Facebook’s IPO has raised hopes in Silicon Valley that the tech industry’s days of wine and roses will soon be back with hundreds of start-ups going public. Even President Obama seems excited. He recently proposed an “IPO on-ramp” to help young, smaller companies go public.
Sadly, everyone is going to be disappointed.
We are not going to see the flood of IPOs that happened during the late 90’s. The rules of the game have changed. The infrastructure to facilitate IPOs is no longer there, and the regulatory environment has changed. Joe Grundfest, a professor and a colleague at Stanford Law School, outlines four reasons why the path to the IPO has become so steep for aspiring companies.
First, regulatory costs for companies that aspire to go public have increased substantially. Lawyer and auditor fees have mushroomed in the wake of the Sarbanes-Oxley Act, and these professionals cannot be paid in stock. They require cold, hard cash that could otherwise be spent on engineers, sales staff, hardware acquisition, marketing, and other revenue generating functions. Then, once a company goes public, it has to scale up its board membership to comply with more extensive governance requirements as outlined by the NYSE and NASDAQ. And larger boards are more expensive in terms of both the cash and equity commitments required on the part of the company.
Second, the financial markets have changed. It is increasingly difficult for a new company to persuade investors that its investment thesis isn’t otherwise captured in a more efficient form by any of a number of industry-based indexes. Only larger companies with a unique story can pass this hurdle. This means that companies such as Facebook and Google can still go public, but an army of smaller, less-differentiated firms will have a hard time.
Third, the analyst sector, which does the intense, company-specific grunt work for IPOs, has been decimated. The Wall Street Analyst settlement, which tried to remedy the misleading reports that analysts were allegedly publishing, eliminated the incentive for financial firms to hire the armies of analysts necessary to cover smaller IPOs.
Fourth, many of the largest and most successful sectors display winner-take-all characteristics early in their evolution. Again, look at Facebook and Google, both of which have been buying up companies that are either in direct competition or are developing complementary technology. In the 1990’s, the smaller companies might have survived to be able to go public, but not today. Put another way, in the 1990’s we could run the race to find the dominant firm after the competitors went public. Today, however, the race is usually over early in the game.
So, the tidal wave of IPOs isn’t going to happen. But this isn’t a bad thing.
Yet another professor from Stanford Law School, Dan Siciliano, says that venture capitalists prefer companies with as clear a path as possible to an IPO. Why wouldn’t they? IPOs provide big returns, great liquidity, and positive publicity.
It used to be that VCs’ preference for the IPO determined the fate of most tech startups. Today, the VC’s IPO preference is becoming increasingly irrelevant because most technology startups, especially those in software and cloud computing, don’t need as much money to get off of the ground as they used to. Fledgling tech companies have a larger network of angels, incubators/accelerators and sometimes the relatively deep pockets of their own serial entrepreneur founders. This makes it possible for some companies to achieve break-even cash flows earlier than in the past.
Siciliano argues that an over-heated technology IPO environment can create a frenzy of VC funding like what we saw during the dot com bust—when start-ups made the all or nothing dash to the IPO. This leads to unhealthy boom and bust cycles. What is better is to have companies with a long-term focus—which grow and add jobs steadily. VCs and entrepreneurs looking for exits can always pursue acquisitions by long term players.
So we don’t need to be overly concerned if we don’t see a burst of IPOs. The innovation and job creation will still happen. These jobs just won’t be in investment banking. We just need the IPO market to remain robust enough to periodically mint future angel investors and provide the healthy returns for top-tier venture capital firms.
Full disclosure: The Washington Post Co.’s chairman and chief executive, Donald E. Graham, is a member of Facebook’s board of directors.