INNOVATION CLUSTERS

Capital Markets Matter

Helping High-tech Startups Prosper Requires Financial Reform

The financial crisis facing promising young high-tech startup companies today is sadly not the sole result of the current credit crisis but rather extends back over the past ten years to the dotcom stock market meltdown in 2000, which both shocked the financial markets and closed the window for initial public offerings to all but a handful of innovative new companies. The current credit crunch only exacerbates the financial problems faced by startups in our capital markets today.

But with crisis comes opportunity, which is why policymakers in Washington need to enact several key reforms to help capital market formation work more efficiently for startup companies looking for money to grow our nation’s stock of innovation and create new and more abundant jobs. Fortunately, President Obama agrees that the science-and-technology economy in our country is the foundation of our prosperity and deserves a good deal more nurturing than has been the case in the past.

Here’s one obvious example of the importance of fostering venture capital-backed company successes and the resulting impact on our economy: In 1990 Microsoft Corp., Dell Computers Inc., and Cisco Systems Inc. had combined sales of $2 billion, but ten years later their combined sales were $80 billion. These and other technology behemoths began as venture capital-backed startups, and the same is true today for the next generation of Microsofts, Dells, and Ciscos.

The tech economy is supported on the shoulders of the venture capital sector, which I have labeled, for purposes of abbreviation, the EVITA sector, or Entrepreneurial Venture-backed, Innovation-centric, Technology-flavored Activity, which provides critical sustenance for companies founded by gifted entrepreneurs and aimed at the financing journey from the “embryo to the IPO,” exploiting innovative intellectual property, including business methods, to change our lives for the better. I mention the “embryo to the IPO” because this is where capital markets regulatory reform comes into the picture. Reopening the IPO window is critical, in my view, to keeping the tech economy, and accordingly the economy of this country, on a solid and robust growth path.

Next, we need to unlock even more private capital to fund early-stage startups. Today we are leaving billions of dollars of potential gross domestic product growth stranded in the wilderness because seed money for promising EVITA companies sits on the sidelines. As a paper by two of my students at New York University notes:[1]

The economic impact of the seed money gap is staggering. At a conservative minimum, at least $4 billion is lost to the United States economy each year. More realistically, the economy losses closer to $100 billion per year because of the funding gap. Socially, the losses are just as great. Products and services that would improve the lives of countless people are either never developed, or significantly delayed.

The answer to our broken IPO financing pipeline and our moribund seed-stage venture financing landscape lies in a series of regulatory reforms that are admittedly arcane for non-financial types but nonetheless crucial to the future of our economy. Below are my (sometimes controversial) suggestions to rebuild our IPO markets and re-engage seed stage investors in the creation of new, competitive companies and industries across our country.

Sarbanes-Oxley Reform

This is perhaps the second-most controversial reform suggestion I will make. The costs of complying with the financial reporting requirements of the Sarbanes-Oxley Act by public companies are overblown by some critics, and the expenses of complying with these reporting requirements are slowly coming down. Nonetheless, to help young high-tech companies tap the public markets for new capital, policymakers need to undertake a bottom-up review of the regulatory burdens on both public and private business firms, including but by no means limited to Sarbanes-Oxley.

Given the way government works, mandates to the agencies themselves to reduce unnecessary paperwork, make-work tasks, unnecessary reviews and endless waiting periods is, typically, fruitless. The classic solution is an end run—an independent study group manned by the neutral and knowledgeable—to cut through the sludge, hold hearings, and render detailed recommendations for reducing wasted effort and pointless expense.

The core idea is to eliminate frictional costs without sacrificing hard-won transparency. Audit fees of $1 million are an enormous burden for a venture-backed IPO candidate to contemplate. In my view, a report by the knowledgeable commission I suggest, including representatives of emancipated audit firms that are already moving in the direction of lowering unnecessary costs, is a critical need.

