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As talk about an initial public offering from Google has turned into the real thing, many professional investors have taken the development as a sign that the IPO market is beginning to get back on its feet after a three-year drought. But what if it isn't, what then?
For venture capitalists and angels who back early-stage companies, initial public offerings are one of two main ways to cash out of successful investments (acquisitions are the other) and recycle capital into new investments. IPOs have been a cyclical phenomenon, popular during the stock market booms of the 1960s and 1990s, and falling out of favor during the Street's down periods, such as the 1970s and, most recently, the early 2000s. IPOs not only help fuel stock market growth, but economic growth as well, enabling investment capital essential for the growth of companies like Microsoft (MSFT
), Dell (DELL
), Starbucks (SBUX
), and many others to circulate and recirculate.
RAISING THE BAR. But what if the Google IPO talk isn't a sign of new life in the IPO market? What if it is a harbinger of a different kind of IPO market -- one in which only a very few exceptional outfits with huge valuations, in excess of $500 million, can go public, while the vast majority of companies that might have been IPO candidates several years ago -- those with valuations in the neighborhood of $100 million, in other words -- are instead shut out of the market? (Speculation about Google's potential valuation has been in the range of $20 billion to $30 billion. See BW Online, 5/3/04, "The How and Why of Google's Auction".)
If the height of the bar for IPOs has actually increased by a factor of five or more, U.S. capital markets, and in effect the entire American economy, would then be in for a significant trauma. The U.S. way of raising capital, promoting entrepreneurship and creating jobs, which has been the envy of the rest of the world, would be detoured.
Consider the fact that smaller companies, many fast-growing "gazelles," are credited with creating 10 million new jobs between 1994 and 1998, while large corporations lost two million jobs, according to research by David Birch of Arc Analytics. In that statistic, you begin to appreciate just one potential ripple effect of the very real possibility that the IPO cycle as we know it has ended.
LONGER AND MORE EXPENSIVE. In my view, this is the precise process that is unfolding. If you examine the numbers behind the optimistic headlines proclaiming that startup businesses and venture-capital financing are again in vogue, you begin to see the future taking shape. An analysis of venture-capital investing conducted at the end of last year by the PricewaterhouseCoopers/Thomson Venture Economics Survey noted that "venture capital investing ended the year on an up note." But deep in the analysis of the survey, this trend was noted: There has been "a marked shift toward later-stage investing in the fourth quarter and for the entire year 2003 as existing portfolio companies moved further toward maturity."
Essentially, that observation tells us that venture-capital firms are pouring additional funds into their existing investments because the normal exit route -- initial public offerings -- is closed to nearly all the companies in their portfolios. A report recently published by online financing publication thechilli.com appeared under the headline, "IPO market picking up again." But deep in its analysis of the 2003 public financing market, a venture-capital expert was quoted as saying: "In 2002, companies required about 3½ years of private financing prior to their IPOs, but his year's companies took almost six years to reach this exit milestone." And bear in mind that 2003 saw the debuts of only 21 U.S. companies debuted in public markets.
What is behind the possible demise of the IPO market? While the down economy is certainly a factor, there are three other more significant structural trends working against IPOs:
• The growing expense of being publicly held. Thanks to the excesses of the 1990s, and the various scandals, arrests, and stockholder suits that resulted, the costs associated with being a public company are steep and growing more so. As just one example, consider directors' liability insurance, which has soared to about $120,000 annually per director, from about $20,000 during the 1990s. Sarbanes-Oxley has added hundreds of thousands of dollars to the annual legal, accounting, and other costs of public companies.
• The disappearance of small-company investment bankers. During previous IPO up-cycles, there was always a community of investment bankers -- operating in a tier below such giants as Goldman Sachs and Merrill Lynch -- that specialized in arranging public offerings for smaller companies. Thanks to consolidations and failures, those firms, such as Robertson Stephens, Hambrecht & Quist, and Montgomery Securities, are no longer around to handle smaller-tech IPOs, while other niche players, such as Adams Harkness & Hill, moved upstream to handle the larger IPOs.
• The separation of brokerage/investment banking and securities analyst functions. This growing trend makes it more difficult for smaller public companies to gain analyst coverage. Without that attention, it is next to impossible for young public companies to get investors to buy in, and create a market for the smaller stocks. Analyst coverage will increasingly go only to the largest public companies.
The trend toward fewer, and larger, IPOs, will have a profound affect on the financing process we have long known. Fast-growing companies will increasingly require more support from venture capitalists, for longer periods of time. New tiers of venture capital and private financing will likely spring up.
In the final analysis, though, the new landscape could well have a chilling effect on entrepreneur and investor motivations alike, for the simple reason that, without a readily available public market, valuations for emerging companies will likely fall. Corporations have traditionally paid lower prices for companies via acquisition than individual investors have been willing to pay via IPOs. Lower returns over longer periods of time have never been a great way to bring in new investment.
Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.
Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.
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