The Rise of the Secondary Market for Emerging Growth Equities– Necessary But Insufficient

On Tuesday, May 10 I joined Sandy Robertson, Ian Sobieski, Lee Hower, and Scott Painter as a panelist at the SharesPost Executive Forum held at the Rosewood Hotel on Sand Hill Road.  Below are excerpts from some of my comments with some additional explanation that time constraints didn’t allow me to include in my remarks:

Our moderator, David Weir (CEO of SharesPost), opened the panel by framing the liquidity problem for VC-backed companies as follows:

  1. Framing the Issue
    1. Amount of venture capital raised has exploded
      1. i.     Pre bubble period 1991-1996 totals $28 billion
      2. ii.     Bubble period 1996-2000 totals $243.6 billion
      3. iii.     Post bubble period 2001-2009 totals $218.2 billion
    2. Number of IPO’s has shrunk while average size has increased
      1. i.     Pre-bubble average 520 IPO’s per year
        1. 80% of IPO’s <$50MM
      2. ii.     Bubble period IPO’s average 539 per year
      3. iii.     Post bubble average IPO’s 129 per year
        1. Less than 20% of IPO’s <$50MM
    3. Median age of a venture backed company hits 8.7 years in 2007- the longest gestation period since 1991:

      What has driven these changes to the capital markets and are they permanent or temporary?

My full answer to this question follows:

Public companies with equity market capitalizations of less than $1 billion have been negatively impacted by these market changes—and within this group, companies with capitalizations of $500 million or less have suffered the most.

I strongly disagree with the argument that these are cyclical changes driven by macro-economic forces.  In the U.S. these are very clearly structural changes.

Whether or not they will be permanent depends on our legislators and the securities regulators—before anything can change to establish a positive trend, both of these groups must first recognize that the problem we have today is the result of the convergence of two different but related forces: a series of technology driven structural changes in the equities marketplace combined with unintended consequences of well-meaning but poorly conceived securities regulations applied to that marketplace between 1996 and 2003.

A longer exposition of the factors listed briefly below can be found in extensive research on this topic developed by Grant Thornton (David Weild and Edward Kim):

1996: The rise of online discount brokerage led to the loss of retail commissions supporting small cap stocks (this was a technology driven change in the market);

1997: The implementation of the New Order Handling Rules, passed in September 1996, which had the effect of reducing the economics to provide support for stocks by market makers as they became bystanders and the bulk of the trading action moved off-exchange to electronic execution. (This is a good example of technology driven market change being accelerated by new securities regulations).

1999: Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm-Leach-Bliley Act.  This enabled consolidation among the brokerage houses and banks, which led to the loss of multiple distribution channels for securities and reduced the ability for small players to survive.

2000: Regulation FD was passed to create a “level playing field”, reacting against whisper numbers, favored research analysts, and the “hedge fund information advantage”—all in the name of giving everyone simultaneous access to the same corporate disclosures—which absolutely did not happen.

2001: Decimalization (further loss of economics to provide market support for small companies), by reducing minimum commissions from 12.5 cents or 6.25 cents to 1 penny or 2 pennies per share, had the unintended consequence of making it unprofitable to make markets in emerging companies that are not well known, relegating them to being thinly traded and ignored by most investors.

2002: Sarbanes-Oxley creates more friction for companies that want to go public, but likely much less of a factor than people think, by imposing accounting and compliance costs for small companies that easily exceed $2 million per year.

2003: Spitzer’s Global Research Analyst Settlement, which had the unintended effect of depriving small companies from getting research coverage.  The Spitzer settlement further gutted the economics for underwriters to provide company research in the aftermarket since research cannot be paid for with underwriting fees.

To be clear, the sum of all these parts means that, in the US, the public marketplace for companies with less than $500 million in market cap is a Ghost Town.

We should all be concerned about this because small companies are the engines for job growth and new job creation in America.  The NVCA has developed research going back forty years showing that over 90% of the job growth created by venture-backed companies occurs AFTER their IPO.  So it should be no surprise to our government and to economists that we aren’t getting the job growth that we need in our tentative recovery from 2008—we need IPOs to create jobs.

It’s nice to point to the few favored companies in the media right now that are attracting all the attention—such as Facebook, Twitter, Linked In, Zynga, Groupon, and a few others—but there are over 20,000 other venture-backed companies that are in purgatory—even if only 10% of those companies could go public as small cap companies, that could be transformational in terms of job creation and also materially improve the liquidity cycle for the US VC industry overall.

Some critics argue that the market is telling us that these companies aren’t ready to go public, using the bursting of the bubble in 2001-2002   as the prime example of what happens when companies that should not go public come to market.  In my view, this is a myopic analysis for one simple reason.  Success in business rarely happens in a straight line.  Many very successful companies go through “near-death” experiences in their evolution, and successfully executing an IPO raising less than $100 million in capital should remain an option for young companies.  The market may have a taste for $100 million initial public offerings today, but that’s because there is a liquidity problem, not because there is something inherently wrong with raising $50 million or less in an IPO.

Consider the following companies that all raised $50 mm or less when they went public: ADOBE, AMAT, EA SPORTS, YAHOO, XILINX, INTEL , ORACLE, EMC, DELL SYMANTEC, COMPUTER ASSOCIATES, INTUIT, NETAPP, AND PAYCHEX, to name a few.  And let’s remember that, at the time of these IPO’s, few if any of these companies were household names.  How many of the next generation of future category leaders will be stillborn or lapse into obscurity through acquisition because they could not access the public markets to stay independent or viable?

When you boil it all down, the fundamental reason for the lack of small US IPO’s has to do with the absence of liquidity in the aftermarket for small cap public stocks.  The emergence of a more liquid secondary market, facilitated by market makers such as SharesPost and SecondMarket, is a necessary and important answer to the structural dysfunction of the primary public equity markets for emerging growth companies in America.  But it is not enough.

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