Reopening the IPO Window
High-Tech Startups Need Access to Public Capital
An EVITA (Entrepreneurial, Venture-backed, Information–dependent, Technology-flavored Activity)-driven economy is not, at first glance, a hostage to malfunctions in federal securities laws that govern the issuance of stock in startup companies trying to commercialize science and technology innovation. After all, startups are privately held until they go public or are purchased by listed companies. Young tech companies have plenty of freedom to prosper or fail before they ever ask a public investor to buy their stock.
Initial Public Offerings historically have been a pillar of U.S. venture capital.
What’s more, private stock sales are advantaged by the safe harbor in Regulation D, whereby young companies can access capital from accredited investors who are deemed sufficiently sophisticated by regulators to understand the risk of investing in high-risk, high-reward private equity. This means young entrepreneurs and their private capital backers have legal, although limited, access to the vast pools of alternative-investment players in U.S. and global capital markets.
There is, however, room for significant improvement in our federal securities laws to help young and promising—though still very risky—emerging growth companies tap the public markets for funds to fully commercialize their products and services. Why? Because Initial Public Offerings historically have been a pillar of U.S. venture capital. An open and liquid public market receptive to high tech companies in relatively early stages of their development allows entrepreneurs and their VC backers to construct their pricing models and to value their portfolios.
This is critical because the use of IPOs in standard portfolio-pricing models invigorates the private investment process up and down the line. IPOs justify a portfolio of risky investments on the theory that, if some percentage turn out to be “portfolio makers” as a result of an IPO “exit,” in which the venture capital investors are able to sell their equity in a startup at many times the amount they initially invested, then the VCs can take risks they would not otherwise be in a position to take if company sale were the only way to monetize their investments. The IPO is the rising tide which lifts all boats.
Moreover, IPOs add to the choice of available public securities for investors to review and allow venture-backed companies to grow as independents—think Microsoft, Yahoo, Google, Amgen—and not a division of IBM, Time Warner, or Pfizer. Without venture capital backing, Apple Computer, Intel, Yahoo, Amazon.com, and e-Bay would be ideas, and not mega-corporations.
Problems in the IPO Marketplace
The IPO market comes and goes, of course. But, so far at least, even though it shuts down every now and then, it has always returned. This time, we are not so sure. One unintended result of the crackdown on corporate fraud and investment banking malfeasance is the demise of research analysts covering new and small companies. Newly public companies, if not covered by the analysts employed by the investment bank which brought the company public, often have no research coverage at all, which in turn means institutional investors will probably not invest in these stocks.
But consider this: When Intel went public in 1970, it offered $8 million of stock and sported a market value of $53 million.
Today about 60 percent of the stocks trading on the Nasdaq stock exchange have one equity research analyst covering them, and 40 percent have none. Not surprisingly, the combination of the absolute abandonment of small- to mid-cap research and market-making by underwriting firms, and radically higher costs for small cap-issuing companies, has substantially raised the bar for the size of company that can go public on today’s Nasdaq.
As recently as 1996, the average deal size of a Nasdaq IPO was $34 million, and the average market capitalization was $133 million. Ten years later, the average IPO deal size was $113 million, and the average market cap was over $330 million—a size that only a much bigger company can sustain. Some of this is the inevitable byproduct of the spectacular crash of the late 1990s technology bubble, during which it was clear that some companies went public too early.
But consider this: When Intel went public in 1970, it offered $8 million of stock and sported a market value of $53 million. Cisco Systems Inc.’s IPO in 1990 raised only $50 million, at a price which yielded a post-deal market cap at IPO of $226 million. E*Trade Financial Corp.’s initial offering raised $59 million in 1996 at a market value of just $165 million. The point is that these companies created the majority of their value and the jobs that came with that value after they were public. Today, these three companies sport market caps of about $126 billion, $160 billion, and $9 billion, respectively, and employ among them hundreds of thousands of people.
Today, unfortunately, few if any of these deals would be doable. The offering and overall market value of companies akin to Intel, Cisco, and E*Trade would be too small for most underwriters. The more likely outcome is that the companies would be sold. In fact, again for the last six years running, 90 percent of all the exits from venture-backed companies have been through mergers-and-acquisitions transactions instead of through the IPO market, which accounted for well over half of the exits in the 1990s.
This is the real competitiveness issue. The evidence suggests that we are now killing our most promising companies, our future “national champions,” before their time. Does anyone seriously believe Cisco would have grown more if it had been acquired by Digital Equipment, or that Microsoft would have thrived inside IBM?
