Week, "Startups: The Upside of a Downturn", providing advice and encouraging entrepreneurs not to wait to start a business during a recession-- on the contrary, he identifies a recessionary environment as supportive of well-crafted new business opportunities.  For a link to the full article, click here.  

I've excerpted some of the core concepts in the article below:

"My advice for other tech entrepreneurs thinking of launching right now? Don't wait. A recession is your ally in building a lean, thriving company. Consider the following four advantages.

Less competition. An economic downturn clears the competitive landscape for startups. Most of the "me-too" companies with inferior products and weak business models go out of business, and fewer are started. Plus, it becomes a lot easier to do licensing deals with universities and business partners—no one else is.

Lower costs. It is a buyer's market, and you can negotiate deals on real estate, equipment, and materials like never before. Salaries are lower for new hires, and there is little pressure to give big salary increases to existing staff.

Easier to recruit and keep employees. You will readily find people who have been laid off and are eager to get back to work. They will accept lower salaries in return for stock and take the risk of joining a startup. And rather than focusing on getting a job with a competitor who pays a little more money, employees are usually content to build tenure and focus on your success.

Less pressure to expand. Rather than rushing to expand your business, you have the luxury of doing it right. You can conceive of better products, test them carefully to make sure they work and meet customer needs, and experiment with different business models. Since you are not in a frantic rush to get a product out or build market share, you can do things more methodically."

What Motivates Entrepreneurs? That Depends on Your Age and Gender...

VentureBeat has published a guest column that I wrote on this topic "Recession: A Good Time to Trade Money for Power?" based on new research analyzed by Professor Noam Wasserman of Harvard Business School (HBS).

On October 23, 2008, I moderated a panel on Effective Board Leadership for Long-Term Success at the Forum for Women Entrepreneurs & Executives at the offices of Wilson Sonsini Goodrich & Rosati (WSGR) in Palo Alto and presented this data, which suggests that men and women entrepreneurs from ages 20-50 can flourish even in down economies.  The panelists were Shellye Archambeau, CEO of MetricStream, Jacqueline Akerblom of Grant Thornton, and Steve Bochner of WSGR.

The data, originally gathered by Dr. Tim Butler of HBS, identifies differing motivating factors behind male and female entrepreneurs—and it reveals fascinating, unanticipated results. The study focuses on what motivates males and females across three age categories: 20-29, 30-39 and 40 and older. The data points out the unique differences as well as similarities between men and women at each stage.

Wasserman, who coined the term “Founder’s Dilemma” in his ground breaking research, is an active blogger on issues related to founder frustrations and has recently written about the conflict founding CEO’s face between wanting to be ‘Rich vs. King’ (Harvard Business Review, March 2008).  As we examined the data in the context of women entrepreneurs, one of the most interesting conclusions is that there is no clearly analogous ‘Rich vs. Queen’ conflict for women entrepreneurs, as women executives who choose the startup path are motivated very differently from their male counterparts.

Crisis demands innovative solutions-- an economy facing increasing rates of unemployment, scarce credit, and general fear, uncertainty, and doubt may be just what the doctor ordered to fuel the entrepreneurial spirit. 

I received the following comment about the VentureBeat story from a 20-something female CEO:

Great article Pascal!  Very inspirational

What I find interesting however is the comment about personal/family interests driving the reason for majority of women 20-29 to choose Autonomy as #1.  This is counter-intuitive to me and most women in this age group I interact with (although we may be very unlike the norm).  For the most part this age group is dedicated 150% to career and therefore the flexibility of defining your own hours, etc is somewhat irrelevant.  I know for me the top reasons that motivate me are intellectual challenge (I LOVE learning so many new things every day), the ability to affect the outcome and impact results, and the dedication of the people in this environment.

 

A New Dawn for America

I feel particularly optimistic tonight, and I see sunlight in America's future. Gathering with my family in front of the TV, and listening to Senator McCain's gracious concession speech, my greatest hope is that a sense of bipartisanship, motivated by the desire to act in the best long term interests of America, will drive our country forward to a truly better place through the difficult times that remain ahead.  It is easy to be cynical about politics and elections, but the demographic facts about this election stand cynicism on its head.  As Barack Obama said tonight, in America, anything is possible.  As we go forward, let's not forget this.  We can rise above our own selfish interests to do the right things for our country. Tonight, I am more proud to be an American than ever before, and I feel very fortunate to be a first generation American who not only has lived the American dream, but who continues to believe in the American dream for my children and for all Americans.

"In this country we rise or fall as one nation, as one people."

President-Elect Barack Obama

November 4, 2008