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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?

The SEC's Colossal Failure of Oversight-- Isn't This a Violation of the Business Judgment Rule?

The damning New York Times headline, "SEC CONCEDES OVERSIGHT FLAWS FUELED COLLAPSE," from a September 26th article by Stephen Labaton, will hopefully end up as more than a footnote in the long list of misdeeds by the 'stewards' of the American economy that have brought American capitalism to the precipice of systemic financial collapse. According to the article, a report by the inspector general of the SEC asserts that "voluntary regulation does not work" and that the SEC's oversight program for the investment banks "was fundamentally flawed from the beginning."

The article goes on to state:

The report found that the S.E.C. division that oversees trading and markets had failed to update the rules of the program and was “not fulfilling its obligations.” It said that nearly one-third of the firms under supervision had failed to file the required documents. And it found that the division had not adequately reviewed many of the filings made by other firms. The division’s “failure to carry out the purpose and goals of the broker-dealer risk assessment program hinders the commission’s ability to foresee or respond to weaknesses in the financial markets,” the report said.

We should not gloss over the importance and the far reaching nature of this indictment of the SEC by the SEC's inspector general. The most fundamental fiduciary duty in business is the Duty of Oversight. Oversight is a theme which binds together the more commonly referred to fiduciary Duties of Care, Loyalty, Confidentiality, and Disclosure. Violators of the fiduciary duties listed above often seek refuge in the Business Judgment Rule and try to to hide behind 'squishy' judgment call concepts like "good faith" and "honest belief". But the Business Judgment Rule stands on oversight, and the SEC clearly failed in its duty of oversight of the investment banks. In my view, in addition to the bankers, the regulators themselves should also be held responsible for this crime against America.

Below is a definition of the rule, taken from the white paper, "A Simple Guide to the Basic Responsibilities of VC-Backed Company Directors", written by the Working Group on Director Accountability and Board Effectiveness:

Business Judgment Rule
Creates a presumption that in making a business decision, the directors of a company acted on an informed
basis, in good faith and in the honest belief that the action taken was in the best interests of the company.
The business judgment rule helps protect a director from personal liability for allegedly bad business
decisions by essentially shifting the burden of proof to a plaintiff alleging that the director did not satisfy
its fiduciary duties. This presumption and the protections afforded by the business judgment rule are lost if the directors involved in the decision are not disinterested, do not make appropriate inquiry prior to
making their decisions, or fail to establish adequate oversight mechanisims.

All corporate directors and persons in positions of accountable oversight responsibility need to commit these rules to memory-- and, more importantly, to act on them in the daily course of business.

Building Alliances Between Venture Capitalists and Corporations- A Consistent Imperative

Building alliances between venture capitalists and corporations has never been more important than in today's extraordinarily volatile capital markets. We may be looking at a Brave New World in finance when markets re-equilibrate (and eventually they will), but knowing how to partner with large corporations-- who are both strategic business development partners as well as potential strategic acquirers of emerging companies-- will remain a constant for venture capitalists.

The National Venture Capital Association (NVCA) kicks off a new corporate webcast series on Friday, October 17, 2008 with a special complimentary webcast featuring Claudia Fan Munce, Managing Director, IBM Venture Capital Group, and Dan'l Lewin, Corporate Vice President, Microsoft Corporation, who have generously sponsored Partnerships for Prosperity: Building Alliances Between Venture Capitalists and Corporations.

I will be moderating the webcast, and we will discuss some of the challenges and best practices that venture capitalists should follow in order to optimize their relationships with IBM and Microsoft. The models that IBM and Microsoft follow are by no means identical, as they are influenced by different corporate cultures and business priorities. Claudia and Dan'l will share helpful tips on how to best work with their organizations as well as more general insights on successful corporate partnering strategies for VCs.

The new webcast series will follow this special launch event with other relevant content featuring global corporate leaders whose organizations seek to partner with venture-backed companies.

This webcast is complimentary to all NVCA members-- to register CLICK HERE TO LINK TO THE NVCA WEBSITE

Best Practices for VC Directors Involved in M&A Transactions in Today’s Challenging Environment

Dave Barry, Managing Editor of Dow Jones Financial Information Services, has invited me to join a panel of M&A experts on September 26 to discuss best practices and some of the key challenges currently facing VC-backed company boards involved in mergers and acquisitions. Joining me on the panel are Jeff Laborde, Vice President in Goldman Sachs’ Technology Investment Banking Group, who represented our portfolio company Rapt earlier this year in Rapt’s acquisition by Microsoft. John Peters, former CEO of our portfolio company Reconnex, which McAfee acquired recently, will also be a panelist. Ron Star of Howard Rice joins us to bring the legal perspective to this webinar.

Any venture capitalist involved in or considering an M&A transaction knows that the dynamics of acquisitions in today’s market have shifted such that there is an asymmetric negotiating advantage favoring large corporations (greater resources, always able to ‘wait until next quarter’). Levensohn Venture Partners completed three acquisitions of our portfolio companies so far this year, so I have a very current perspective on the challenges and opportunities of the technology M&A market.

This webinar should be both lively and enlightening as my fellow panelists bring deep experience and best practices knowledge to the discussion. Today, and until we see a robust IPO market re-emerge for growth companies with market capitalizations below $1 billion, M&A is the only way to generate liquidity for most venture portfolios. We will discuss the challenges associated with getting deals done and recommend best practices to optimize outcomes for emerging companies.

To register online for Best Practices for Board Members Priming VC-Backed Companies For M&A
on September 26, 2008 go to http://events.dowjones.com/webinars/20080926.html

Remembering Keith Benjamin

Keith Benjamin, who has been one of my business partners for more than six years and a friend since we first worked together on an IPO in 1993, died on July 29th. He was a kind and loving person who adored his family, loved his work and was passionate about everything he did. We will miss him very much.