IPO Market Reforms

The first element needed to bring back the IPO is a liberalization of the rules governing IPO market processes, entailing what I call the “long runway,” or a system for allowing the marketplace to review IPO candidates in a leisurely way.[2] We need to remove the hysteria, resembling nothing so much as the opening weekend of a Hollywood movie, from the current process. There has been a little progress in this regard, but much more needs to be done.

In addition, we need to restore, under the appropriate guidelines and rules, the role of the sell-side analysts who do the investor research on these small companies after they go public so that the shares of newly-listed small- and mid-cap companies can tell their story to institutional investors on an on-going basis. This is very hard today because institutional “buy side” interest in smaller public companies disappears when analytical coverage is AWOL.

In fact, for a public company, lack of research coverage by the major investment banks, including the members of the underwriting syndicate, means a berth in the so-called “orphanage,” with stock prices trailing off and liquidity diminished to the “trading by appointment” level. This lack of research coverage—the result, in my opinion, of over-reaction to the dotcom IPO scandals of the late 1990s—is now the reason startup companies face such long odds going public, and then surviving and growing as public entities the way Microsoft, Dell, and Cisco did two decades ago.

I agree with former investment banker (and poster child for the dotcom feeding frenzy) Frank Quattrone, who proposes that our federal regulatory agencies—prodded if necessary by a commission such as the one I have hypothesized—focus on and adopt tried-and-true steps to restore the integrity and objectivity of the sell-side analysts but allow them to be paid on the basis of merit. The core idea is to wall off the Goldman Sachs Group Inc. analysts from the Goldman investment bankers and salespeople, but to allow the analysts to be paid the going rate out of corporate finance revenues. This pay structure must insure that compensation is not tied to the amount of such revenues and that base pay and bonuses are administered by a compensation committee of independent directors, advised by independent counsel and consultants, who will make sure an analyst cannot be fired for trashing Goldman-backed IPOs and M&A valuations.

Executive Compensation

Tying the compensation of corporate managers to the performance of the company shares, thereby aligning management and ownership, was a 1980’s “reform” driven by investors activists and their media acolytes, but which was instituted only half way. To complete the process, I urge we introduce a tax efficient structure entailing a ten-year time horizon for judging the effectiveness of executive compensation alongside a clawback provision governing that compensation so that any bonuses judged unworthy over 10 years can be reclaimed by shareholders. This provision should mirror the compensation arrangements for company executives with compensation arrangements for the managers of private equity funds with investment time horizons of ten years.[3]

In fact, as far back as 2004, I suggested the clawback mechanism, in an interview with Broc Romanek in Corporate Executive’s online edition.[4] In the wake of today’s financial crisis, this kind of reform is more urgent than ever, and would benefit investors in high-flying IPO offerings that, over time, may come crashing back to earth—as happened at the end of the dotcom bubble. These kind of compensation rules would ensure that executives keep their eye on the long-run performance of their companies.

Tax Reform

One of the more troubling tax reforms proposed by the Obama administration is to tax the so called “carried interest,” or the percentage of the profits earned by the managers of private equity funds, hedge funds, and venture capital funds alike for investing in successful companies. Rewarding venture capitalists for taking investment risks alongside institutional investors in their funds is a critical element of a successful EVITA sector. Taxing the carried interest at ordinary income rates would be major step backwards for these venture firms, and will not raise significant revenue.

The real unjust enrichment problem is with management fees charged by the big hedge funds, private equity funds and a few large VC funds. These fees go way over-the-top and are tied only to the size of the fund and not to performance. Reintroducing the idea of budgeted management fees is the right reform in this regard.[5]

Conversely, the negative influence of fast buck artists—including hedge funds and other so called “activist investors”—on the fortunes of public companies is increasingly clear. The case against the activists, who are in my view the equivalent of casino capitalists, is eloquently expressed in a piece by Marty Lipton, who argues that the activists trumpeting “shareholder democracy” and their academic and media acolytes are making it difficult for corporate boards to function in the long-term best interests of the company, the employees, patient investors … and, in fact, the country.[6]

Marty’s concerns are spot on, in my view. Indeed, the latest meltdown is just the latest indication of what happens when the stewards of major public institutions are obsessed with instant gains that appear too good to be true and typically are too good to be true. Our financial system should be built to secure long-term, sustainable growth in the private sector. Accordingly, I suggest that taxes on securities transactions should be adjusted so that, if new capital-gains taxes are on the launching pad, then gains on long-term investments should be taxed at a significantly lower rate than short-term gains.

