Archives For IPOs

Groupon’s tmi

Larry Ribstein —  28 July 2011

The WSJ reports that the SEC is on Groupon’s case for reporting “adjusted consolidated segment operating income” of $81.6 million while noting that subtracting marketing costs would produce a loss of $98 million.  Groupon recently added that adjusted CSOI “should not be considered as a measure of discretionary cash available to us to invest in the growth of our business or as a valuation metric” and that, according to the WSJ’s paraphrase, “investors should look at standard financial metrics such as cash flow, net loss and others when evaluating its performance.”

Apparently the SEC thinks Groupon shouldn’t disclose CSOI at all because it’s gross revenues rather than “profits.”  But does the SEC really know what investors should rely on?  Might not CSOI be a more realistic measure of future earnings than focusing on the investment the company made to produce that income?  Maybe not, but as long as it’s accurate, why not just give investors all the information with the appropriate qualifiers?

Then, too, Groupon co-founder Eric Lefkofsky committed the sin of “gun-jumping” by saying that “Groupon is going to be wildly profitable.” Sort of reminds me of Google’s famous Playboy interview.  As I asked back then:

[S]houldn’t the First Amendment have something to say about this broad regulation of truthful speech? See my article (with Butler), Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994), a chapter in our Corporation and the Constitution.

I recognize that there’s a point to this regulation:  to protect investors from rushing into horrendous investments like Google in 2004.

Today’s WSJ reports on the US’s slide in stock listings, which explains the NYSE/Deutsche Borse move.  It notes that

  • U.S. stock listings are down by 43%, or by 3800, since 1997.
  • Listings outside the U.S. have doubled.  
  • U.S. IPOs since 2000 are down 71% from the 1990s. 
  • IPOs by VC-backed startups are down from 90% in the 1980s to 15%.

Some reasons:  firms have lower compliance costs, fewer shareholder suits, lower d & o insurance costs, and lower listing fees, no SOX (or Dodd-Frank).

Nasdaq is seeking to compete with London’s AIM by opening an exchange for small companies that don’t meet its general listing requirements.

But this won’t solve the problem.  In the long run, the US securities laws compete in a global market.  Although other factors, including the growth of foreign markets, help explain the above shifts, these other factors increase the competitive pressure on US law.  Congress and the SEC are going to have to stop acting like they’re alone in the world.

Last week I argued that the SEC’s considering relaxing the rule requiring 1934 act registration of stock classes with more than 499 shareholders was not what it seemed.  I noted that while this might look like a move toward liberalization by permitting more Facebook-style markets, it actually furthered a trend toward closing US securities markets by effectively excluding ordinary investors.

John Carney cited my post and argued that

The SEC wants to preserve its authority in public markets and refuses to reduce the regulatory burden of companies with public stock. The investment banks want to increase their fees, and find that they can do this in private markets more easily than they can public market, where they are forced to compete with low cost brokers. So Wall Street and the SEC are cutting a deal that keeps both sides happy.

He added that in making this move the SEC ironically would be encouraging “some of the very practices the SEC and other regulators fought so hard to eliminate not so long ago” — specifically, using hot stocks as leverage to get high brokerage fees from clients. 

More recently we got news of a 17-page March 22 letter from Congressman Darrell Issa, chair of the House Oversight and Government Reform Committee, to SEC Chair Schapiro asking a lot of questions about what the SEC is and is not doing.  Issa wanted to know, among other things, what the SEC thought about why the US IPO market had declined and what the SEC was doing about it, and the costs and benefits and constitutionality of rules shutting off issuer communications during the “quiet period.”

Interestingly, Issa seemed particularly interested in the costs of the 499 shareholder rule in terms of inhibiting liquid markets in non-publicly traded shares, and whether this rule really serves to protect investors.  This letter would seem to explain the SEC’s latest deregulatory wobble and why the SEC is not as concerned about these private markets as Carney and others expected it to be.

But this leaves unanswered the question of what is the best overall policy:  encouraging more private markets or freeing public markets from their regulatory shroud.

Perhaps the SEC should pay more attention Issa’s whole letter, including the part about what happened to IPOs, and another part requesting information about who, if anybody, was analyzing regulatory costs and benefits at the SEC. The minority Republican SEC members have been urging this sort of cost-benefit analysis.

But as Carney noted, the politicians currently in charge of regulating the securities markets are not exactly taking the long and deep view.  Congress jerked their leash, and they seem to be sniffing down the path of least resistance.

