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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.

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."

It's Time for America to Get Back Into the Storage Business

I used to be in the moving business. Eighteen years ago, after working for seven years in the risk arbitrage business, one of the many 'moving' businesses of Wall Street, I left New York to come to San Francisco in order to get into the 'storage' business. America's strong economic foundations are rooted in multi-year business building and long-term risk taking. We are now bearing witness to the sour fruits of moving securities around like meaningless scraps of paper for short-term profit and the securitization of risk into a daisy chain of the unknown and the unmanageable.

Over the past 20 years, the average holding period for stocks has declined from 2+years to just 3 months as of earlier this year. A root cause of the relentless volatility in the equity, commodity, and debt indexes is the steady erosion of long term thinking in investing, not only in this country, but all over the world. How many public company CEOs have lamented the wholly inconsistent demands of managing quarterly earnings expectations for fickle institutional investors while maintaining a consistent long term operating strategy to maximize shareholder value?

It's time for a global re-boot of the investor mindset so that people can start investing responsibly-- there are many reasons why Warren Buffett is such a successful investor, and long-term thinking is one of them.

I can thank Brett Haire, my boss at First Boston during the 1980's, for inspiring me to leave Wall Street and risk arbitrage behind. I remember once asking Brett for permission to accumulate a long-term, unhedged position in the spin-out of a company that we were researching for investment. Brett looked at me, incredulous, and said, "Pascal, we're in the moving business here, not in the storage business." At that moment I realized that I did not want to be in the moving business and initiated the career path that led me to become a venture capitalist.

America needs to get back in the storage business at many levels and actively promote the entrepreneurial spirit that built this country one brick at a time at the same time that we re-build our securities markets. Let's learn from our mistakes.

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.

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

"Fat, Dumb, and Happy"-- Intel CEO Craig Barrett Comments on American Competitiveness at Risk at Aspen Ideas Festival

KPCB's John Doerr interviewed Intel's Craig Barrett at the Aspen Ideas Festival on the impact of technology on our society and dives into the topic of the sustainability of American competitiveness in innovation. This topic is front and center for the American venture capital industry, as the National Venture Capital Association (NVCA) declared yesterday that a U.S. capital markets crisis exists for the start-up community. Just as the capital markets problems for emerging US companies are structural and have been building for years, Barrett accurately points to underlying structural issues in the U.S. educational system that put America at risk of losing its ascendance in innovation leadership.

Some ominous signs-- Intel used to make 90% of its investments in the US-- today the split is 50% US, 50% Asia. While the U.S. still has the best engineering schools in the world, Barrett points out that 60% of PhD graduates from US universities are foreign nationals. He notes that, due to our current visa policy, the US is stupidly sending them home after the US taxpayer has subsidized their education in this country. Watch the video:

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

Missing the Point-- WSJ Reports on Splitting the Chairman and CEO Roles in Public Companies

The Wall Street Journal's January 14th article "When Chairman and CEO Roles Get A Divorce" explores the increasing trend toward separating the Chairman and CEO titles.  Unfortunately, it fails to raise a critically important question-- is it advisable for former CEO's to remain on their own boards as independent directors, much less as chairmen? 

The article points out that "36% of Standard & Poor's-500 companies have separate chairmen and CEO's, up from 22% in 2002, according to the Corporate Library, a research group in Portland, Maine."  The article does not note that the S&P 500 lags significantly behind all public corporations in this regard, as 49% of all U.S. public companies have inside chairmen vs. 51% that do not, according to the Corporate Board Member / PricewaterhouseCoopers Survey, What Directors Think 2007.

The Journal writes in the context of James Cayne's resignation as the CEO of Bear Stearns last week, noting that Cayne remains board chairman.  Reporting from London, the WSJ reporter, Joann S. Lublin, observes the following:

"As at Bear Stearns, splits in the top posts at American businesses are often the result of a leadership transition or financial trouble.  In numerous cases, the chairman is a concern's retired CEO.  Yet the gradual emergence of non-CEO chairmen in the U.S. raises a sticky question: How do you perform a role that rarely existed until recently?"

While the article goes on to discuss the dynamics of groups that have been formed to provide peer support for independent board chairmen, I would like to pose a different, and perhaps more difficult, question.

Why doesn't Jimmy Cayne make a clean break from Bear Stearns and become the chairman of another board?

Keeping former CEO's on the board of your company is generally contra-indicated for several obvious reasons:

*First, most former CEO's have strongly held continuing views and core beliefs as to how the company should continue to be run;

*Second, it is emotionally very difficult for former CEO's to let go of such strongly held convictions; and

*Third, people have a natural tendency to second-guess other people.

These emotionally charged issues are only compounded when a CEO moves to the chairman's role under a cloud of some sort, as Ms. Lublin observes above. 

I wrote an extensive article on this topic in the Spring 1999 issue of Directors & Boards magazine, "The Problem of Emotion in the Board Room", in the context of the challenges faced by public and private companies.  A strong case can be made that former CEO's should normally not remain on the board of their former company, as chairman or otherwise.  They can be great directors and great chairmen, but they should accept these roles at new companies where they can perform in leadership positions without the emotional baggage they carry in the transition from the incumbent CEO role. 

I concluded the Directors & Boards article with the following:

"Walter Wriston, who retired as CEO and as a director of Citicorp in 1984, observed in a 1993 article in Directors & Boards that 'In short, there are a myriad of reasons for the retiring CEO to leave the board, and few if any arguments for the other course... the human desire to stay on with a company that has been home for many years is stong and understandable, but the world is so full of so many other interesting things to do that the desire to stay should be resisted doe one's own sake and for that of the company.' "

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.