A lower tax on patient capital, say the sale of shares held for five years, is the way to go. We need to reward patient investors so that public companies can pursue long-term goals, including research and development and innovation. Our economy gets no positive impetus when S&P 500 companies must pander to day traders by buying back stock, dissipating working capital in the form of special dividends, eliminating critical long-term capital expenditures, and auctioning the company to a (seemingly) higher bidder.

Restoring Risk Capital to its Rightful Place in Venture Financing

Perhaps the largest need at the moment, assuming we can re-open the IPO window and make public company status again desirable and a realistic goal of venture capital activity, is to rehabilitate angel investor financing. As Silicon Valley entrepreneur Michael Malone and ABC.com columnist Tom Hayes put it recently in a Wall Street Journal column titled “Entrepreneurs Can Lead Us Out of the Crisis:”

The marquee venture capitalists have little time nor inclination anymore to invest seed capital in early stage companies. The real heroes these days are the nonprofessional investors, the “Angels.” These folks aren’t always the high-net-worth people we imagine, and often they aren’t as sophisticated as we think.

Angel investors, who put their own funds into early stage start-up ventures, have been badly burned in today’s financial markets (as has everybody else), which means the quest for risk capital among startup companies, regardless of how attractive the proposition, is becoming consuming to the point that the search is in many cases simply not realistic. We need to bring back the angels because, without them, the venture process never gets started.

One place to start is at the Small Business Administration. Thus we ought to take a look at the so-called preferred securities program, which authorized the SBA to fund venture capital partnerships which qualified as Small Business Investment Companies, or SBICs, by making equity capital (versus loans) available to those groups. This program tanked because the SBA’s participation was limited on the upside and unlimited on the downside, a “heads you win tails I lose” proposition which, after the dotcom meltdown, deserved to be thrown under the bus, as indeed it was.

That does not mean, however, that the program could not be brought back to life, but restructured so that the risk/reward formula for the SBA and the taxpayers is configured to give the government a level playing field with private capital. Furthermore, the benefits should accrue to venture capital funds focused on early stage ventures, funding the gap between the friends and family round and the late stage mezzanine round … and certainly not including buyout funds that dominated the earlier program.

The second project, which does not require the commitment of taxpayer capital, is to pull together, in one online data source, a directory of as many angel investor clubs as can be located—all for the convenience of entrepreneurs seeking angel capital. The list need not be confined to groups specifically labeling and identifying themselves as “angel clubs” or “groups” because there are a variety of entities that fulfill the same function, including online matching services such as

• SBA-sponsored Active Capital business plan competitions
• Venture capital clubs as they are often styled
• University-sponsored colloquia such as the MIT Enterprise Forum
• Events sponsored by investment banks and other commercial sponsors at which private companies present their business models.

To make such an information platform attractive and useful, however, one additional step could usefully be taken—a Zagat-type inquiry directed to each organization seeking critical information for both angels and other investors, including the “track record” of the organization. The information provided in the directory should include:

• How many investments has it made
• How many members does it have
• The total amount invested in companies presenting
• Average investment size
• Investments made as a percentage of investment proposals presented.

Further, the survey should collect the equivalent of restaurant reviews of the angel group from previous users (tossing out rants from the obviously disgruntled) so that applicants for capital can make up their own mind whether to zero in on that particular group.

