Editor’s Note: This testimony was delivered by a16z managing partner (and former chairman of the board of the National Venture Capital Association) Scott Kupor to the Securities and Exchange Commission as part of their investor advisory committee meeting agenda “discussion regarding capital formation, smaller companies, and the declining number of initial public offerings” in June 2017. You can see some of his previous writings on this topic here. Kupor is also the author of the new book, just out, Secrets of Sand Hill Road: Venture Capital and How to Get It.
Mr. Chairman, Commissioners and members of the Investor Advisory Committee, thank you very much for the opportunity to speak today regarding capital formation and the dearth of initial public offerings (IPOs).
By way of background, I am the CEO and Managing Partner for Andreessen Horowitz […] a multi-stage venture capital firm focused on IT-related investments. I also serve as the Chairman of the Board of Directors for the National Venture Capital Association. Prior to joining Andreessen Horowitz, I held several executive positions in a publicly-traded software company and was also an investment banker.
There are three related trends concerning IPOs and capital formation to note:
First, the raw number of IPOs has declined significantly: From 1980-2000, the U.S. averaged roughly 300 IPOs per year; from 2001-2016, the average fell to 108 per year.
Second, the characteristics of IPO candidates have changed:
Third, the cumulative effect of these changes is a hollowing out of the broader U.S. capital markets: the number of publicly listed stocks in the US declined by 50% from 1996 to 2016, while other developed countries have experienced a 50% increase over the same time period, creating a large listings gap relative to GDP growth over the last twenty years.
I believe there are a number of implications from these trends:
First is jobs. Publicly-traded companies drive employment growth — companies that go public increase employment by 45% relative to private companies. Jobs of course remain key to the goal of sustained and broad economic growth, particularly growth and greater income equality in areas of the country that are undergoing structural unemployment challenges resulting from a modernizing economy.
Second, I believe that we are at risk of creating a two-tiered capital markets structure in the U.S.: one in which the majority of the appreciation accrues to those institutions and wealthy individuals who can invest in the private markets and a second for the vast majority of individual Americans who comprise the retail investor base in the public markets.
Third, the long-term success of the US capital markets as a hub for global financial activity is at risk if the number of publicly listed companies continues its 20-year downward trajectory.
Unfortunately, while the data are clear, how we arrived at our destination is much less so.
The following represents my views on the three key drivers:
First, it does not pay to be a small cap company in today’s capital markets. While the overall efficiency goals of the Order Handling Rules, Reg ATS, Decimalization and Reg NMS are laudable, the impact of this market efficiency has been felt disproportionately by smaller cap, and thus lower trading volume, stocks. As spreads have narrowed, the economics for market makers have all but disappeared, making it unprofitable to trade in small cap stocks. Sell-side research, which had been traditionally funded via the trading spreads, also went away. In addition, the Global Research Settlement and Reg FD have contributed to the changing role of the research analyst — both in terms of the economics of the business and the role of the analyst vis-à-vis the buy side. The economic challenges for investment banks that once specialized in this area thus increased and contributed to the consolidation that has taken place.
As a result, the small cap trading market is anything but liquid:
Not surprisingly, therefore, institutional investors comprise only 27% of small cap shareholders, compared with 81% for larger cap stocks.
Thus, companies who would otherwise be small caps are loath to go public until they are a mid-cap or large-cap company. They fear being stuck in an illiquid trading environment, making it very difficult to raise additional capital in the public markets or to use their stock currency for acquisitions, both often critical to growing their businesses.
Second, even if you are a large cap company that enjoys a liquid trading environment, it is difficult to balance long-term growth goals with the increasingly short-term investor orientation in public markets. At some point, if the pressures of being a public company are too great (and there is ready availability of capital in the private markets), companies will simply prefer to stay private for as long as possible. While these companies will ultimately go public, the time to going public will elongate and thus the returns to public market investors will continue to be muted.
Third, the costs of being a public company are material. I want to be very clear on this topic, as I believe it is nuanced. While it is no doubt true that Sarbanes Oxley significantly increased the costs of being a public company and that other regulatory costs have also been imposed over the years — for example, the costs associated with more liberal proxy rules, say on pay rules, and conflict mineral disclosure rules — many of these reflect the SEC’s dual mandate of investor protection and facilitating capital formation. And I believe strongly in that mandate.
So, I am not advocating for the elevation of one goal over the other, but rather suggesting that a one-size fits all approach to regulatory costs, independent of a consideration of the company’s financial resources to comply with those costs and the implicit funding tradeoffs, is required. These are monies that arguably could be directed otherwise toward growing the company or investing in research and development and, at the margin, the decision to go public has to incorporate this tradeoff. This issue is most acute for the small cap IPO candidate pool that is more likely to defer going public until it can rationally amortize these costs over a much higher base of earnings.
In the interest of completeness, the academic research also points to other potential theories that account for the decline in both small cap IPOs and in IPOs more generally.
For example:
Given all of this, what can we do in the way of reform?
I believe that a comprehensive approach to reform is required given the variety of factors at play. And, as noted above, I believe all reform considerations need to be aligned with the SEC’s dual mandate around investor protection.
I do want to commend this organization for the positive work around the JOBS Act. There is no doubt that testing the waters, confidential filings and the scaled regulatory requirements have improved the on-ramp to the public markets.
However, now is the time for us to consider the market structure issues that impact what the “public markets highway” looks like once these companies in fact exit the on-ramp.
In particular, I would suggest that the Committee consider the following:
First, we need to explore all avenues toward increasing liquidity in the small cap market as a means to engendering broader institutional support in that end of the market. Among the things I think the Committee should consider are:
Second, I believe the Committee should consider new mechanisms to balance short-term investor pressures with the desire of many public company management teams to focus on long-term investments. Among the suggestions are:
Third, I believe that the Committee should undertake a comprehensive review of the costs of all current regulatory requirements to determine their economic impact on issuers of different sizes and to implement a more rigorous cost-benefit framework that requires an understanding of the marginal trade-offs new issuers and existing public companies make between investments in the growth of the company vs monies required to meet regulatory requirements. Again, none of this is to suggest that the core tenet of protecting the safe functioning of the capital markets against bad actors should be diminished. Rather, we need a refined framework that recognizes that the same nominal cost of regulation applied to IBM is disproportionate when applied to a sub-$1 billion market cap company.
In summary, I would offer the Committee the following observations:
I thank you for your time. While I have tried to offer a number of suggestions, these are by no means exhaustive. I am happy to make myself available to the extent the Committee determines to continue its work in this area and look forward to your feedback.