More on SOX costs to startups

Apropos of yesterday’s post about the consequences of SOX reducing small firms’ access to public markets, the WSJ reports some data on vc-backed ipos:

[R]egulatory reforms and other changes in the stock market are making it harder for start-up companies to launch initial public offerings of their shares, depriving Wall Street firms and venture-capital firms of lucrative IPO fees and profits. Last year, 41 start-ups backed by venture-capital investors became publicly traded U.S. companies, down from 67 in 2004 . . . .

The article points out that this isn’t just because of the tech stock bust: 168 vc firms went public 1992. Also, the average time from vc startup to to IPO has increased to more than 5½ years from less than three years in 1998.

The article attributes this decline largely to two SOX-related phenomena. First, now that analysts can't be compensated on investment banking business, this has reduced analyst coverage for smaller firms, whose trading generates smaller total fees.

And then also, of course, there’s SOX's new auditing and reporting requirements, which “makes it more expensive to be a public company, requires top executives to vouch for the accuracy of their books and includes stiff penalties for violations, all of which makes start-ups think twice about going public.”

To go back to yesterday's question: Who cares? The WSJ points out that

the trend limits [vc-backed firms’] ability to grow. Public companies can use their own shares to buy other businesses. Without shares, private companies have to tap their own often-limited supply of cash to grow -- or persuade their venture-capital backers to cough up more money.

A comment to my post minimized the problem by saying that “those firms can still get cheap equity capital from the private equity market.” But, as I said yesterday, “investors' ability to exit at the back end into public markets is . . . important to the venture capital market.” The WSJ article quotes a vc fund exec as saying "[w]hen we're making an investment now, we're really assuming [a merger or sale] would be the exit."

So, as the WSJ article points out, while VC firms are "awash in cash for investments these days. . . the trend toward fewer IPOs also is crimping their returns.” Also, “the longer venture capitalists hold investments, the more money they tend to sink into them, potentially lowering returns." Of course, if the returns are lower, the money flow into the funds can be expected to slow.  They may not be "awash in cash" for long.

The article focuses on investment firms' lost fees. In the short term, at least, these firms can chase other opportunities. The bigger problem is the effect all this may have on the level of entrepreneurial activity – the big firms of the future that don’t get off the ground.

Comments

[Robert Schwartz]

My father practiced securities law back in the 1960s. He took a number of companies public. mostly in regulation A offerings of $100,000. All but one of them are gone. The one is The Limited which is worth billions of dollars and is one of the largest employers in this area.

The market that supported those little IPOs disappeared years ago. By the 1990s the little regional brokerages that had created that market and maintained it, had been merged out or driven under.

SOX was just the last nail in the coffin.

Is it a good thing or a bad thing, that micro IPOs no longer exist?

On one hand most of the issuers went under without a trace. So investors lost money. On the other hand investors made a boat load of money on the success stories like the Limited and (another one in central Ohio) Wendy's. To the best of my knowledge the whole thing was actually a winner.

What the micro IPO provided to entrepreneur was a source of relatively cheap public capital, with few restrictions on management. Venture funds are more expensive (at least in terms of dilution and rights) and more onerous. I think the trade-off for the whole economy has been bad and that we need to find a better set of solutions to the problem of entrepreneural capital formation.