pascalsview

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

Aspen Ideas Festival: Peter Hirshberg Interviews Jim Steyer About How Children Must Learn Responsible Digital Citizenship on the Web

Technorati's Chairman,Peter Hirshberg, is on the move at the Aspen Ideas Festival-- his video blog provides an excellent forum for impromptu commentary from influential thought leaders in various fields who are attending the conference (link below). Globally, children are developing differently as a result of the pervasive influence of the Internet in their social relations. Jim Steyer, CEO of Common Sense Media, explains why it is imperative to define 'rules of the road' for every kid on the Internet and the role that his organization plays as a thought leader in this area. According to Steyer, "this is a huge issue of ethics and responsibility . ... kids get this, parents are clueless but know they should." Despite many challenges when it comes to media content regulation, Steyer is optimistic about the future. This important discussion that ties directly into the that we discussed at our Socrates Society seminar last week on issues of the Media and our Conflicting Values. to watch the video: click on the following link:

http://fora.tv/myfora/PeterHirshberg/clip/127/Aspen_Ideas_Festival_Interview_Jim_Steyer

Re-Defining the Public Interest in the Media Torrent of the Internet

Media and Our Conflicting Values: Day 3

On our last day of this Socrates Seminar, we jumped squarely into the discussion of the Internet that we all wanted to have since Day 1.

First, we acknowledged the disruptive transformation of the media away from its historical one-to-many controlled distribution model, which was largely restricted to professionally produced print, radio, and linear video broadcasting content. We discussed how the Internet’s broadband infrastructure has supported the development of a global multi-media content stream now defined by many content creators, both professionals and amateurs. Today we are inundated by countless streams of data broadcast in a free flow of information that is truly a torrent of bits.

Research has shown convincingly that the attention span of Americans has shortened substantially over the past several decades and that the rate of change in this direction continues to accelerate.
Are we doomed to being Information Snackers, a nation of dilettantes distinguished only in being a mile wide and an inch deep in our thinking? Does this trend raise troubling questions and pose risks to the integrity of our democratic society?

I think so. Why?

First, because we are drowning in choice. While America’s obsession with Freedom is empowering, too much choice is debilitating. We have too many choices in the Internet Age of mass customization in digital media. While people like to speak of their love of choices, in fact, people hate choices. Notice the incredible power of global brands today after the initial view that the dawn of the Internet rendered traditional brands worthless.

What are some of the nasty implications for democracies overwhelmed by media choices? In my view, the hyper abundance of choice makes individuals increasingly susceptible to manipulation by groups that have an agenda—especially an agenda associated with power and manipulation of masses of people (does anyone doubt that Al Qaeda has developed a sophisticated web presence, for example?)

The web has massively reduced the costs of coordination among large groups and truly revolutionized social collaboration on a large scale—for a positive example, consider the fundraising powerhouse of the Obama campaign and the massive empowerment and inclusion in the democratic political process of otherwise alienated and disenfranchised groups of American society.

There are many good things associated with these paradigmatic changes in the American political process enabled by the Internet borne media revolution.

But we should also consider the corner cases, the potential for abuse, for manipulation, for the propagation of lies through the digital media. We need to remember the potential for Tyranny of the Majority in a digital media search construct that determines what rises to the top by its popularity.

As Newton Minow, Chairman of the FCC said in his historic address to the National Association of Broadcasters in 1961, “some say the public interest is merely what interests the public. I disagree. … broadcasting, to serve the public interest, must have a soul and a conscience, a burning desire to excel, as well as to sell; the urge to build the character, citizenship and intellectual stature of people, as well as to expand the gross national product.” Promoting citizenship! A novel concept, and one that I have written about extensively in this blog in the context of the Democracy in America Revisited Series and Professor Michael Sandel.

In my view, being right and doing the right thing should have nothing to do with what is popular and everything to do with the responsible exercise of leadership (something that is in very short supply in America today). Having technology drive people to the most popular result only accelerates the mediocrity that Alexis de Toqueville foresaw for American democracy.

We should not let our passion to uphold the First Amendment’s guarantee of freedom of speech trump the obligation that we have as a democratic society to keep our citizens informed of objective facts so that they can responsibly exercise their civic responsibilities. To be clear, I do not see this statement as being unsupportive of the First Amendment in any way.

Unfortunately, our discussion on Day 3 did not address a redefinition of the Public Interest.

Domain expertise, an objective mastery of the facts and the nuances associated with a specific body of knowledge, requires more than a passing acquaintance with that domain (would you go to a doctor for surgery who is not truly an expert in his/her field?). In my view, the knowledge crisis facing our next generation will be rooted in the misconception that surface knowledge is sufficient to impart expertise.
We are certainly still in our infancy in this new realm of digital media, but it is abundantly clear that technology has left our regulatory institutions in the dust. While I am a strong believer in the positive power of the market, I fear for those members of our society who will be left behind, for the voices that will not be heard.

