On Monday, August 10, Barron’s ran a story “Does the IPO Market Shun Smaller Companies?”, written by Mark Veverka, asserting that “venture capitalists want to widen the playing field for the underwriters.” The story includes quotes from former National Venture Capital Association (NVCA) chairman Dixon Doll of DCM and investment banker Paul Deninger, who is the vice-chairman of Jefferies & Co. It accurately points out that, when it comes to IPOs, many venture capitalists have mistakenly defaulted to choosing the large investment banks (such as Goldman Sachs, Morgan Stanley, and Credit Suisse) as lead underwriters for their portfolio companies. This practice has created “a near oligopolistic hold on tech IPOs” by these large investment banks. Such market power allows bankers to shapes the profile of those companies worthy of going public to favor the natural demand from their largest clients: short-term trading focused hedge funds and large institutional investors that demand highly liquid public securities.
The collateral effect of this market reality is that the vast majority of emerging VC-backed companies are effectively barred from going public. To be clear, there are plenty of strong venture-backed companies today that should be public but that do not meet the valuation or liquidity criteria of the three large remaining investment banks (more on this below). Unfortunately, outside of the IPO-syndicate-bias and the much-maligned Sarbanes Oxley, the article does not address far more serious systemic regulatory consequences that further exacerbate the problem– such as the combined impact of decimalization and the Spitzer decree (taking trading commissions down from $0.125 per share to $0.01 or $0.02 per share and requiring that equity research be paid for by commissions ) which have effectively gutted both the after-market trading and research support that emerging company IPO’s need.
While the article notes that “the objective is to get back to late-80s, mid-90s practices, allowing more start-ups access to capital so they can remain indepenedne tand create more opportunities for venture capitalists to cash out”, the emphasis on who is cashing out is misplaced. More accurately stated, the institutional investors who fund the venture capital partnerships need more opportunities to cash out– and these institutions are largely public pension plans, college endowments, and other true long-term investing financial institutions. Why do they need to cash out? Because they are also the main players who have historically reinvested in the next generation of innovation.
Sadly, the article completely ignores the implications of this systemic liquidity crisis. If we look at the historic record, the most important point overlooked by this story is that smaller companies need to go public because they are the engines of growth that drive the U.S. economy– both in terms of job creation and GDP growth. The IPO chasm that exists today is the result of the death of the sub $50 million IPO. For a clear example, see the following list of 17 companies that went public and raised $50 million or less between 1971 and 1996:
These companies only raised $367 million in the public markets and they account for 470, 000 U.S. jobs today. Adjusted for inflation andmeasured in 2009 dollars, the $367mm in total dollars raised by this group equals$670mm, and only 2 of these 17 companies’ IPOs (EMC $80mm; and Oracle $70mm) exceed $55mm in 2009 dollars. While today these companies are household names, when they went publicthey were largely unknown. How many companies are unable to go public today because they aren’t big enough to merit the attention of the large investment banks who cater to short-term traders? How many future engines of U.S. GDP growth and job creation will be still-born and be forced in to a merger? Should they be starved of liquidity because they need to cash out investors, build working capital, but it is unavailable to them because they need less than $50 million?
Deninger points out in the article that “In recent years, VC firms have become too dependent on mergers and acquisitions as the exit strategy of choice. . .. In fact, most tech-start-ups are ‘built for acquisition’, as opposed to being built to become the next publicly held Microsoft or Oracle.” An addendum to his quote should be that merger synergy is code for firing people. Mergers trigger job losses; IPO’s create jobs.
In my view, it is wholly inconsistent with the Obama administration’s economic growth objectives for the current systemic liquidity crisis in our equity capital markets to be strangling our emerging technology growth companies while they are still in their venture capital cribs. We need to raise awareness of this severe problem because it threatens an entire generation of American innovation. Venture capitalists only make money if their investors make money, and many of their investors are the stewards of America’s pension plans. VC’s need to build companies that are cash flow positive as private companies, not only so that they can improve their negotiating leverage in the event of an acquisition but, more importantly, so that they can wait to go public until the regulatory constraints that have killed the sub $50 million IPO are lifted.
In closing, the article incorrectly asserts that “ironically, the tech IPO market is re-awakeining just as the NVCA prepares to roll out its initiative.” The few IPOs so far this year are drops of water in the desert, and those that are in the queue, while they represent outstanding companies, do not represent a sufficient number of companies to make a material difference for the institutional investors and the many entrepreneurs who have the most at stake. Let’s not misinterpret false positives at the expense of the future of the American economy.