Evidence of the SOX effect on IPOs

Larry Ribstein —  11 January 2011

Last week I noted that Facebook’s big private sale to Goldman was a symptom of how higher disclosure costs have helped make private firms reluctant to take the once-expected step of going public:  “[I]t seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.”  Gordon Crovitz picked this up yesterday in his WSJ column.

Today comes some evidence that higher disclosure costs, and specifically SOX, in fact have something to do with this phenomenon — Bova, Minutti-Meza, Richardson and Vyas, The Sarbanes-Oxley Act and Exit Strategies of Private Firms.  Here’s an excerpt from the abstract:

[W]e establish three principal findings. First, SOX appears to have shifted the incentive for firms to exit the private market via IPO to exit via acquisition by a public acquirer. Second, * * * [f]or our median-sized private target, the estimated dollar value decrease in deal proceeds when one moves from a high level to a low level of pre-acquisition SOX compliance is $1.3 million. Finally, public target deal multiples are not affected by a public target’s level of pre-acquisition SOX compliance. These findings suggest that SOX-related costs have both restricted the action space of possible exit strategies for private firms and led to lower deal multiples for those private acquisition targets that are less likely to be SOX compliant prior to acquisition.

The study’s basic intuition is that SOX makes it cost less for a public firm to acquire a private target than for a private target to do an IPO because the public firm can apply its existing SOX infrastructure to the newly acquired firm. This is consistent with the basic idea that SOX’s big problem for private firms is that its infrastructure costs are not perfectly scalable.  The effects of variations in target firm SOX compliance support the inference that this is, indeed, a SOX effect and not attributable to some other cause.

This means that in order for an IPO to be preferable to being acquired, a firm has to meet a higher value threshold than it would without SOX.  Thus, the authors conclude, “as a result fewer private firms should choose the IPO option as an exit strategy, post-SOX.”

Moreover, because increased SOX compliance costs are impounded into the price of the acquired firm, SOX compliance affects the price of private, but not public firms. (To be sure, SOX compliance also affects the value of the firms because they are more transparent and hence less risky.)  This could make it harder for private firms to be acquired by public firms post-SOX, although the authors don’t directly measure that effect.

Thus, the authors conclude, “[t]he combined results suggest that the costs to SOX are not restricted solely to public firms, and that an indirect cost of SOX may be its impact on restricting the exit opportunities for owners of private firms.”

To return to the conclusion of my prior blog post, “rules designed to make the markets safe for ordinary investors have ended by excluding them.”

Larry Ribstein

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Professor of Law, University of Illinois College of Law

3 responses to Evidence of the SOX effect on IPOs

  1. 
    north fork investor 12 January 2011 at 11:37 am

    Steven Davidoff also expresses some viewpoints relevant to this topic and not entirely consistent with Prof Ribstein’s viewpoints.

    http://dealbook.nytimes.com/2011/01/11/with-facebook-debate-renews-over-i-p-o-regulation/

  2. 
    north fork investor 12 January 2011 at 11:11 am

    I came across something that serves as some evidence that there is something to the idea that SOX drives venture capital backed firms to exit via the merger market vs an IPO. see

    http://www.businessinsider.com/alan-patricof-greycroft-ipo-market-2011-1#

    for the views of well respected venture capitalist alan patricof. But some of his policy prescriptions are giant steps backwards in stock market technological efficiency.

    And generally speaking the view that market regulatory changes like SOX designed to reduce fraud ends up excluding the retail investor from opportunities is a non-sequitur. Retail has always been excluded for the most part from free lunch profits and has always been one of the primary dumping grounds for garbage and toxic waste.

  3. 
    north fork investor 11 January 2011 at 6:59 am

    It’s so funny. I read all those earlier pieces, yours from the fourth; Crovitz’ yesterday and it is so clear that neither of you know very much about the venture capital IPO process and the real considerations causing venture capital backed companies to go public or sell or defer a liquidity event.

    SOX and Reg FD and other disclosure issues are way down the list on considerations that these kinds of decision makers take into account in deciding to go public vs selling vs defering a liquidity event.

    Without a doubt the most important considerations are market-related ie are investors clamoring for a deal or is a buyer knocking at the door. Believe me if there is a single buyer at a price close to the public market exit price (present valued in a series of risk-adjusted public offerings and it could be materially below), the institutional VC investors prefer the sale to the IPO because the pop is bigger. And there are legal securities law considerations that take time to process for an IPO that are independent of SOX. You can’t write an s-1 in a day. You can’t do your due diligence in week (or even a month)with a private company.

    And that is why the Facebook “private placement” is brilliant marketing. It’s forcing the company to go public in 2012 and it’s putting a stamp of valuation approval from Goldman and its clamoring private wealth customers at $50 bb.

    Facebook isn’t going public not because it hates SOX and retail investors but because this is most likely the best way to get the valuation it wants when it has its process ducks in line to market a registered offering.

    It is not SOX related in the least. And you won’t hear that SOX considerations are serious ones from any VC-backed large scale venture. Didn’t effect Google. Won’t effect Facebook.

    SOX has nothing to do with keeping retail out of the Facebook offering.