Larry makes a strong argument below for why the proposed SEC rules changes reported today in the WSJ should not be heralded as some great opening up of US securities markets, but that the changes are little more than political posturing to prevent addressing the real problem of the costs imposed by securities regulation more generally. I don’t disagree that the proposed rules changes Larry targets are, at best, window dressing to release some (well-justified) pressure created by innovative market-based solutions to circumvent the rules that lie more at the root of the securities market problem.  So long as the costs associated with “public” placements are so high, investors and issuers will continue to look for ways to expand their access to capital within the “private” placement market, which by definition excludes many (especially smaller) investors.

That said, I will point out that one of the quotes in the article bemoaning this proposal comes from an institutional investor–one of the groups that is more likely to benefit from the current 500 entity cap. If raising the cap would not open up the market meaningfully to new potential investors, I wouldn’t expect to see such negative comments from one of the groups who will face this greater competition in the supply of private equity. So while the proposed changes certainly don’t address the real problem, it seems they may make the market a bit more open (and less subject to contrived and costly work-arounds like special purpose vehicles) than it currently is.

However, among the rules changes being proposed is one that should open up the market to greater access even to smaller investors (up to whatever new cap might replace the current 500 entity rule). And it’s a rule  change that appears a direct response to something Larry blogged about here just earlier this year.

According to the WSJ report, the SEC “is considering relaxing a strict ban on private companies publicizing share issues, known as the ‘general solicitation’ ban.” The current regulations are currently under Constitutional scrutiny as a potential violation of 1st Amendment speech rights, as a result of a case by Bulldog Investors that Larry discussed in his earlier post.  Again, how far will the ‘relaxing’ go and will it be a substantive change in the underlying problem, or just another hanging of curtains? But there should be no doubt that more open communication about private equity investment opportunities should further open the market to smaller investors.

All this to say, I believe Larry is on point for the big picture, but the proposed regulation changes don’t seem to be all bad. Of course, the devil is in the details–so we’ll have to reserve judgment until the specifics are revealed before having more confidence in that conclusion.

The WSJ reports that the SEC is considering raising the 500-shareholder limit on the number of holders of a class of securities a company can have before having to register that security with the Commission under Section 12(g) of the 1934 Act. The SEC reportedly is also considering relaxing the “general solicitation” restriction on private offerings.

At first blush this seems like a pro-market liberalization.  The story notes that “the agency has a responsibility to encourage companies to raise capital as well as to protect investors.”

But look again.  The SEC move clearly results from market arbitrage moves by hot firms like Facebook, Twitter and Zynga to open an end-run around the 500 shareholder rule.  I noted last January that Facebook got around the limit by selling all the stock to one person, a special purpose vehicle, which only wealthy investors can trade privately under an exemption to the 1933 Act.  (And maybe only non-US rich people.  Shortly after the story reported above, I noted that Goldman had moved its Facebook market exclusively offshore.) The SEC was also worried about insider trading in this new private market.

In other words, the market created this exemption, not the SEC.  Faced with inexorable market demand and arbitrage the SEC is considering making the escape route official. This resembles the “check the box” tax rule a decade ago which opened the door for LLCs after numerous unincorporated vehicles had challenged the government’s ability to put a lid on exempting unincorporated firms from the partnership tax. 

The SEC’s other option was reducing the various regulatory taxes on IPOs and public companies under the 1933 Act, SOX and Dodd-Frank which created the pressure on the 500 share limit.   In my earlier post I noted that VC partner Ben Horowitz had told the WSJ that

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

By expanding the private market for new firms, the SEC would release some of the political and market pressure building against over-regulation of going public.  Rather than liberalizing regulation, it would help protect existing regulation. 

The costs of this choice are significant.  Consider that in 2004, Google went public when it ran up against the 500 shareholder requirement.  Now, instead of IPOs, we have a market reserved for rich people. As I said last January:

[T]he increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted

The emerging market for rich people is especially ironic in view of the SEC’s increased push against insider trading. While the SEC is going all out in its Quixotic task to “level the playing field,” it is emptying that playing field of the people for whom it’s supposedly unlevel.

