I liked the Friday, August 7 Wall Street Journal editorial, Washington vs. Silicon Valley, but it does not go far enough. In Silicon Valley, Boston, Austin, and other innovation centers across the country, entrepreneurs and their backers (who are not limited to venture capitalists) are all keenly aware that Washington’s addiction to enacting hasty, one-size-fits–all financial regulation will continue to have far-reaching unintended negative consequences for the U.S. economy:
“… Sarbanes-Oxley compliance costs, Eliot-Spitzer’s stock analyst settlement and the economic downturn have created an historic drought in venture-backed companies going public. . . . It boggles the mind that Washington would enact new policies sure to prolong this (IPO) drought and strike at the heart of American innovation.” (from the WSJ editorial)
The U.S. IPO drought testifies to a systemic liquidity crisis for emerging growth companies that is putting at risk an entire generation of innovative American companies. IPO’s are essential to job growth in America and to maintaining a balanced innovation ecosystem for two important reasons. First, the National Venture Capital Association has published data revealing that over 90% of the jobs created by venture-backed companies occur AFTER they go public—and this relationship holds over the past 40 years. Second, emerging growth companies lose negotiating leverage in acquisitions when they have no other viable liquidity alternatives. Between 2001 and 2008 mergers and acquisitions (M&A) accounted for 87% of venture-backed company exits, up from an average of 44% in between 1992 and 2000.
Large corporations are generally not known for being innovative and even less for creating new jobs after acquiring other companies (merger “synergy” is code for firing people). In the current liquidity starved environment, some acquirers are able to drive draconian acquisition terms, including features such as two-year contingent calls on up to 100% the cash proceeds to selling investors.
Venture capital partnerships are typically ten-year partnerships with historically proven expectations that significant liquidity will be delivered from successful partnerships to investors by year 6. The median age of a venture-backed company at the time of its IPO has increased from 4.5 years in 1998 to 9.6 years as of year-end 2008. The median company age at the time of an M&A exit has increased from 3 years to 6.5 years over the same time frame.
What makes this combination untenable is that the IPO drought, combined with lengthy “tails” on lower-value merger payouts, pushes liquidity out much closer to the end of life of the partnerships themselves, making it impossible for investors to re-cycle their prior risk capital to fund the next generation of innovative companies based on previously valid asset allocation models. The massive institutional investor losses incurred from investments in asset classes unrelated to venture capital due to the global financial crisis have only fanned the wildfire fire burning in the American innovation forest.
We must solve the IPO problem, and a review of historic IPO data pre-technology bubble suggests that we need to achieve an average of 130 IPO’s per year to restore equilibrium to the venture-backed company liquidity cycle. While Sarbanes Oxley compliance costs and the stock analyst settlement are part of the problem, the root causes include the decimalization of stock trading commissions and the death of the sub $50 million IPO.
Investors take risk in order to reap rewards. Washington needs to recognize, first and foremost, that entrepreneurs, venture capitalists, institutional investors, market markers, and underwriters all seek to be rewarded for committing risk capital (which includes sweat equity) to making these highly risky ventures successful. If the upside is taken away by regulations that make the risk/reward equation unattractive, risk capital and entrepreneurs will leave the U.S. That exodus has already begun, and it is evident in many statistics that testify to America’s slipping global competitiveness since 1999.
Sadly, risk aversion is the order of the day in Washington at a time when we need risk takers to lead America to a new cycle of sustainable economic growth through new job creation. It’s past time for our policymakers to unwind the unintended consequences of a decade of ill-conceived securities regulations that have already weakened our innovation ecosystem. Let’s start by advocating policies that will bring risk-taking entrepreneurs and technology innovators back to the table before the American cupboard is bare.