Most young tech companies that manage to go public today end up berthed in the so-called “orphanage” among other penny stock listings, with the stock price trailing off, and trading diminished to the “trading by appointment” level; this is particularly true if they go public through the back door—by virtue of a shell or so called SPAC reverse public offering. Penny stock listings are not just illiquid, meaning they lack enough trades to generate interest among general investors. They are also ripe for manipulation by stock speculators. Such a financial environment tilts strongly against the IPO as an exit mechanism for venture capitalists and their entrepreneurs.
Add in the geometric increase in litigation by the plaintiffs’ bar as stock prices spiral downward and you have a situation where an increasing number of issuers in the venture space will simply dump the IPO prospect and sell out at the first opportunity. This is bad news all around for the venture industry.
Pragmatic Policy Steps
But caution is, of course, the rule in this area when considering reforms. U.S. securities regulation has served this country, and the EVITA sector, well since 1933. So what to do? There are several steps to take.
We need to enact so-called “broker/dealer lite” regulation, which would qualify the hordes of unregistered “finders,” many quite legitimate, who currently operate as money finders in a legal “gray area.” The Securities and Exchange Commission has rightly concluded that private placements will be advantaged if companies willing to abide by a realistic rule are offered a relatively inexpensive and uncomplicated system—the “lite” in broker/dealer “lite”—for registering that recognizes their limited scope of operations. The regulation is on the launching pad—we need to launch.
We also need to clean out the 10,000 or so nominally public companies with no reason to remain public other than providing a feeding ground for penny stock fraud. The ability to take, at reasonable costs, companies in the so-called orphanage and make them private again, or to merge them, will clear the U.S. markets of confusion and clutter. We need a streamlined system for micro-caps to revert to private status fairly and cheaply.
We also need to re-open the IPO window for venture-backed companies with market caps between $200 million and $700 million by, among other things, developing new regulations and new incentives for equity research analysts to provide unbiased research coverage of these companies for institutional investors. The trick is to work out compensation regimes for coverage of mid-cap companies by talented people. The British know how to do it and we can take a page out of their book.
Finally, I believe we need to pull together the best minds to work out a new trading system that will enable qualified private issuers—emphasis on qualified—to file on their Web site, if they so elect, information which mimics the digital data rooms that VCs require in EVITA transactions—and not a 200-page prospectus designed to please an audience of bureaucrats—and permit limited trading among qualified—emphasis again on qualified—investors. These two steps would server as a warm up to a full dress, fully baked IPO if intermediate market performance warrants it.
What’s more, the clear need for young tech companies to be able to tap public equity capital markets earlier in their existence is critical to our nation’s long-term scientific and economic competitiveness.
Such systems are coming into vogue in the institutional debt market. I have long plumped for a similar facility, adapted to the EVITA economy with appropriate safeguards, such as admission to the exchange through a strengthened investor-identification system—the so-called NOMAD system—as employed by London’s Alternative Investment Market. The idea is to relax conditionally—as the SEC has promised—the so-called “general solicitation” disqualifier under Regulation D and free up sophisticated angel investors and their registered advisers to kick the tires of a number of promising companies, finding the ones which trigger interest.
Post investment, these qualified institutional investors would then have limited “liquidity opportunities”—a chance to sell their shares in these promising companies—so that conventional IPOs could go forward once the candidates have been able to navigate spring training. Such a system would allow those young companies that have achieved passing grades from the sophisticated investor community to qualify, based on the track record during spring training, for a public listing.
None of these steps are easy to take given the complexity of the issue and the various legislative and regulatory players involved in the reform process. But neither are these reforms beyond the capabilities of dedicated policymakers to craft. What’s more, the clear need for young tech companies to be able to tap public equity capital markets earlier in their existence is critical to our nation’s long-term scientific and economic competitiveness.
Science Progress is dedicated in part to exploring these and other issues related to the financing of science in this country. The purpose: to illustrate to science-and-technology academic researchers and entrepreneurs, venture capitalists, other financial investors, and state and federal policymakers that careful financial regulatory and tax reforms can ensure the U.S. economy continues to prosper due to the robust commercialization of innovation.
Joseph Bartlett, an advisory board member of Science Progress, serves as counsel at Fish and Richardson P.C.; Courtesy Professor, Johnson School of Business, Cornell University; and Founder and Chairman of VC Experts. Inc.
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