Alarmed by the continuing lack of initial public offerings for venture-backed companies as well as other obstacles that these startups face in securing financing or “exits” such as stock offerings, the National Venture Capital Association wants some major changes made.
Calling the current environment a “capital market crisis,” the NVCA It includes a call for more partnerships, additional paths to “liquidity,” less regulation and tax changes. The group laid out the strategy Wednesday at its annual board meeting in Boston.
Pittsboro, N.C.-based Biolex, Triangle-based Aldagen and Atlanta-based Alimera are three regional venture-backed companies that have pulled IPO plans in recent months.
Early reaction included of Private Equity Hub, one of the most widely followed journalists in the private equity sector.
“What’s important to realize about NVCA’s presentation is that it argues that VC-backed problems are systemic, rather than recessionary,” Primack wrote at PE Hub.
“For example, the (Eliot) Spitzer-prompted separation of research and investment banking has caused massive drainage of the analyst pond, thus making it far more difficult for VC-backed companies to obtain coverage. And as much as I hate relaxing regs that were designed to protect investors, I’ll concede that small-cap companies should not be under the exact same rules a large-cap companies. Or at least they should have a more streamlined process (particularly vis-a-vis [SarbanesOxley] compliance).”
However, Primack also noted that venture-backed firms themselves in many cases simply aren’t ready for public markets no matter the state of regulation, economy or tax rates.
The NVCA is not simply pointing a collective finger and telling other players in the private equity markets, including government agencies, to alter the ways business are done.
The association is also making some changes by expanding the “ecosystem” in which it and venture capitalists operate.
“Within the last decade, venture-backed companies have been faced with fewer choices as it relates to investment banks and accounting firms that will assist in the IPO process,” the NVCA said. “While the major investment banks continue to operate, the ‘four horsemen’ boutique investment banks of the 1990’s (Alex Brown, Hambrecht & Quist, Montgomery Securities, and Robertson Stephens), which specialized in IPOs of venture-backed companies, no longer exist. Further, the fall of Arthur Andersen and the resulting pressure placed on the Big Four accounting firms has, in many markets, left a void in terms of quality auditing services available for these smaller companies.
“Against this backdrop, the NVCA believes that the venture capital industry must do more to promote alternative ecosystem partners while engaging with existing members to identify ways to better serve the needs of emerging growth companies,” the group added. “The Association has begun to engage in talks with boutique and major investment banks as well as the Big Four and other public accounting firms about how they can also better serve the needs of small cap companies. The NVCA also intends to encourage the use of a broader array of service providers such as the ‘Global Six’ including Deloitte LLP, Ernst & Young LLP, Grant Thornton LLP, KPMG LLP, PricewaterhouseCoopers LLP and BDO Seidman LLP.”
After only six IPOs in 2008 and a decade of “alarmingly low” number of IPOs, the NVCA said the “venture capital industry, investment banking, accounting professions, law firms, stock exchanges and the government” must work together “to enact measures to restore a vibrant IPO environment once the overall economy stabilizes.”
A forthcoming study from financial analysis firm Global Insight spells out the importance of venture-backed firms executing successful IPOs, according to the NVCA. The report will say that in 2008, public companies that were once venture-backed:
• Accounted for more than 12 million U.S. jobs
• Generated more than $2.9 trillion in revenues, which equates to 21 percent of U.S. GDP.
• IPOs trigger job growth – 92 percent additional jobs at these firms “occurs once the company enters the public markets.”
“The consensus is that the most significant improvement to our capital markets will only be achieved if both the private sector and the government address the breakdowns that have occurred within their respective systems,” said Dixon Doll, a co-founder of the NVCA and its chairman. He also is a partner at the venture firm DCM. “While there are regulatory and legislative avenues to explore, the venture capital industry recognizes that we can affect positive change by adjusting the way we do business and are willing to do so to enact this change.”
Other that “Ecosystem Partners,” the other three pillars as spelled out by the NVCA:
Pillar II: Enhanced Liquidity Paths
There is consensus among many within the capital markets ecosystem that the distribution system that connects sellers and buyers of venture-backed company new issues is broken. There are many drivers behind this disconnect including mismatched expectations in terms of issue size, the lack of sell side analysts, and the propensity of hedge funds to buy and sell stock quickly. All of these factors contribute to a lack of an adequate distribution channel and considerable post-IPO market volatility.
To offer small venture-backed companies an enhanced distribution system for the sale of initial stock, the NVCA endorses concepts such as Inside Venture which is a private market platform that connects qualified companies that intend to IPO within 18 months with pre-screened cross-over investors. These buyers commit to buy and hold these stocks for the long term. Other providers with similar models include Portal Alliance (NASDAQ), SecondMarket and Xchange. Additionally, the NVCA will help raise awareness about pro-active M&A roll up strategies of smaller portfolio companies to achieve IPO critical mass and global alternatives to the U.S. public markets.
Pillar III: Tax Incentives
The NVCA has long asserted that the government must support a tax structure that fosters capital formation and rewards long term measured risk taking. To support a more vibrant IPO market, the U.S. must maintain tax policies that have been proven to encourage venture capital investment so that the pipeline of promising IPOs is as robust as possible. Further, Congress should consider adopting new tax incentives which would stimulate IPOs, at least in the short term.
The NVCA will continue to advocate strongly for a capital gains tax rate that is globally competitive and preserves a meaningful differential from the ordinary income rate. The Association asserts that venture capitalists who are successful in building new companies should continue to be taxed at a capital gains rate for any carried interest that is earned over the long term. The Association also intends to explore the possibility of a one time tax incentive for buyers and holders of IPOs as well as increasing the holding rate for capital gains status to two or more years.
Pillar IV: Regulatory Review
From a regulatory perspective, the last decade has been characterized by a series of broad sweeping regulations aimed at curbing serious abuses within the financial system but fraught with unintended consequences for small pre-public and public companies. From Sarbanes Oxley (SOX) to the Global Settlement to Reg FD, small venture-backed companies have been faced with costly compliance and increasing obstacles to enter the public markets as a result of regulations intended for larger multi-national corporations. The NVCA strongly supports regulation and protecting investors where necessary but does not support a "one-size-fits-all" regulatory approach.
To wit, the NVCA will advocate for a full systematic review by the Securities and Exchange Commission of recent regulations which impact small cap companies. This review would include interpretations of SOX, pre-IPO financial reporting requirements, the separation of analyst and investment banking functions, and private placement requirements. There are opportunities within existing regulations to tier compliance so as not to overburden emerging growth pre-public and public companies at a time when they need support from the government, their auditors, and the markets.