This move from public to private has broad ramifications.  The US traditionally has the broadest and deepest public securities markets in the world.  Indeed, the securities laws were enacted in the 30s to encourage participation by ordinary investors, and the securities laws have been interpreted consistent with that goal.  The problem is that Congress and the SEC have taken this goal too far, overburdening the US markets with regulation.  Coupling the shrinkage of the public market with an expanded option for rich people hastens this evolution away from strong US capital markets. 

At the same time, the US faces increased global competition.  As I discussed last week, evidence on IPOs suggests that public markets elsewhere in the world are catching up with the US.

The privatization of US markets could have important indirect effects.  Broad public participation helps democratize capitalism.  A move in the opposite direction could deepen Americans’ suspicion of capitalism as the playground of the wealthy.  Also, the securities markets are the primary source of data about large companies.  Closing these markets reduces transparency for everybody and not just investors.

The better move is to reverse the regulation that prompted this trend toward closing the public markets. The SEC is opting instead for short-term political expediency.

IPOs going elswhere

Larry Ribstein —  31 March 2011

A couple of months ago I asked “what happened to IPOs.”   I noted then that the decline in US IPOs had something to do with US regulation, including SOX and Dodd-Frank. 

A new paper by Doidge, Karolyi &  Stulz, The U.S. Left Behind: The Rise of IPO Activity Around the World suggests it has something to do with the rest of the world catching up.  Here’s the abstract:  

During the past two decades, there has been a dramatic change in IPO activity around the world. Though vibrant IPO activity, attributed to better institutions and governance, used to be a strength of the U.S., it no longer is. IPO activity in the U.S. has fallen compared to the rest of the world and U.S. firms go public less than expected based on the economic importance of the U.S. In the early 1990s, the declining U.S. IPO share was due to the extraordinary growth of IPOs in foreign countries; in the 2000s, however, it is due to higher IPO activity abroad combined with lower IPO activity in the U.S. Global IPOs, which are IPOs in which some of the proceeds are raised outside the firm’s home country, play a critical role in the increase in IPO activity outside the U.S. The quality of a country’s institutions is positively related to its domestic IPO activity and negatively related to its global IPO activity. However, home country institutions are more important in explaining IPO activity in the 1990s than in the 2000s. The evidence is consistent with the view that access to global markets helps firms overcome the obstacles of poor institutions. Finally, we show that the dynamics of global IPO activity and country-level IPO activity are strongly affected by global factors.

Put the two stories together: the rise of the rest of the world leaves the US less room for regulatory excess.

What happened to IPOs?

Larry Ribstein —  4 January 2011

So Facebook finally had its public offering.  But it didn’t look like your father’s IPO.  Instead, Facebook sold $500 million in stock to one person. The stock will be held by a single special purpose vehicle so Facebook avoids going over the 500-investor-limit for avoiding the disclosure obligations of a public company.  Wealthy investors get to trade interests in that interest.  Facebook gets that cash (plus an expectation of another $1.5 billion in stock sales) for growth, a $50 billion market valuation (of which 14 billion belongs to Zuckerberg), stock it can use for acquisitions and hiring — many of the goodies post-IPO companies get. 

According to Steve Davidoff, this won’t work if Facebook is deliberately circumventing the securities laws, and “Goldman’s planned special purpose vehicle and any other vehicles formed certainly appear to be cutting it close.” Facebook therefore may have to start reporting anyway, but not until May 2012, by which time it may be ready to go public, which it may want to do anyway.  The tactic at least enables Facebook to delay an IPO for as long as possible.

Per the VC partner Ben Horowitz, quoted in the WSJ,

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

Meanwhile, Dealbook reports the establishment of another trading system for private firms.

Another Dealbook story adds that “[l]ots of people would stand in line to buy shares in Facebook, but for now, only an exclusive few — wealthy clients of Goldman Sachs — will be able to.”

 “This is a topsy-turvy world,” said Scott Dettmer, a founding partner of Gunderson Dettmer, a law firm that has advised venture capitalists, start-ups and entrepreneurs since the 1980s. He added that even a few years ago, “there were all sorts of business reasons to go public, but for entrepreneurs it was also a badge of honor.”

But now, private market alternatives

have become more attractive for companies, in part because of the increased regulations imposed on public companies but also because of the rise in short-term trading, which leaves some executives feeling they have lost control of their companies. * * *

Ben Horowitz, a partner with Andreessen Horowitz, a venture capital firm, said the cost of being a public company had risen to about $5 million a year, from about $1 million a year. Mr. Horowitz, an early employee of Netscape, said that such costs would have eaten into the meager profits of the pioneering Internet company when it went public in 1995. Additionally, accounting and legal requirements have become distractions for many start-ups, said Mr. Horowitz, whose firm is an investor in Facebook.

