IPOs Are Dead; Long Live IPOs

The numbers are startling; one technology IPO last quarter, only six in 2008. Is innovation dead? Did Google/Microsoft/Cisco consume all the promising start-ups? Did Sarbanes-Oxley render IPOs too hard and costly? Yes, if you believe columnists, conferences and collective wisdom.

They’re wrong. IPOs aren’t popular because they are perilous. Choosing extra risk now is like stocking up on peanut butter energy bars during a salmonella outbreak. The downside is ugly. New “unseasoned” issues are like new car models, rife with unknown quirks. We know their lineage and plans, but the future is mostly hope and speculation. Hindsight shows that newly public companies are prone to err when first under the marketplace spotlight.

The question isn’t “why aren’t investors buying IPOs now?” but rather “why do investors ever buy IPOs?” The answer is that institutional investors, the principal IPO buyers, exist to take calculated risks. If convinced potential reward overcompensates for added risk, fund managers will belly up to the IPO bar and order a double. Conversely, when offered safer, appealing choices, investors will skip the umbrella drinks and opt for the single malts. These days, risk reminds us of Jagermeister shots: something that used to be fun.

However, unless entrepreneurs now dream of Hondas–not Ferraris–and unless these “damn the torpedoes” folks checked their aspirations in the umbrella stand, the IPO market will be back.

The process of going public is tougher than it used to be but it’s still an entrepreneur’s crowning achievement. Need proof? Name four famous tech company founders. How about Sergey, Larry, Steve and Bill? Now name four tech legends who sold out to Cisco (CSCO), Microsoft (MSFT) or IBM (IBM). OK, name one.

IPOs are proof that ideas and hard work create recognizable value. No other exit affords founders both the glory and the independence. More tangible reasons to go include the start-up promise to employees; “Work long hours for low pay today, and tomorrow you too can afford a Tesla.” There’s no guarantee of success, but if it’s realized, there is an agreement that it will be shared by all. An IPO is the deliverable on that deal.

Secondly, acquisitive growth companies often prefer shopping with stock over cash, but agreeing on private-stock value is difficult. Public equity is a better currency because of its undeniable, third-party valuation. Finally, Silicon Valley’s history proves that yesterdays’ IPOs fund seed capital for tomorrow’s innovators.

A healthy economy needs a robust IPO market, begging the question: With so few of late, are we up the creek? To the contrary, five pointers suggest when we emerge from the current mess; our IPO market may be healthier than it has been in a decade.

1. Sarbanes Oxley is good for IPOs. According to Morgan Stanley Research, over a 20-year period, north of 60 percent of technology IPOs trade below their offer price. High on the list of reasons why newly public companies flounder is their failure to heed the wisdom of Paul Masson; they sell before their time.

The distractions are enormous and expensive. It’s genuinely difficult to lay the rails while driving a bullet train. Natural business challenges are compounded by the Sarbanes Oxley albatross. Fine-point accountability requirements force order on the chaos inherent in rapidly growing companies, but unquestionably slow the journey to market.

At an average small company cost of $3.0m, SOX implementation takes a major bite out of profits. However, while this expense initially reduces calculable company valuable for those using current earnings to set the IPO price, over time, accountability reduces corporate risk and therefore should increase returns. In fact, if a company can’t afford the expense and hasn’t endured the hardship of thoroughly documenting its systems, is it really ready for the teachers’ retirement fund, corporate pension plan or other public investors? It was easier to go public before SOX but, for investors or issuers, was it better?

2. The demise of investment banks is good for IPOs. Today, we lambast investment banks because they earned it. Formerly sure-footed firms ran full speed into a bog they didn’t understand. Those whom Tom Wolfe once christened “Masters of the Universe” and “BSDs” have morphed into LSWs (little shriveled walnuts).

How does this help the IPO market? In the heyday, technology IPOs were shepherded by boutique investment banks focused on, and economically aligned with emerging growth companies. Those banks didn’t invent, sell or swap CDOs or SIVs. Rather, in the 1990s, following the wisdom of the day, they sold out to diversified, theoretically better-capitalized, larger banks. Those acquiring banks emulated Audrey, the man-eating plant from “Little Shop of Horrors,” demanding ever larger revenues to sustain their mass, leaving new issuers who generate small fees with little IPOs, an acronym of their own; SOL.

Now, with large investment banks hanging with the pterodactyls, there’s an opportunity for boutiques to rise again, a turn that could be very good for the IPO market.

3. The implosion of hedge funds is good for IPOs. Hedge funds vary in size and style but until recently, the market movers who mattered were the fast-money behemoths. These players often care about IPOs only on day one. In a whiplash market, even longer term investors had little opportunity to amass measurable holdings of new issues. With the fast money players sidelined, patient “investment” (versus speculative) funds may again have time to develop confidence in management, a prerequisite for accumulating big positions in newly public stocks.

4. The new administration is good for IPOs: “It has not been the path for the faint-hearted, for those who prefer leisure over work, or seek only the pleasures of riches and fame. Rather, it has been the risk-takers, the doers, the makers of things…who have carried us up the long rugged path towards prosperity and freedom.”

Public recognition of the entrepreneurial spirit, and its critical role in our economy, by President Obama in his Inaugural Address. Enough said.

5. Constrained venture capital is good for IPOs. Comfortable start-ups, with logo-emblazoned, fleece-clad employees sometimes grow flabby. Conversely, start-ups scraping by to pay bills must focus on building and profitably selling products. While some genuinely need millions for development, others require only cheap computers and smart people willing to work like politicians during primary season. Eventually, outside investment fuels expansion, but examples from Apple (AAPL) to Intuit (INTU) to Google (GOOG) prove that, as the lottery once advertised, all it takes (at first) is a dollar (or a credit card) and a dream. Less venture money sloshing around today will likely mean fewer but stronger start-ups tomorrow.

It isn’t broken, please don’t “fix” it. Today’s IPO market is not healthy, but it is rational. Government’s role should be to insure that observant, active, on-the-ball regulators have the tools and backing to seek out and slam down financial cheats, thereby restoring confidence in the markets. If government can find a way to restrict extortionist lawsuits filed whenever a stock drops, that would help too. Otherwise, well-meaning administrators should stand clear.

When the markets settle and when the blue plate specials on blue chip securities abate, when the investment merits of an IPO are self-evident, a better and stronger market will be ready.