IPO Reform: Some Immodest Proposals (Part 1)

Joseph W. Bartlett, Founder of VC

There are a number of reasons why venture capital has flourished in the United States, surpassing the performance of any other country or region (at least until now), some of which have to do with the legal and accounting structure which has been, sometimes overtly and sometimes stealthily, friendly to emerging growth finance. However, there are certain, undeniable problems with the current IPO system. Part 1 of this article will look at the current IPO process and identify some of the most apparent flaws. In Part 2, we will present a series of specific (immodest) proposals for IPO reform. In Part 3, we will set out a hypothetical comparison of the current system (the Short Runway) vs. the suggested option (the Long Runway).

The basic foundation elements are familiar ... a stable legal system, an independent judiciary, specific rules governing commercial behavior (the Uniform Commercial Code, for example), enforceable contracts, disinterested government regulation, minimum official corruption and a relatively fair, nonconfiscatory tax regime. Other nations enjoy those benefits, such as the U.K., for example, the original source of much of U.S. law and institutional structure. Science has had a lot to do with it as well. Science developed in government laboratories (National Institutes of Health and the Defense Department) and in government-supported academic institutions like Harvard, MIT, CalTech, Stanford, Berkeley. Again, however, other nations enjoy at least most of the cited resources with the possible exception of the spin offs from DOD-sponsored research, e.g., at Los Alamos, Argonne and the DARPA Project.

Lesser known legal accommodations, friendly and sometimes critical to the rise of venture capital, include such well kept secrets (at least to the non-professional eye) as the Plan Asset Regulation, a Department of Labor ruling (years in the making) which quietly but effectively released the assets of private and public pension funds for venture capital investing. Literally trillions of dollars have flowed into this space since 1979[1], when DOL insulated the fiduciaries of pension assets from liability for investing in high risk/high reward situations such as venture capital funds. Similarly, Regulation D brought order out of semi-chaos in the private placement arena, freeing up private equity investment from a number of nonsensical regulatory burdens (keeping track of the number of offerees, for example) and thus stimulating legitimate activity enormously. In the tax area, Revenue Procedure 92-73 has legitimized the practice of compensating the managers of venture capital funds (and making them very rich in the process) with tax free grants of profits interests, the tax burden to be imposed only when portfolio assets are in fact harvested. Rev. Proc. 92-73, actually crystallized a practice that had been going on since the business began; but the IRS made the rules clear and safe from idiosyncratic and eccentric threats, such as occurred in the early stages of the 8th Circuit Campbell case (Campbell v. Comm'r). In fact, the Internal Revenue Code has been quite generally accommodating to the early stage sector. Entrepreneurs can obtain valuable equity interests in a start up company through Section 351, built in part on the semi-fictional notion that they are contributing "property" to the mix in exchange, tax free, for sweat equity. Sweat equity is also available at bargain prices (again without immediate tax) through the Service's tacit recognition of the counterintuitive idea of 'eat 'em up preferred,' the preferred stock's liquidation preference sheltering real economic value in the common stock from tax whenever common stock is being, in effect, given away to the firm's managers. And, that glorious American invention, the employee stock option, has enabled start up firms to pay their help with non-cash consideration, non-taxable as of the date of the grant ... and, indeed, not even a charge to the firm's GAAP income. The tax treatment of "non-qualified" stock options is in fact one of the reasons a high tech company like Microsoft can enjoy what amounts to phantom tax deductions, significantly sheltering its income in periods when Microsoft stock is rising. (In fact, U.S. corporations generally are paying out less and less of their cash in taxes to the Internal Revenue Service but that is another story.)

There are other happy elements, some of them deliberate and some of them accidents, favoring venture capital. A low rate of tax on capital gains, for example, is important, along with an extremely low rate for long term investment in "qualified small businesses," and no tax at all if the investment is rolled over within a relatively short period into another venture capital opportunity. Somewhat farther afield, a relatively efficient bankruptcy process gives the participants comfort that business failure is not a lifelong catastrophe. The Private Securities Litigation Reform Act and the "bespeaks caution" doctrine, coupled with the tendencies of an increasingly conservative federal bench, have cut back on the exposure of directors of early stage companies to personal loss in the event of business failure. Pre-emption of state "blue sky" laws has also removed a large and sometimes expensive level of nuisance regulation.

The foregoing list is not meant to be exhaustive. It simply illustrates that venture capital is widely recognized as critically beneficial to this country in any number of ways. The technology itself is useful and, in the case of bio-tech, sometimes life saving; the jobs created are generally high end; and the wealth has been extraordinary. Naturally enough, the bureaucrats swallowed their inherent instincts ... to regulate wherever possible ... and have given the "animal spirits" of U.S. entrepreneurs relatively free run.

Given that pattern of successful adaptation, the occasional, and quite important, failures to adapt are particularly noticeable.

