I have just finished reading yet another article on the subject of the impending revival of the IPO market for venture financed companies. I also recently heard a partner in a prominent Massachusetts law firm, explain that the IPO market for venture financed companies was going to “come back” this fall. The recent IPOs of Rosetta Stone and Bridgepoint Education (neither of which was venture financed) seems to have people panting. Oh, yea, and there was a Chinese company that went public on the NASDAQ recently. Hence all the titilting trailers hoping to foment excitement for the movie to be released this fall. There has been a lot of discussion about why the IPO market is in the dumps, and it cannot be separated from the general economic collapse we are all experiencing, but people seem to be focusing on a few items as if “fixing” these will somehow bring back IPOs. It is not at all clear that these discussions are focusing on the right issues.

A couple of things: First, no one wants to see exits come back strong more than I do. As I have noted many times, the lack of exits (including but not limited to IPOs (as lawyers like to write) is a major drag on the innovation economy. This last sentence is more in the nature of a disclaimer concerning what I am going to say next than anything else. Second, when various opinion leaders start in on what is wrong with the IPO system, they inevitably target the wrong things. How many times have you heard the public market woes blamed on Sarbanes Oxley’s heavy handed legislation? Third, have you ever heard anyone say that the problem is that the venture backed companies model is not really building great companies (although I suppose it depends upon what you mean by “great”) but rather building companies with tight investment theses not suited to be public?

In response to the lawyer mentioned above, let’s get some of the facts right: The last IPO of a venture financed company was RackSpace, which went public on August 7, 2008. It bombed. Here is what Fortune had to say at the time:

Rackspace took the IPO plunge Friday and fell flat on its face, which will only make other startups more hesitant to follow its lead.

 

The web-hosting company had planned to offer 15 million shares at between $12 and $16 per share in a modified Dutch auction, but hopes ran even higher. Scott Sweet of IPO Boutique told TheStreet.com that Wall Street chatter indicated Rackspace (RAX) share would price as high as $17; MorningNotes pegged it at closer to $16. The shares ended up pricing Thursday night at $12.50, and they began trading closer to $10 per share. They rose as high as $11.58 in mid-day trading before settling back near $10.

 

If people were looking for this deal to turn things around for the market, it certainly hasn’t done that yet….

The fact that a couple of non-venture financed companies are going public is relevant only to the extent that it is evidence that someone can go public. Non-venture financed companies are, I believe, not necessarily built on a tight concise tight investment thesis, as many (most?) venture financed companies are. 

A company built on a tight, narrow investment thesis is not likely to be a good candidate for a sustainable public company because its prospects are not likely to be big enough. ThermoElectron was a huge success as a public company, Google, Microsoft, EMC etc. -- all great companies. RackSpace? Many venture financed companies have identified and are addressing a narrow pain point (it could be big in the sense of a sales potential of hundreds of millions in some cases more). At the risk of stating the obvious, these companies are logical product extensions for bigger companies. The VC industry tends to reward tight thesis companies with investment and to shun larger more broad less defined visions. I suspect that business schools teach tight business plans in their entrepreneurship courses, but I could be wrong. A tight narrow thesis may make a fine VC investment, but it has limits as a public company.

On to Sarbanes, everyone blames Sarbanes for putting a wet towel on the hot IPO fire. It has come to symbolize the deadening hand of government regulation. Personally, I agree that all Sarbanes did was transfer wealth and power to the big four accounting firms. (By the way, the very people who were not minding the store when Enron et. al. pulled their shenanigans, which suggests that perhaps accountants are not the right people to wield all that power.) Having said that, what is the real impact of Sarbanes on the IPO market? It makes IPOs (and regular public company existence) more expensive and more painful than it needs to be. I can’t say that I have made a study of this, but based on what I hear from my clients and contacts, for a small public company (one with a market cap in the mid hundreds of millions) the incremental cost of accounting services is a couple hundred thousand more per year than it was before Sarbanes (with a big hit on the IPO). If the economics of being public are so tight that a difference of $200K moves the needle, maybe you should reconsider going public. Now, I am not in favor of paying accountants more for less work, but let’s get real, Sarbanes is not what is wrong with the IPO market.

The most insightful comment on why the IPO market for venture financed tech companies is so bad that I have read recently came from Startable (a blog written by Healy Jones of Atlas Venture). He wrote, and I quote, “the big buyers of small-cap technology IPOs have left the building - I’m not 100% sure why but I bet it has something to do with the fact that in the late 90’s a bunch of crap was sold to them.” 

To bring back the IPO market, companies need to bring real long term value to investors. This means building great companies on great visions rather than add ons for IBM, Google, EMC et. al. The buyers have awoken from their torpor and all the finagling with accounting rules and SEC regulation in the world wont help – we need good candidates for IPOs.