Sarbanes Oxley's collateral damage: US public markets ?

I mentioned two days ago the continued decrease of the volume IPOs of VC-backed companies. Discussing it with a VC friend, we sort of joked about the efficiency of the Sarbanes Oxley regulation that is essentially scaring away from the public markets a generation of companies – hence reducing in a round about way the potential for fraud and abuse from these new companies.

This morning, Benchmark Capital’s Bill Gurley is pointing to a Wall Street Journal piece (that I could not read b/c you need to be a subscriber) from the CEO of the Nasdaq market warning of the potential demise of US Markets due to Sarbanes Oxley:

He is properly concerned that the overly bureaucratic Sarbanes-Oxley (SOX) processes could lead to the end of global domination by the U.S. capital markets. Ironically, the two gentlemen that created SOX did it with the intention of “preserving” U.S. capital market leadership. Their fear was that people viewed our markets as too risky, and so they created SOX to ensure that investors would “trust” our markets.

It turns out that SOX is doing the opposite – it is ensuring the demise of the leadership of U.S. capital markets. New up and coming companies outside the U.S. are now shunning the U.S. markets in mass. Let us not forget that the Nasdaq has and as always had “weaker” listing requirements that the NYSE. And eventually, the then new and up and coming companies like Microsoft, Cisco, and Intel eventually came to dominate the Fortune 500 – and they all started as emerging companies that preferred the Nasdaq. Now companies are going to “prefer” other markets with requirements that are less stringent than the SOX laden U.S. markets.

The liquidity and efficiency of US public markets has alwasy been pointed out as a key advantage the US VC industry has over Europe and Asia. This advantage is fading away with the relative lack of IPOs, and as I mentioned, there might be opportunities for European exchanges to build/become the next Nasdaq.

Another twisted thought: is this actually shielding us from Bubble 2.0 – since it is limiting potential excess to VCs and other professional investors ?

Update: note that I am not suggesting that the fundamental reasonning behind Sarbox - transparency and accountability - is bad, quite the contrary. It just so happens that the current implementation of the regulation is  a tax to US businesses because of its heaviness.

Comments

[Geek 2.0]

Interesting point.

Bubble 2.0 is perhaps already underway. The difference is, this bubble is driven mainly by "Geeks", who will continue to develop and launch innovative web apps, regardless of SOX. The barrier to entry is so low. A developer can go from idea to launch in a few months without any outside funding. And once the market "proves" his application, the funding he will get (if he needs it) will be smart and justified.

The question then is...will SOX deter VCs from investing in Web 2.0 startups which have a growing user base ? Seems unlikely.

[craig]

I'm not a SOX cheerleader, but I wouldn't attribute too much of the decline in IPOs to this regulation. As it is, small cap, public companies enjoy certain exemptions. In addition, the relatively primitive scope of most newly minted companies make compliance far less complex a process compared to their older, larger corporate brethren. Considering the accounting nonsense that went on in Bubble 1.0 stocks, board members and investors holding IPO stocks for more than 10 minutes might actually sleep better knowing that the numbers and controls have been better scrutinized this time around.

[Torabisu]

I disagree with your glum assessment. I agree with Greifeld about the need to lower the barrier to entry for companies wishing to IPO in the US, but I also agree that in the long run it will be transparency that determines where the capital flows... (and companies will choose the markets that have the most capital).

In the mean time I expect companies to follow Foldera's lead and find alternative ways to market.

[Jeff Clavier]

Thank you all for your comments.

Geek 2.0> I don't disagree that there is a Bubble in company creation, and as long as not all these cos get funding, the only consequence of that Bubble will be a shortage of co-founder/talents.

Craig> I actually think that the cost of implementing Sarbox in a company is actually mathematically delaying their IPO as it impacts the profitability profile. I have heard, but can't find a written note about this, that the estimated delay was about 18 to 24 months. And I have heard a number of my VC friends pointing to Sarbox as the main reason why their portfolio cos aren't public yet - even if their financial perfomance would allow them to do so.

Torabisu> Time will tell but using a reverse merger to make your way into the public market is not the best way to attract broad investor support. And once again I am not saying that transparency and accountability are a bad thing, quite the contrary. One would wish that it was done with less impacts on companies.

[Scott Rafer]

I think its too early to declare the demise of the IPO option for this era of dotcoms. If this is 1997 all over again (as I believe), we're behind on the number of IPOs for the first three months of the year but not nearly to the degree that people are complaining about (particularly considering the effects of federal deficit spending not seen since the last "small-government" Republican administration we suffered under during the 80s.)

[maxbley]

It is not only that foreign companies are shunning US capital markets. Even US companies are exploring listings abroad instead of at home. We are seeing this in particular in the UK, where the more lightly regulated AIM market is attracting companies from the US as well as other countries.

We recently looked at technology IPO activity (with >$15m raised) in the US and Europe for the period 2002-2005. In 2002 and 2003, 80-90% of tech IPOs were in the US. In 2004 45 out of 72 IPOs were in the US (62%). In 2005 it was 45 out of 87 (52%). In other words, while the European IPO window is now re-opening and the number of listings is increasing, it is flat in the US. This is clearly traceable to the effects of Sarbox.

[Ken Fromm]

As SRafer says, its still early but in talking with any number of people who have been officers in small to mid-size public companies, the sentiment I most often hear is never again (if at all possible).

SOX is a big deal (much as I pointed out in an AlwaysOn blog 3 years ago). But it's not just that. The personal liability, the limits on disclosure, the damned-if-you-do/damned-if-you-don't nature of many of the regulations make taking a company public only for the strong at heart (or the naive). I'm sure we'll see some S1s being filed in the next 12 months, but almost all will be with the idea of moving an acquirer to the table.

But reforming SOX doesn't go far enough. We need to eliminate the disclosure rules plus put in place some form of rationalization of securities. Accreditation requirements, state and federal security regulations and filings, to name a few all have artifacts related to other eras and other bubbles. There is way too much friction in the mix and with global marketplace for securities, that is not a good thing.