Thus, for example, for any number of years regulators and the industry have attempted to devise ways to introduce small investors to the private venture capital space. There have been a number of initiatives to overcome the seemingly insuperable problems. An obstacle of long standing stems from the structure of private investment vehicles focused on venture capital; to be successful, they must be exempt from entity level tax. Existing VC funds are tax exempt, as partnerships, under Subchapter K of the Internal Revenue Code as long as they don't creep into 'publicly traded partnership' status ... i.e., have too many individual partners. Since, by definition, an investment vehicle fueled by small investors is likely, if it wants to be a real player, to wind up with more than the allowed number of partners (and thus, be liable to entity level tax, which is competitively fatal), the only recourse is Subchapter M of the Internal Revenue Code ... the exemption for registered investment companies. However, the strictures of the Investment Company Act of 1940 simply do not fit well with venture capital investing. A VC fund's portfolio is highly illiquid, meaning that the shareholders themselves are illiquid and cannot be allowed to redeem in any realistic sense ... an open end mutual fund structure is not feasible. Closed end funds, which do not redeem shares periodically, are at a disadvantage because they customarily sell at a discount from net asset value, meaning that the fund is worth more dead than alive. Moreover, some of the compensation features of the typical venture capital fund offend the very foundations of the Investment Company Act, to the extent that the latter is designed to discourage excessive speculation. Some of those problems were worked out in a 1980 amendment to the Investment Company Act creating "business development companies;" but the legislation did not accomplish much in the final analysis. Most of the BDCs formed post-1980 have gone out of business for one reason or another. And, publicly traded partnerships were eliminated as pass through entities (and, therefore, eliminated 'period') with a few grandfathered exceptions, by the 1987 anti-tax shelter legislation. Finally, the Idealabs, CMGI, Divine, etc. conception ... that a public holding company could function as a de facto public venture capital fund ... was put to sleep (perhaps forever) by the dismal performance of those entities, labeled "incubators," post the dotcom meltdown.

Given the amount of capital available from institutional and super high net worth individuals, plus corporate venturers, the space does not lack for liquidity, however, and the failure to include the "little guy" in the process has not been a major disadvantage. In fact, it may be that small investor doesn't belong in high risk/high reward, highly illiquid venture capital investing ... particularly if he or she has no realistic ability to understand the risks and to bear the potential consequences of total loss of capital.

The more important failure, and the one that this piece focuses on, is our (i.e., government and industry) inability to rationalize the IPO process, a particularly important failing since IPOs are a major driver of successful venture capital investment. Without realistic IPO exit opportunities, much of the attractiveness of this important sector may wither.

To illustrate, consider the current state of play, based on what I am labeling (see hypothetical case study in Part 3 of this monograph) the Short Runway model. IPO securities are, typically, sold to the public on the basis of a hectic flurry of activity surrounding the effective date of the offering. There are, to be sure, oral indications of interest collected by the underwriters from potential buyers over a period of time prior to the effective date ... after the so-called "Red Herring" prospectuses (named for the red label attached to the front page) have been distributed to institutions and investment banks. The actual sales fulfillment process is, however, very tightly compressed. To get the final version of the prospectus in shape the company, its counsel, its accountants and underwriters work heroic hours, often staying up for two straight days and nights at the printer so that the documents can be filed and become effective by 10 AM in the morning on the targeted effective date. Form orders are accepted until 4 PM that day, when the underwriting syndicate decides whether it goes "firm" and in fact underwrites the offering, or abandons it, ... in the former case, underwriting it in the true sense of the word, meaning that the investment banks put their own capital on the line to insure that the securities are in fact sold and paid for. (The settlement date is three days away, T+3 as it is called.) The syndicate members are on the phone non-stop to firm up the orders they have orally solicited. The potential buyers do not, in fact, know the exact price until the morning of the effective date and have to make up their minds in a very short period of time (although they have had clear indications of the pricing objectives since the target range has been widely disseminated. The supply of shares is in elastic; other than the company (and, subject to the so-called 'Green Shoe' option which allows the underwriters to call another 15 percent of the offered shares from the company), there is no other supply; Consequently, if the demand exceeds the supply. After the initial allotment has been sold, anybody who wants to buy the stock has to buy it from someone who was lucky enough to get in the initial offering price, despite the fact that initial buyers are discouraged from 'flipping' in the early stages of trading and the managers of the offering, the investment banks, threaten to refuse to allot stock in subsequent IPOs to individuals and institutions who engage in 'flipping.' As a consequence, there is a very restricted supply in after-market trading once the initial stock has been distributed; if the demand exceeds the supply, and in robust IPO periods the demand almost always does exceed the supply, fundamental economics indicate that the price of the commodity, in this case, stock, will shoot up. The danger that the underwriter will be a real underwriter ...i.e., be long on the stock, versus just acting as an agent ... is therefore minimized.

The problems with the Short Runway structure are obvious. The prospectus and registration statement contain a plethora of information concerning the applicant, data which has been circulated extensively (as required) during the pre-effective period bit, outside of the institutions which invest in IPOs professionally, there is a real question whether the market itself has had the time or the quiet space in which to absorb the data and compare it in a state of reflection.. For the lucky few, getting an allocation of stock at the IPO price is, in effect, the equivalent of getting free cash. But, those who own stock at the trading price zenith are frustrated and angry. A lot of the current litigation involving IPOs, the Congressional hearings, the grand juries and the general gnashing of teeth at the practices of the leading investment banks, is driven by the process itself. If you sift through the hyperbole and look at what is actually happening in the market place, one realizes that, by and large, the law has not been technically broken. Whether the buying public or the Congress or the U.S. Attorney's office is reacting to disappointment driven by the very nature of the process itself or the peccadillos of any one individual or group of individuals, the problem should be attacked structurally, rather than by seeking headlines and scapegoats. In the last section of this piece, I address an alternative, which I call the Long Runway option, and urge its adoption.

