The struggle to revive the IPO market is a microcosm of the larger debate: Is government regulation strangling the economic recovery?
IPOs — “initial public offerings” of stock to outside investors — occupy a special place in the folklore of American capitalism. We are, it is said, the world’s most entrepreneurial nation. People with new ideas can raise money, often from venture capitalists, who can recoup their investments many times over through an IPO if the company succeeds. Down that path have traveled Apple, Starbucks, Home Depot, Genentech and many others. But if early investors can’t cash out, they won’t invest in the next round of startups.
Outwardly, the IPO market seems healthy. In 2011, Zynga, an electronic game company, raised $1 billion from its IPO, and Groupon, the cyber coupon firm, tapped the market for $700 million. The Godzilla of IPOs — Facebook’s — might raise $5 billion this spring.
Unfortunately, appearances are deceiving. The IPO market “has never really recovered from the 2000 collapse” of Internet startups, says Harvard Business School professor Josh Lerner, a venture capital expert. “There are some spectacular (successes) — the YouTubes, Googles and Facebooks. Where there’s a drying up is midlevel companies.” From 1985 to 2000, the annual number of IPOs averaged 154, reports the National Venture Capital Association. In 2011, there were 52.
Precisely, contend the venture capitalists (VCs). Only colossal winners can easily do IPOs; many successful, smaller companies can’t. And misguided government regulations, say VCs, are the main reason.
The Sarbanes-Oxley Act is one alleged villain. Enacted in 2002 after accounting scandals at Enron and WorldCom revealed misreported profits, Sarbanes-Oxley imposed costly new auditing requirements to make it easier for top managers and outside accountants to catch mistakes and fraud. But the added annual costs can exceed $3 million, reducing a new company’s profits and its value to investors.
Consider a company with $5 million of profits that might justify an IPO at a multiple 20 times its profits — a stock sale of $100 million. Some money would go to investors, some to the company for expansion. Now suppose its annual Sarbanes-Oxley costs are $2 million. Profits drop to $3 million, and the company’s new value at the same multiple is only $60 million. The company’s appeal to investors falls; so do returns to VCs. The diminishing ability to raise new capital arguably weakens innovation.
The threat isn’t entirely hypothetical. Economist Peter Iliev of Pennsylvania State University studied 301 small publicly traded companies. Though the companies were roughly the same size, some were subject to Sarbanes-Oxley, and some weren’t (there was an exemption based on firms’ market value). Accounting and auditing expenses at the covered firms were much higher; their stock market value was about 18 percent lower, Iliev found. The stock market, he wrote, treats the Sarbanes-Oxley compliance costs “to be a permanent tax on firms.”
To lighten the tax, the venture capital industry wants Sarbanes-Oxley liberalized. It may get its wish. Legislation passed by the House with bipartisan support would generally give companies up to five years after an IPO to comply with the audit requirements as long as the firms’ revenues are below $1 billion.
Case closed? Not exactly. Some economists dispute the adverse effects of Sarbanes-Oxley. Stand-alone startups simply aren’t as valuable as they once were, argue economists Jay Ritter, Xiaohui Gao and Zhongyan Zhu in a new paper. Rather than an IPO, it’s more sensible for many startups to sell to larger corporations. Their profits “will be higher as part of a larger organization that can . . . bring new technology to market faster,” the study says. This, and not Sarbanes-Oxley, explains why most VC-backed startups are acquired by bigger firms. In 2011, there were 429 such purchases.
The case against Sarbanes-Oxley is also weakened by the fact that it doesn’t cover many small, publicly traded companies. Firms with less than $75 million of “public float” (the value of publicly traded stock) are exempt; that removes about 60 percent of public companies, estimates Securities and Exchange Commission Chairman Mary Schapiro. In addition, after an IPO, companies already have a two-year grace period before complying. In a letter to the Senate, Schapiro cautioned against relaxing audit standards. “Too often, investors are the target of fraudulent schemes disguised as investment opportunities,” she wrote. VCs counter that companies are still subject to anti-fraud prohibitions.
The contest between regulation and deregulation rarely poses a black-and-white choice. There are competing goals and narratives. Here, the quest for greater reliability in accounting statements competes with greater freedom for entrepreneurs and their backers. It’s the fear of financial fraud against the lure of new products, technologies and jobs. Which deserves precedence now? High unemployment and the sluggish economy suggest erring on the side of risk-taking and expansion.