IT'S OFFICIAL: The IPO Market Is Crippled -- And It's Hurting Our Country

Alan Patricof 400x300

On October 13, 1971, Intel Corp, a manufacturer of semi-conductor memory circuits went public with a common stock underwriting of 350,000 shares at $23.50 per share for a total of $8.225M and for a post money value of $58M. 

In the previous six months the company had revenues of $3,978,000 and profit before extraordinary items of $93,000.  This offering included 42,000 shares for selling shareholders. 

There were 64 underwriters in the group of which only 5 remain today as an independent entity with the original name (coincidentally one of the survivors in another form was the lead underwriter for the offering – CE Unterberg Towbin & Co.)

On April 18, 1972, CE Unterberg Towbin also took Datascope Corporate public, “a company engaged in the design and development of medical instrumentation” with an offering of 105,000 shares at $19 per share raising $2,011,000 of which $977,000 went to selling shareholders. 

The company post offering value was $9M.  There were no other underwriters.  In the previous six months Datascope had revenues of $973,000 and a profit after full taxes of $130,000. 

In 2009, Datascope was sold to a Swedish company for $865M and had reported annual revenues at the time of $230M.  Intel recently reported revenues for their third quarter ended September 30th of $11B. 

To add further to the flavour of what the public markets and IPOs were like:  In 1972 Storage Technology went public with an offer of $13M; In 1976 Four Phase Systems raised $15M and Cray Research raised $10M; In 1977 Tandem Computers went public raising $9.4M and in 1980 Sci-Tex raised $6.8M. 

As recently as 1986 Adobe had an IPO raising $6M.   None of these companies could have gone public in today’s environment even adjusting for inflation.  Virtually all the buyers at the time were individuals and there was a robust “over the counter” after market for young companies. 

Transactions took place over the telephone and spreads were well above today’s prescribed margins.  Bids and offers were published daily in the pink sheets along with their market makers.  As noted above, almost all of the underwriters are gone today and all trading, which was done over the telephone, is now done electronically.

The mounting pile of regulations forced the IPO market to shrink

As a result of a series of developments over the past two decades and particularly since Sarbanes Oxley was passed in 2002, the IPO market, and thus the number of overall companies who are public has actually declined rather than increasing in line with the growth of overall trading volume and rise in the Dow Jones averages.

The number of annual U.S. issuers listing IPOs on U.S. exchanges has declined since 1996 from 756 to a low of 36 in 2008 and 50 in 2009 and 120 last year according to Dealogic. By contrast, there have been 346 Chinese issued IPOs listed on China exchanges in 2010 even though the U. S. GDP is 3x larger than China's.

We are clearly losing our edge as the place to raise capital to nurture and sustain growing companies.

10 years ago 9,100 companies filed annual proxy statements with the SEC; in 2009, 6,450 filed and in 2010 through June only 4,100 companies filed according to Wharton Research Data Services. Many more companies are going off the market through mergers, going private or to a lesser extent failing.

Significantly from 1960 through 1996 according to Wharton's study, 7,725 stock names have disappeared and only 4,299 new ones arose to replace them.

The problems facing an IPO for a smaller company have a compound and cumulative effect:

1) many of the firms who underwrote small companies are no longer in existence.

2) The investment bankers who remain cannot afford, in today's institutional world, to provide research coverage for companies with small capitalizations as it is not economic. The Global Research Settlement and Rule FD exacerbates this issue as it greatly restricts how research departments can operate.

3) The allowed spreads on trades is too small to cover trades in low activity stocks, and

4) As a result of Sarbox and other associated costs, going public and being public has become prohibitively expensive for small companies.

What does it mean for all those small companies? >

We're throwing away our tech startup advantage

As a result of the above, venture capitalists have had to face up to the facts, and orient their investments to exit through merger and acquisition for the most part at an earlier stage and at sub $100M market caps.

Correspondingly VCs are avoiding financing capital-intensive companies which will clearly require significant follow-on funding, thus putting a damper on those industries and companies which in the past have generated technological leadership for the U. S.

This is occurring at a time that similar type companies are finding hospitable markets in Hong Kong, Shanghai, Singapore, India etc. This is exacerbated by the H1B Visa restrictions which have basically forced qualified, talented individuals from abroad to fulfil their start-up dreams in another more hospitable environment. We are in effect abdicating our leadership in technology start-ups to the rest of the world.

And it has been clearly demonstrated, first by the Kauffman Foundation and then by the National Venture Capital Association, that start-ups are the key engine for job growth in this country with over 92% of all job growth within public companies takes place after they are public.

So with fewer companies able to tap into the public market we are just placing another nail in the coffin of job growth and we are indirectly encouraging entrepreneurs and their start-ups to sell out prematurely to larger entities rather than build long term sustainable businesses (Facebook being a clear exception.)

Ironically, all of the changes introduced by the Congress and SEC to create a level playing field such as decimalizing trading, reducing spreads thereby encouraging electronic trading, separating research from investment banking to prevent collusion in recommendation of new issues specifically and stocks in general, has forced investment banking firms to reduce their research coverage to far fewer and only the large cap companies.

The laws were designed to assure individual investors got the same benefits as institutional investors, but in point of fact, it has created a less efficient environment and has increased the cost of raising capital for small emerging companies and in many cases stifled their growth opportunities.

What can we do about this mess? >

Change we can believe in?

Changes are called for to bring back underwriters for small cap IPOs, increase research coverage, make trading and maintaining markets profitable, and create overall a more attractive environment for small cap IPOs.

The idea of possibly creating a new market based on manual market making and allowing greater spreads, relaxing rules for research departments (allowing them to talk to their IB depts.), and raising Reg A from $5M max to $25M or $30M and get blue sky exemption are just some of the actions possible.

Clearly, not eliminating the rules, but loosening up some of the requirements of Sarbanes Oxley, is another needed change, especially for smaller companies.

Perhaps most importantly the U. S. government must give greater attention to the role that angel investors, venture capitalists and perhaps even more importantly public market retail investors can play in stimulating new business formation by entrepreneurs and do everything possible to remove obstacles that impede these investors. Even more so they should act creatively to stimulate these sources of capital.

The recent extension of Section 1202 of the IRS code which provides significant tax benefits for investing in small qualified companies is a very positive step and could in itself have a catalyzing impact on public offerings. Under the Tax Relief and Job Creation Act of 2010, individuals who invest in 2011 in companies who have raised less than $50M previously, and if they hold the stock for five years will be exempted not only from any taxes on the gain but preventing the Alternative Minimum Tax (AMT) from offsetting the benefits.

Investment bankers should recognise this as a very effective tool to merchandise investments publically into small growth companies. At the end of the day, the greatest source of job creation will come from young public companies.

In any scenario there is a large untapped market of individuals who can be encouraged to participate in a form of a viable public market for young growth companies. But in order to do that we need to modify the rules to make it equally attractive to investment bankers to focus on this size market.

In the end, the true winners will be the growth companies who could access a new pool of under-utilized capital.

So that's one problem we need to fix. Here's another >

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