There are, unfortunately, a number of other problems in today's public markets which also suggest structural reform, in order to enhance the IPO model, is in order. First, some sobering statistics (from a presentation made by US Bancorp/Piper Jaffray at a recent conference).

  • "[I]nstitutional investors account for approximately 80 percent of all trading volume for stocks listed on the three major stock exchanges.

  • "A typical investment bank's sell-side equity analyst needs to generate $10 million in trading commissions per year to support the sales/trading operation and the costs of research.[2]

  • "Over 95 percent of the total market capitalization of companies on the NASDAQ, American and New York stock exchanges is accounted for by companies with greater than $500 million in market capitalization.

  • "Conclusion: Mergers and acquisitions represent the only real means for most mid-cap companies to realize a premium valuation and significant liquidity.

How do I read this data? For the reasons stated below, the IPO window may be shut for a long, long time.

Thus, the data illustrates something that has been known to insiders for the last several years. There is a growing "orphanage" in the U.S. public markets, peopled by companies the valuation of which is below the necessary threshold ... below that market cap (about $500 million) which commands the attention of the analysts, and, therefore, institutional buyers. Reinforcing the bias against small cap public companies, many of the asset managers have merged in recent years; an individual who used to manage $1 billion (and could get in and out of a small cap company without her trade moving the market against the trader) now manages $10 billion.

A company whose stock is in the orphanage has the worst of all possible worlds ... the expense and nuisance of public registration not counterbalanced by genuine liquidity nor an accurate trading price which real liquidity would bring. Moreover, thinly traded stock tends to trade off. Stock that came public at a share price of, say, $15, once fallen into the orphanage, can slip into single digits even though the company is doing just fine. Perhaps the worst statistic of them, vide a study recently reported in The New York Times,[3] is that a stock which slips from double to single digits has only a 3.4% chance of recovering into double digit land.

Absent analyst coverage then, it is up to the management of the company to create interest one way or another in the stock ... a long and arduous process which has given rise to the saying. "The road show never ends." One wonders what the CEO and the CFO are doing about running the business if most of their time is spent hopping from city to city to keep the interest in their stock from flagging. Another way of putting the problem is the view entertained by some shrewd critics of the system, who claim that the cost of IPO capital is a notional (or implied) 25 percent (plus or minus), compounded. The central idea is that, whenever any company essays an IPO, there is an expectation that, at least for companies not extremely well positioned, the results will compound at a rate of something like 25 percent, an expectation that is encouraged by promotional material in the course of the pre-IPO road shows.[4] When and as there is a subsequent hiccup in that result (e.g., by way of a missed quarter), the market tends to kill the stock these days, particularly for companies in the orphanage, driving the shares below the magic ten dollar figure ... a dungeon from which, apparently, they almost never recover.

In short, one wonders whether there could not be a way of fixing a lot of the problems with emancipated and forward looking regulation and institutional restructuring. This is the question we will seek to answer in Parts 2 and 3 of this article.

[1] Lerner, Boom or Bust in the Venture Capital Industry and the Impact on Innovation, HBS Working Knowledge, Nov. 5, 2001.

[2] "One analyst's capacity to adequately understand and communicate the prospects for a company is about 20 specific names. As a result, the trading commissions per stock should be about $500,000 per year. The average institutional commission is $0.05/share on each side of a trade. The reported trading volume generated by the investment bank must be 10,000,000 shares per stock per year. (Note: the actual number of transactions may be as low as half of the reported figure due to double counting of NASDAQ trades). Estimated trading days in a year: 250. The resulting minimum reported daily trading volume for one investment bank is 40,000 shares/day per stock. If the investment bank is the most active market maker in the company's stock, it could represent up to half of the trading volume. Resulting minimum reported daily volume required is 80,000 shares/day. " US Bancorp./Piper Jaffray presentation, IIR Family Office Forum, June 25-26, 2001, Chicago.

[3] "'Bottom Fishers' beware. When stock prices sink to single digits, the odds are that they are sunk for good. That is the conclusion of a study by Thomas W. Watts, Internet infrastructure analyst at Merrill Lynch. Going back to 1985, Mr. Watts studied the trading of 1,900 publicly held companies spanning the technology sector. He found that of those companies whose stocks had fallen to single digits, only 3.4 percent rebounded to $15 or higher within the next year. Most of those that didn't bounce back in the first year never did." Morgenson, Market Watch, N.Y. Times Business 16 (Apr. 8, 2001).

[4] "The demand for small- and mid-cap stocks is generally restricted to opportunities in high growth companies in rapidly expanding markets with the prospect for the size of the company to grow substantially within the next 12 to 18 months." Ibid.