Financial Times (London, England), June 5, 2007
An anxious question is increasingly being asked in
America's entrepreneurially intense technology communities: could we be seeing the death - or at least the decline - of exit strategies? When backers of high-risk ventures have ready routes to realise returns, they invest more. The
US has long enjoyed multiple and largely uncongested exit avenues, a big factor in its entrepreneurial vibrancy. Now some in its technology communities fear those avenues are narrowing, perhaps closing.
There have traditionally been three routes to take venture money from a successful enterprise: initial public offerings, corporate mergers or acquisitions and private equity buy-outs. In
Silicon Valley, concern is growing that all these routes to entrepreneurial riches are under regulatory attack.
The rise of US-backed IPOs overseas is well documented. But equally important has been the drop in domestic deals and dollars raised. Between 1990 and 1995 - before the technology bubble and its bursting - US markets produced an annual average of 170-venture-backed IPOs, raising Dollars 5.56bn. In 2006, 56 venture-backed IPOs raised Dollars 3.72bn (Pounds 1.9bn). Today, according to Institutional Investor magazine, the market's appetite for venture-backed enterprises is so weak that at least one Silicon Valley venture capital firm has cancelled plans for new funds.
Attention has focused on audit costs imposed on public companies under Sarbanes-Oxley, the corporate governance legislation. According to aCRA International study cited by
TheStreet.com, for a lower-end start-up about to go public, these additional audit costs average Dollars 1.5m in the first year and Dollars 900,000 in the second.
But Sox is damping IPO fires in other ways. In January, the legendary
Silicon Valley venture capitalist and entrepreneur, Jim Clark, resigned as chairman of Shutterfly, the photo-printing web service. As he explained in a letter quoted by
CNET News Service, Sox "dictates that I not chair any committee due to the size of my holding, not be on the compensation committee because of the loan I once made the company (and) not be on the governance committee".
For high-technology start-ups, the key to success is having access to "smart" capital - the participation of experienced hands who bring both brains and funding to the game. Sarbanes-Oxley has put limits on the brains public companies may enlist if those brains come with too many dollars. Diminishing access to talent may pose a bigger cost to going public than oversized, largely wasted audit costs.
But going public - or even issuing stock options in privately held corporations - is becoming increasingly tricky. One reason is the new section 409A of the tax code. Enacted with the 2004 tax act, it deals with the valuation of stock options. Cash-poor but opportunity-rich ventures depend on options to reward workers to whom they cannot pay competitive salaries. While regulations implementing 409A remain in flux, the section is sending a chill through the tech and venture capital com-munities.
The law attached severe financial penalties to misvaluations. But what is the correct way to value options in a company that is not publicly traded? The Securities and Exchange Commission has become increasingly aggressive in challenging valuations during the registration period preceding an IPO. The result has been expensive re-evaluations, reduced reported earnings and "sand in the gears" of transactions. Once 409A is fully implemented, there will be the risk of IPOs triggering tax penalties and interest and lawsuits from employees with devalued compensation packages.
If Sarbanes-Oxley and 409A have made IPO exits harder, lawsuits and the Arthur Andersen prosecution following the Enron scandal have complicated all exits. Wall Street analysts see more risk and less pay-off in studying small companies. With less information available, the market for low-capitalisation stocks becomes thinner. As taking such companies public at a good price later on becomes harder, companies and private equity funds think twice about acquiring them.
The capital that venture capital firms and entrepreneurs can justify investing in a scheme rises and falls with the ease of getting their dollars out if all goes well. Inadvertently, Congress, regulators and prosecutors have made passing through the exit door harder. If this is not reversed, the result will be fewer rapidly expanding companies and new jobs. That would be an exit strategy for the US's economic growth.
The writer is managing director of the White House Writers Group and chairs the Pacific Research Institute.