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted.

My colleague Tom Hazlett (George Mason University) has a characteristically thoughtful and provocative column in the Financial Times on the recent Clearwire joint venture and what it tells us about the “innovation commons” and current public policy debates such as network neutrality, spectrum property rights, and municipal wi-fi. Here’s an excerpt:

Clearwire-Sprint-Intel-Google-Comcast-TimeWarner-McCaw blasts away barriers to broadband and a flock of public policy myths. Stories about the coming era of municipal wi-fi, the obsolescence of property rights to radio spectrum and the desperate need for “net neutrality” fall to pieces. For years these tales were spun from the triumphal assertion that the “innovation commons” of the post-internet economy changed everything. The “Chicago School” tools to prosperity – establish property rights, deregulate, let market competition rip – were dusty relics of a bygone era.

So broadband was a crummy cable-DSL duopoly, and local governments’ wireless networks would fix that. Mobile telephony was a crummy oligopoly, and more unlicensed spectrum – as used for wi-fi and cordless phones – would fix that. And to protect it all, the internet’s “open end-to-end” environment needed some regulatory muscle: rules prohibiting discrimination by internet service providers, control freaks who, left to their grabby impulses, would increasingly squeeze customer choices. Network neutrality rules would fix that.

But here’s “New Clearwire”. The chief advocates of muni networks are shelling out to build private networks, instead; the lobbyists for more unlicensed spectrum are paying to purchase licensed spectrum; the champions of net neutrality are getting preferential non-neutral customer access by buying the internet service provider…. New Clearwire tells us that a “fully-open, third pipe” has arrived in the broadband market – and their corporate network, crafted with exclusive spectrum and preferential access, and gobs of private capital — will deliver it. That, truly, is a great leap forward. Thank goodness for the “innovation commons”. The Chicago School could not have said it better.

For those interested in small company finance, I’ve recently posted on SSRN a draft of the short piece I’ve written for the Entrepreneurial Business Law Journal symposium issue. The piece is entitled “The Truth About Reverse Mergers” and can be downloaded here. Here’s the abstract:

The Article examines the reverse merger method of going public. It describes the principal features of reverse mergers, including deal structure and legal compliance. Although reverse mergers are routinely pitched as cheaper and quicker than traditional IPOs, the Article argues that such pitches are misleading and, for many companies, irrelevant.

is here, over at eCCP, and differs somewhat from Thom’s.

The takeway excerpt is:

Credit Suisse has important implications for antitrust practice. The decision’s effect is to narrow the scope of antitrust law and to invite efforts by regulated industries to narrow it still further. The court’s “clearly incompatible” standard is new and (though it purports not to) seems to water down considerably the old “plain repugnancy” test of Gordon v. New York Stock Exchange, Inc. 422 U.S. 659, 682 (1975). Under the new incompatibility standard, there no longer has to be an actual conflict between antitrust and other federal law for antitrust implicitly not to apply. Even a mere regulatory overlap may now be sufficient to trigger antitrust immunity. (Recall that in Credit Suisse the Court assumed that both antitrust and the SEC disapproved of the tying and other practices in question, and yet the Court still considered the two bodies of law incompatible on account of the regulatory overlap.) ….

Going forward, the Court will need to tighten the rule in Credit Suisse if it wants antitrust to continue to operate as Congress intended it to in conjunction with the compartmentalized maze of federal regulatory law. No one thinks that securities firms should be exempt from the legal obligations that generally flow from non-securities law (antitrust aside). If we expect to hold securities and other regulated firms accountable for torts and breaches of contract, or for crimes and discrimination, then why not also hold them accountable for antitrust violations? If Congress says otherwise, that is one thing. But if Congress is silent on the question, a federal agency should not have have any more power than a state to confer antitrust immunity upon those that it regulates. Of states we require a clearly articulated policy that presents an actual conflict, not merely the possibility of future potential incompatibility. From federal agencies we should not expect any less.

Just yesterday, in its historic decision in Leegin, the Court strongly reaffirmed its confidence in the Rule of Reason’s workability by overturning Dr. Miles and extending the rule’s reach to vertical RPM. That workability should make us equally confident that antitrust can peacefully coexist with the reguatory state.