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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.

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.

Fred Amoroso and Carol Bartz on Director Accountability and the Value of Annual Board Assessment

SpencerStuart recently published the 2007 Silicon Valley Board Index, which updates useful statistics on Silicon Valley public boards, ranging from average annual board retainers for directors ($35,600 in 2007 up from $25,000 in 2003) to the continuing lagging percentage of female directors serving on Silicon Valley public boards (48% in 2007, up from 44% in 2003 but well below 91% for the S&P 500).

This year's report also includes a Roundtable Discussion featuring Carol Bartz, Executive Chairman of the board of Autodesk (formerly also President and CEO) and a Cisco director; and Fred Amoroso, President and Chief Executive Officer of Macrovision and Chairman of the board of Foundry Networks.

Co-authors Nayla Rizk and John Ware of SpencerStuart pose the following question, which is of particular relevance to VC-backed private company boards:

"Clearly, the way boards see their role has changed.  One way more boards are using to continually define their role and hold themselves accountable is the annual board assessment.  How do your boards handle evaluations?  Do you conduct individual evaluations?"

AMOROSO:  We've actually spoken a lot about whether we should do formal evaluations and, to be honest, it's a sensitive topic.  Not everyone likes to go through that level of scrutiny.  We've offered a kind of self- awareness approach.  A few of our board members have actually gone out and participated in director training in different areas, so they are more aware of some of these things. . . . Board training is going to be one of the things we'll see more of over time.

BARTZ: We do have board evaluations. . . . We've actually found it quite useful to collect information from each member and then tally it.  Then we can talk about it-- such as, "We've all given ourselves a low score here, what do we want to do about it?" . . . It's very important to be self-aware.  Even though we don't evaluate directors person by person, the board evaluation process makes everyone self-aware.  We include questions such as "Does everybody participate?"  "Is everyone adequately prepared?"  And if you are sitting around the room and we collectively got a low score on "Is eveyone prepared?", then you have to do a little self-evaluation.  You know, "Gee, maybe they are talking about me."  I think it is very effective.

As I read through these answers, I was struck by the fact that these observations are equally true for private companies.  As we have written in "A Simple Guide to the Basic Responsibilities of VC-Backed Company Directors", avoiding scrutiny of their own actions is a natural inclination for company directors because the CEO reports to the board. 

But shouldn't the board be held accountable to an absolute minimum standard of acceptable performance? Yes!  It is a critical legal requirement, through the exercise of the director's duty of oversight, to scrutinize company management.  At the same time, directors cannot be exempt from scrutiny themselves--  lest we forget what has occurred at the Adelphia's, Tyco's, and Enrons of the world...

As Bartz, points out, generating self-awareness is the key-- to the extent that asking questions about elements of the board's collective performance generates a "Gee, maybe I..." moment, that is a positive accomplishment.  These are basic best practices for large and small companies, whether they are public or private. 

Dennis Kozlowski, Mark Swartz, and "the Niceties of Corporate Governance"

 

Floyd Norris posted a story in his blog in today's New York Times, "Unhappy Birthday, Dennis", citing the New York State appellate court's unanimous ruling upholding the criminal convictions of Dennis Kozlowski and Mark Swartz for "grand larceny in the first degree (12 counts), conspiracy in the fourth degree, violation of General Business Law § 352-c(5) and falsifying business records in the first degree (8 counts)", otherwise known as stealing millions of dollars from Tyco and Tyco's shareholders.

In his blog post, Norris walks down memory lane and notes how he wrote a column in 1999 questioning the integrity of the Tyco juggernaut, whose astronomical growth throughout the 1990's was often compared to that of General Electric under the stewardship of Jack Welch.  Bringing us forward to the present day, Norris reflects:

"An investor who bought when I wrote back in 1999 could have gotten out with a nice profit a few months later. But if he held on, he would have since lost a third of his investment.  In that 1999 column, I quoted Mr. Kozlowski as saying there was “no risk that investors will wake up one day and find out there’s something wrong.” Perhaps the operative part of that forecast was “wake up.”

Based on my own direct experience with Kozlowski and Swartz in the context of Tyco's AMP acquistion in 1998-1999, in 2002 I wrote an extensive expose of the Tyco fiasco in Directors & Boards Magazine titled "Tyco's Betrayal of Corporate Governance".  This story followed my Spring 1999 story, also featured in Directors & Boards, titled "The Problem of Emotion in the Boardroom", which dissected the topic of emotional dysfunction in both the public and prviate boardroom, using the example of the board dynamics at AMP, which was Tyco's last major acquisition ($11 billion).  In this case, in October 1998 Tyco interceded as a "white knight" to Allied Signal's hostile takeover bid for AMP in August 1998.

In reading the appellate court's decision (click here for the full text of the decision), I found it particularly galling that Mark Swartz and Dennis Kozlowski have persisted in claiming that they were legitimately entitled to the egregious compensation that they awarded to themselves.  Happily, the appellate court blasts this claim:

" More significantly, though, the entitlement claim was flatly refuted by Mark Foley, the Tyco executive who was responsible for the calculation of the year-end figures on which the annual bonuses were based. In fact, Foley's testimony unequivocally established that defendants received everything they were entitled to under the end-of-the-year formula. Thus, defendants' claims only succeeded in pitting their credibility against that of the committee members and Foley and various other members of their own staff. Defendants even contradicted each other on a number of points. The jury's resolution of this factual issue is amply supported by the weight of the evidence since defendants' self-serving testimony was illogical, internally inconsistent, refuted by Tyco's records and shown to be false by all other witnesses."

But I find the implications of Swartz and Kozlowski's assertions that corporate governance process is irrelevant even more disturbing:

"Most notably, Tyco's annual proxy statements, prepared under defendants' supervision, failed to indicate even the most oblique reference to their multimillion-dollar midyear bonuses. This documentary void revealed more than a few isolated "procedural irregularities," as Swartz maintains, or a "fail[ure] to adhere meticulously to all of the niceties of corporate governance," as Kozlowski would have it. Rather this consistent pattern of documentary omission over a period of years constituted powerful evidence of defendants' intentional hiding of these payments from the directors and led inexorably to the jury's conclusion that defendants took these bonuses without permission or authority. The absence of any reference to these transactions in the chain of documentation available to the committee clearly demonstrates defendants' coverup of their thievery."

Happily, the court soundly rejects these notions, yet I am deeply troubled that anyone, even a desperate person such as Kozlowski, would consider the approach that portraying corporate governance requirements as a "nicety" might carry weight with a panel of judges.

The requirements of corporate governance are not niceties.  They represent necessary processes with a fundamental purpose-- to protect investors and to safeguard the duties of responsible stewardship and oversight that define core director responsibilities.

Kozlowski and Swartz amply deserve to serve their full jail time, and it is cold comfort for investors who lost billions of dollars to see this small measure of justice strongly reaffirmed by the appellate court of the State of New York.

I wonder if Dennis was able to stick a small birthday candle in one of his delicious jailhouse vending machine Payday candy bars today to celebrate his 61st birthday?