I grieve for Keith's family and mourn his passing.

Sarah Lacy, Silicon Valley Host of Yahoo! Finance Tech|Ticker, Interviews Pascal, Sharon Wienbar (Scale Venture Partners), and Jessica Canning (Dow Jones/VentureSource) on Current VC Industry Trends

Last Thursday I joined Sharon Wienbar, Managing Director of Scale Venture Partners, and Jessica Canning, Director of Global Research for Dow Jones/ VentureSource, on Yahoo! Finance's Tech|Ticker program, hosted by Business Week's Sarah Lacy. We discussed issues ranging from opportunities in Clean Tech investing and the current state of tech IPO's to the implications of recent VC industry funding statistics and how entrepreneurs should manage their companies through an economic downturn. Two of the segments were posted this morning and can be accessed at http://finance.yahoo.com/tech-ticker

Marc Benioff and Warren Hellman Advocate Corporate Philanthropy at Jewish Community Federation Business Leadership Council Event

On February 7th, 300 people attended the third annual gala breakfast hosted by the San Francisco Jewish Community Federation's Business Leadership Council (BLC) to hear Warren Hellman, chairman and co-founder of Hellman and Friedman, and Marc Benioff, chairman and CEO of Salesforce.com, speak about the power of business leaders to produce positive social change. 

    The speakers moderated their own discussion, which focused on the positive role that the proactive advocacy of corporate philanthropy can play throughout an organization.  In response to a question from the audience as to whether promoting corporate philanthropy is inconsistent with creating sharholder value, Benioff forcefully replied that "doing good" absolutely builds shareholder value.  I strongly agree.

Warren Hellman, who serves on the board of Salesforce.com's charitable foundation, asked Marc to talk about the 1:1:1 model which he established at the early inception of Salesforce.com.  1:1:1 represents a pledge of 1% of the company's equity (when it was still private); 1% of profits (once you have them); and 1% of employees' paid time (6 business days per year) to charitable purposes.  Today, the Salesforce.com foundation employs 16 full-time staff and manages "tens of millions" of dollars.

The Business Leadership Council (BLC), which I currently chair, reaches out to over 1,500 Jewish professionals in the Bay Area through close to a dozen events each year.  We host smaller seminars (30 to 80 people) on topics ranging from current trends in real estate to protecting intellectual property; and larger networking events (200+ people) designed to bring people together to meet in a community that shares both business and philanthropic goals.  We have barely scratched the surface in reaching out to the 6th largest Jewish community in America.  If you want to learn more about the BLC, go to www.sfjcf.org and click on the Business Leadership Council.   

 

Top Reasons Why Public Company Directors Should be Removed

According to What Directors Think 2007, nearly one-quarter (23%) of the over 1,000 respondents to the sixth annual U.S. public company directors survey feel that a member of their board should be replaced.

Why:

*  The director does not have the skill set needed... 36%

*  The director is not engaged..................................  31%

*  The director comes to meetings unprepared........ 18%

*  The director has been on the board too long.......  17%

The first three categories above should resonate equally with private company directors and certainly with venture capitalist directors.  I have maintained for many years in my corporate governance writings that the most common problems faced by boards cut across issues of revenue size and company maturity.

At their core, these are issues that relate to the mutual accountability of individuals who belong to small groups and the need to avoid systemic dysfunction in order to maximize the opportunity for positive corporate outcomes.

In fact, many of these issues are only exacerbated in VC-backed companies because emerging companies are resource-constrained and under severe pressure to execute over a shorter time frame than larger corporations which have greater resources at their disposal.

Most Public Company Boards Conduct Full-Board Evaluations and Find Them Effective

PriceWaterhouse Coopers and Corporate Board Member recently released their sixth annual survey of directors of public companies, which aggregates responses from over 1,000 corporate directors on a variety of important issues. 

First, some interesting statistics from What Directors Think 2007:

How many people actually serve on public company boards of directors?  At the end of 2007, directors on U.S. corporate boards totaled 48,950 from 5,772 public companies. 

Of this total,  66% hold only one board seat-- a result which certainly surprised me and is unheard of among the multiple-board seat VC  community.

Women occupy 4,544 board seats, or 9.3% of the total.  Out of a total of 5.341 board chairmen, 49% are insider chairmen and 51% are outside chairmen-- a ratio that holds across revenue size categories.

The survey also revealed some very useful information on Corporate Governance--

Respondents rated the following Top Five hallmarks of good governance, in order of priority:

(1) The board holds regular executive sessions without the CEO;

(2) The board is composed mostly of independent directors;

(3) The board or a committee conducts regular, formal CEO performance reviews;

(4) The company has a formal management succession process in place;

(5) The board evaluates both whole-board and director performance.

As a VC, I feel strongly that numbers (1), (3), and (5) above are entirely applicable to VC-backed companies and should be high priorities for VC directors.

In 2007, 88% of public boards conducted a full-board performance evaluation on a regular basis, up from 33% in 2002-- 78% of respondent companies listed on NASDAQ do so even though this is not a NASDAQ requirement.

Only 57% of directors characteriz their board's evaluation process  as effective or very effective-- leaving 38% saying it is somewhat effective and 5% saying it is ineffective.  The authors conclude that "these results show many boards are not maximizing the usefulness of this process which, among other things, directors have told us can improve board communication, provide focus for board and management recruitment efforts, and identify ways to streamline board processes to make the best use of directors' time."

Private company directors should follow this increasing trend toward board and director performance evaluation in far greater numbers-- for more on how VC companies should apply best practices to approach these issues, go to www.levp.com/news/whitepapers.shtml to review material prepared by the Working Group on Director Accountability and Board Effectiveness.