And, on the tax front, we need a tax efficient structure by which angels and founders can mitigate the impact of dilution occasioned by subsequent venture capital financings, which is often very hard on the early money. I am plugging hard for what I call “up-the-ladder warrants,” which would enable early investors in young companies to participate fully when the company eventually goes public or is sold through warrants that will make up for the dilution the angels encounter in follow-on rounds of venture financing.[7]

The exercise price of the warrants would be set at a number that is well out of the money (hence the name “up the ladder”), keeping the VCs content to leave the warrants in place when they invest. Assuming all goes well with the sale or public offering of a startup invested in by angels and VCs, both types of investors can profit from their different types of investments in the startup company. To make this structure compelling for angels, I suggest the gain on the warrants should be treated as taxable under Internal Revenue Code Section 1202, which reduces by half the tax on the gain from the sale of securities issued by Qualified Small Businesses (as defined in the Code), assuming that the investment has been held for five years.

Specific Securities Law Changes

I suggest as well that the SEC finally get off the dime and expressly refashion the bar in the Securities and Exchange Commission’s Regulation D against “general solicitation” and “general advertising” in connection with the search for private capital so that it fits current, fully legitimate business practices in the private placement arena. The bar against soliciting or advertising for private capital is meant to separate private and public offerings in order to protect investors, but it is viewed in the industry as an anachronism and is seldom enforced.

An update is long overdue. The rules should be reconfigured so that whatever regulation is appropriate is in fact the regulation that exists on the books. Widespread (and unofficially countenanced) disregard of a major securities rule is not consistent with best practices or healthy for securities regulation generally.

The same holds true for the question of unregistered finders or those individuals and firms who limit their investment banking functions to helping startups (and other private firms) find private capital.[8] The passage of a so called “broker/dealer lite” amendment to Reg D is long overdue. We should legitimize “finders” who do not have any other attributes of investment banks or broker/dealers as they help entrepreneurs find capital, and regulate them at prices they can afford.

Finally, I would also like to see full legitimacy afforded, with the appropriate oversight, to private trading platforms such as SecondMarket, which will allow trading among sophisticated investors in private securities, thereby affording liquidity to investors in venture-backed companies when circumstances change and cash is needed, either by the limited partners in a venture fund or investors directly in a startup company. SEC regulation of the platform is, of course, desirable. (Full disclosure: SecondMarket has an alliance with VC Experts, of which I am a senior contributing editor.)

Capital Markets Reform is Key

Private capital formation in support of innovation is the province of the private sector, as it should be and should remain. But the federal government, as it goes about its vital financial regulatory work, fiscal responsibilities, and economic development efforts in support of broad-based economic growth and prosperity, needs to take into account how all of these efforts affect private capital formation. In my view, the regulatory reforms, market oversight reforms, executive compensation reforms and securities law reforms outlined in this column are the best places to start. Our nation’s capacity to innovate our way out of the current recession and boost our long-term global economic competitiveness hangs in the balance.

Joseph W. Bartlett, an advisory board member of Science Progress, is Of Counsel at Sullivan & Worcester LLP, a courtesy professor at the Johnson School of Business, Cornell University, and founder & chairman, VC Experts, Inc.

Endnotes

[1] www.vcexperts.com, “An Initial Measurement of the Impact of the Seed Money Gap on the U.S. Economy,” Section 13.1.3, The Encyclopedia of Private Equity and Venture Capital

[2] http://www.joebartlettvc.com/sites/default/files/Bartlett_Shulman.pdf

[3] http://www.joebartlettvc.com/sites/default/files/gzp4n01_.DOC_.pdf

[4] This interview originally appeared in the online version of The Corporate Counsel and the thoughts expressed therein repeated and re-emphasized in Bartlett & Lundburg, “A New Executive Compensation Model,” NYLJ, May 16, 2007.

[5] See e.g., Kreutzer, “Putting The ‘Partner’ Back in Limited Partner,” Private Equity Analyst Plus, 4/9/2009.

[6] http://blogs.law.harvard.edu/corpgov/files/2007/02/20070210%20Lipton%20Address.pdf

[7] http://vcexperts.com/vce/news/buzz/archive_view.asp?print=true&id=109

[8] http://www.joebartlettvc.com/sites/default/files/Document.pdf

Tags: Innovation

Comments on this article

You can skip to the end and leave a response. Pinging is currently not allowed.