Why startups aren’t bothering to go public anymore

As the cliche goes, "there's no percentage in it," at least for now.

These things do go in cycles and the current down cycle reminds me of the 1970s, when the public markets were in a shambles and it took almost a decade to recover. Technology had captured the public fancy in the 1960s and brokers were trumpeting the so-called Nifty Fifty (i.e., stocks on which you could never lose, such as IBM and Xerox), only to have the markets fall and fall hard by the early 1970s. Throughout that decade, then, the public markets featured primarily old-line industries/companies with low P/E multiples, with dim prospects for any form of startling growth, and with limited appeal for the mass of investors. Then, too, that decade featured economic malaise, 14% annual inflation, 18% interest rates, ultra-high individual tax rates, and an absence of vehicles by which individuals could easily participate in the public markets (e.g., no widespread 401k-type vehicles).

This all changed with the flowering of startups in the early 1980s, as Regulation D (1982) cleared the way for a healthy investment environment to get companies launched easily and as the macro-environment became more favorable to investors (low inflation, low interest rates, lower capital gains tax rates, etc.). Startups essentially changed all of world commerce during the next two decades (and beyond) and this led to the unparalleled growth of the NASDAQ as a repository for successful startups whose stock became liquid and freely tradeable. During the early part of that era, the barriers to going public were very low (e.g., little tech companies would go public in the late 1980s to raise as little as $2M). There was a cost to going public even back then in the need to file quarterly and annual disclosure documents, in the need to do formal audits, and the like, but these costs were minor in relation to the upside of gaining liquidity.

All this culminated, however, in the mania of the internet bubble which peaked in 2000 and this in turn led to countless junk offerings made to the public in order to capitalize on the frenzy. Essentially, worthless "concept" companies were offered in droves to public purchasers looking to get rich quick and these all collapsed when the bubble popped. This in turn caused a loss of public confidence in the markets and led to a new malaise from which we have never recovered. Add to that the catastrophe of the meltdown during the past couple of years and we will be lucky if we get any semblance of robust public markets again before perhaps another decade passes.

However, just as the low barriers of the 1980s, etc. led to some excellent outcomes for startups, followed by a speculative orgy and a collapse, so too the regulatory reaction to all this has gone to excess and is plainly limiting companies from wanting to go public. The article does a pretty good job of pointing out some of this excess and, regardless of details, the result is that only a very few startups can even begin to contemplate going public, with many not bothering to do so.

A few consequences of all this (affecting startups at all stages):

1. Most startups are forced to go the M&A route to get liquid and this in turn allows acquirers to low-ball on price and to squeeze on terms (e.g., more earn-outs, more gotcha terms, etc.).

2. The regulatory mindset (which I see as a reversion to 1970s-style thinking) is dominated by lawyer-like concerns and is by no means limited to public companies. For example, IRC 409A was passed to ensure proper valuation of options and other forms of deferred compensation. It now requires even the earliest-stage startups (which have been funded) to incur needless compliance costs by getting "independent valuations" at many stages where no one would have even thought twice about the subject before. Another example: the tightening up of requirements on who is an "accredited investor" - people were relieved when startups were able to dodge a bullet in the Dodd-Frank legislation concerning this issue but even that legislation opened the door to the SEC to add new rules and burdens in the not-too-distant future (efforts are already afoot, e.g., the NASAA is proposing that the SEC limit accredited investors to those who have $1 million in liquid investments - see http://www.startuplawblog.com/?p=650). It is easy to brush this sort of thing off but there is a clear pattern of reverting to 1970s style regulation and hence increasing barriers to investing, all in sharp contrast to what we have known in the recent past.

3. Auditing procedures have been affected by SOX to the point where even routine audits can run into six-figure costs for small companies. Public audits are now horrifically expensive, where even a small NASDAQ company can easily have such costs run up to close to $1 million annually.

4. Sitting on the board of a public company is now something of a menace. Therefore, those who make the key decisions whether or not to take a company public have a natural disincentive to wanting to go in that direction, quite apart from regulatory compliance costs.

The point is that there are now huge barriers, economic and legal, to going public - the exact opposite of the climate of the 1980s when we last busted out of a malaise and saw an explosion of companies availing themselves of the public markets. These barriers exist because of larger trends that took quite a while to develop and they will not go away soon. I am an optimist about this issue but also a realist. The problems will eventually be corrected but not in the short term. It will take considerable time.