Regulation didn’t kill the IPO star

March 23, 2011, 12:24 AM UTC

Want to raise some money for charity? Get Paul Sarbanes and Michael Oxley atop a dunk tank, and invite every venture capitalist you know.

The former legislators — and the 2002 investor protection law that bears their names — have become whipping boys for venture capitalists who have a tough time taking their companies public. The companies are fine, they say. It’s the regulation that is to blame.

Enter the Wall Street Journal editorial board, which has reiterated these arguments in a piece titled What Happened to IPOs? The op-ed coincides with a U.S. Treasury-sponsored conference on how small businesses can better access expansion capital. Plus it doubles as a chance for WSJ to kick out its free-market jams. Here’s a sampling:

The problem is real… It’s unrealistic to expect a repeat of the late-1990s Internet boom, when annual IPOs twice exceeded 270. But how about the early 1990s, before the dot-com mania skewed the numbers? The U.S. averaged 160 a year from 1990-1994, three times the current rate…

New companies are the lifeblood of a capitalist economy. Every venture-backed start-up that grows into a public company could be the next Google, Intel, Starbucks or Amgen. Venture investment adds up to 0.2% of U.S. GDP, but the revenue of companies created with such investment amounted to 21% of the economy in 2008. The diminished ability of start-ups to hit the long ball with an IPO discourages investments at all the earlier stages. Venture capitalists know they need some equity home runs to offset losses in the thousands of firms that never find a market.

At today’s conference, the debate won’t be whether the system of growing young firms into public corporations is broken but over who killed this market and how to fix it. The elephant in the room is the 2002 Sarbanes-Oxley law, which triggered billions of dollars in new compliance costs for public companies.

Ok, let’s take a deeper look at some of these claims:

1. VC-backed IPO activity is unusually low.

It is true that that far fewer VC-backed companies went public in the 2000’s than in the 1990’s. But WSJ leaves the impression that SOX — enacted at the end of July 2002 — was the tipping point. Instead, the real drop-off came between 2000 and 2001, when the number of VC-backed IPOs plummeted from 263 to 41. Moreover, only 22 VC-backed companies went public in all of 2002 (18 of which came before SOX was enacted, but that pace is still much more sluggish than is today’s).

Then there is the issue of mergers and acquisitions, which WSJ ignores completely. IPOs may represent capital formation and jobs to politicians and op-ed writers, but they represent “exits” to venture capitalists. In other words, a way to cash out of a long-term investment. And, when it comes to exits, M&A often is a superior alternative to IPO.

How come? Four reasons:

  1. M&A usually allows VCs to cash out completely (one time payment), as opposed to IPOs that require them to bleed out slowly.
  2. An M&A allows VCs to turn their attention to other portfolio companies, as opposed to IPOs that often require them to stay on the board of directors (or otherwise advise the now-public company).
  3. M&A is less risky than IPO, since the share price doesn’t change due to macro economic issues beyond a VC’s control. Also, M&A exits like YouTube and EqualLogic prove that IPO isn’t the only way to get massive returns.
  4. Not all VC-backed entrepreneurs want to go public. Not because of SOX, but because they are serial founders who view their job as to build something, sell it and move on to the next thing.

Not surprisingly, VC-backed M&A has been on the rise for the past two decades. There were just 20 such deals in 1990, compared to 431 last year. Does the WSJ not think it’s possible that VCs simply have developed an alternative exit for many of their companies?

2. Earlier-stage investment is being discouraged.

When it came to IPOs, WSJ asked that we look back at 1990-1994. Okay. What we find is that 2,792 U.S.-based companies raised venture capital during that period, compared to 8,548 companies that raised venture capital between 2006 and 2010. And that last number doesn’t include the ever-increasing number of “lean” companies being funded by individual angels (only institutional investments are tracked in the MoneyTree data).

In other words, WSJ does not have any quantitative evidence that SOX is discouraging early-stage investment. That’s probably why it simply made the specious claim and moved on.

3. Who “killed” the IPO market? The same person who killed Mark Twain (well, before he died for real). VC-backed IPOs just aren’t dead. Last year’s 72 offerings raised more than $7 billion. Not only is this a massive improvement on the 18 VC-backed companies that raised $2.1 billion in 2008 and 2009 combined, but it also is easily better than the 41 VC-backed companies that raised $3.4 billion in 2001. In fact, VC-backed IPOs in 2010 raised more than twice what they raised in 1998 (see WSJ, anyone can make the numbers work to their advantage).

Indeed, the biggest difference between the past and present VC-backed IPO market is not the number of issuers. It’s the size and quality of issuers.

VC-backed IPOs are larger today than they were in 2002, but the upswing began long before SOX was enacted. Maybe it’s because VC-backed companies going public are particularly ambitious from a growth perspective (given the alternative of selling via M&A). Maybe it’s because banks have become progressively less willing to bother will small underwriting fees. Maybe it’s because the public markets got burned by dozens of pre-revenue companies that used IPOs as financing events, and told such companies to find growth equity in the private markets.

And maybe SOX does, indeed, play a role by putting large burdens on small companies and small burdens on large companies (as a percentage of market cap). And by burdening CEOs with a variety of unwanted responsibilities.

But SOX is hardly “the elephant in the room.” It’s just a tangential scapegoat.