The Government is a steward of the Public Interest, and that Public Interest will, of necessity, be redefined when we face a crisis. There needs to be a cool hand, a slow, deliberative process, that gets us to the right answer. Unfortunately, the history of regulation in America shows us that it is most often reactive and likely to generate severe, negative unintended consequences (Sarbanes Oxley, for example).

While I greatly enjoyed our Socratic discussion, I left the seminar continuing to ask myself, what will force this question, and how great a cost will our society bear along the way?

"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:

Of Free Markets, Regulation, and Tipping Points

A very interesting Day 2! Some highlights:

First Amendment issues and the specific domain of government regulation over free speech are narrowly confined to content creators over the licensed spectrum. For example, had the famous Janet Jackson Super Bowl breast exposure incident occurred on cable TV as opposed to broadcast TV, there would have been no regulatory issue over indecent exposure and hence no grounds for the FCC to get involved.

In short, you can be the willing consumer (or the inadvertent and unwilling spectator) of the most indecent behavior embedded in content on cable TV anytime and cannot object to it on grounds of Public Standards of decency because you have paid for the basic cable TV transport infrastructure. If the content is broadcast over the government licensed spectrum, then it's a totally different story, as you have entered the domain of the Public Trust.

Today, 95% of US homes are passed by cable and increasingly ubiquitous access to the Internet brings streaming media of just about anything you can think of all the time. Most people get their content from new forms of media that are unsupervised and unaccountable to anyone other than The Market. Many people may feel this is not a problem at all-- on the contrary, they may see it as a blessing.

Licensed spectrum broadcast content is now dwarfed by other media transports. In short, the domain of the Public Trust, and thus standards of socially and morally acceptable program, are hurtling toward irrelevancy in our new digital world.

My problem with this is that a few clicks away for ANYONE, especially children, you will find abominable violence, graphic examples of human enslavement for sexual exploitation, and hard core porn. The evidentiary record is increasingly showing that exposure to these types of negative human behaviors has a bad influence on children and absolutely impacts their social development.

The consequences of these trends are not well understood, but, in my view, these tectonic shifts in the landscape of content distribution will reach a tipping point that will trigger new regulation. Can the market self-regulate? Perhaps, but at what cost in the process? While America was built on freedom of speech, the proliferation of freedoms in the Digital Age may substantially fray the fabric of our society before we reach a new equilibrium.

Whether or not we think this is a good thing, we are already in the soup.

Am I My Brother's Keeper? Stewardship of Media Content in the Internet Age

Today we began our Summer 2008 Aspen Institute Socrates Society seminars. My session, moderated by former FCC Chairman Michael Powell, addresses Media and Our Conflicting Values. And plenty of conflicting values emerged in our lively four hour discussion.

My takeaways after Day 1:

* The function of the FCC as public trustee, or steward, of the content broadcast by licensed content creators in America has been made largely irrelevant by the Internet. Historical approaches to media regulation in America are not useful in addressing the challenges of today and of the future, in my opinion.

* We live in a many-to-many world of content generation and broadcasting. The super-empowered individual on the Web wields disproportionate power over groups ranging from a small affinity circle to an entire society.

*Large media organizations also continue to wield huge power in disseminating information and in 'spinning' or biasing content. While the Founding Fathers saw Government control of media/propaganda as the primary threat to free speech, we now live in a brave new world where any fanatic can wrap him or herself in the mantle of truth and spread lies unchecked.

* Defining regulatory boundaries is infinitely more complex when you have a multiplicity of transport mechanisms for different forms of protected free speech from a First Amendment perspective: for example, traditional linear over the air broadcast television, cable television, user-generated content on the web, and newly emerging forms of time-shifting content distribution (what I want when I want it on any device).

* Regulation of speech in any way raises fundamental societal challenges to open, democratic societies.

* The social contract of any democracy faces a basic tension between freedom and maintaining social order.

* Technology combined with human innovation in the media are exacerbating this tension in ways considered impossible just fifteen years ago.

So after Day 1 I have a lot of questions:

When it comes to regulating media and the web, how are we to decide the mechanisms for regulation?
Are we to expect the market to self-regulate? How do we distinguish between content that the market should self-regulate (various forms of entertainment) from content that debases and violates basic human rights (sexual slavery and child pornography on the Web)? How do we stop groups that re-write history (such as Holocaust deniers) from simply opening up shop on the Web and perpetuating lies? How do we prevent false stories about political candidates from being seen and accepted as fact by millions of people prior to elections?

Maybe I'll have some answers, and certainly more questions, after Day 2. This is why we love the Socratic method. For another perspective on the Socrates Seminars, check out Sam Perry's post on Conferenza.