A Tale of Two Markets

Imagine if you will, a marketplace where America’s most innovative and promising young companies can raise capital, reward their hardworking employees with liquidity and take their first steps toward becoming the next leaders of the U.S. economy, all by selling shares of their stock to investors eager to participate in their tremendous growth potential.

Am I describing A) the current U.S. equities markets, B) the emerging secondary markets for private company shares, or C) none of the above?

Sadly, the facts rule out Answer A. In the last decade, our capital markets system has begun to wither as the number of IPOs has dropped to a fraction of what it once was.

If you picked Answer B, you’re probably not alone. Over the past year, the hype surrounding the marketplace for shares of such innovative pre-IPO companies as Facebook and Twitter has grown substantially. However, private trading volume remains a fraction of public trading.

That leaves us with “none of the above,” as well as a real crisis on our hands. Truth is, the U.S. equities markets haven’t resembled the description above since the mid-1990s , which happens to be the last time the U.S. economy was on a sustainable growth trajectory.

To resolve this crisis and get back on the growth track, we need to shift our focus from the symptom—private market trading—to the cure: reviving the U.S. IPO market. Failing to do so could have catastrophic consequences for U.S. economic growth.

The Power of IPOs

Innovative, emerging companies use IPOs to launch themselves on growth trajectories that acquisitions and other capital sources just can’t spark. They use the significant capital influx to improve their products, scale up their operations, expand to new markets and hire new employees.

The connection to U.S. job growth is especially important. IHS Global Insight research suggests that 92% of job growth for young companies occurs AFTER their IPOs. Some of America’s most influential companies—including Apple, Cisco and Genentech—have grown from small caps at the time of their offerings to multi-billion-dollar companies that employ millions of Americans.

Of equal importance, IPOs allow founders and investors to recycle their capital, investing in the next generation of startups. This cycle is key to driving forward innovation and ensuring American competitiveness.

America’s IPOcalypse

Markets have a knack for telling us what’s working and what isn’t. For the first 10 years of the 21st century, the message from the U.S. IPO market has been loud and clear: S-O-S.

From 2001 to 2010, 477 venture-backed companies went public, as compared to 1,973 from 1991 to 2000, a drop of over 75 percent. During the past decade, the median time to get to a public offering has increased from 4.75 years in 1998 to 9.2 years in 2010.

The reason why can be summed up in two words: inappropriate regulation.

Ironically, the same policies lawmakers aimed at drawing investors back to the capital markets in the wake of the financial scandals of the early 2000s have actually discouraged the very types of innovative, high-growth companies they’d want to invest in from going public.

The Sarbanes-Oxley Act’s one-size-fits-all regulations have increased the time and cost burdens for small private companies looking to go public. In aiming to reduce the conflict between investment banks and research analysts, the Global Analyst Settlement has produced similarly seismic changes in the way company stock is covered and sold, effectively eliminating sell side analysts for small cap companies and the removing the primary marketing vehicle for their stock sales. Finally, the Dodd-Frank Act is poised to layer more restrictions on corporate governance and the independence of boards.

This cocktail of unintended consequences has slashed the number of emerging growth companies looking to go public, triggered a drought in the U.S. IPO market and robbed investors and the economy of the benefits that a healthy market delivers. The moribund IPO market has also hobbled the growth of an entire generation of companies that could have become the drivers of tomorrow’s economy.

A Symptom, Not a Solution

The longer runway from founding date to IPO, for those few companies who are considering this path, has placed pressure on founders and early employees for liquidity. At the same time, with the low number of offerings, investors are beginning to look for other ways to participate in the growth of innovative young companies.

Increasingly, these parties are finding each other in the private, secondary markets. In fact, the SEC has even begun to investigate current trading practices there. Perhaps surprisingly, some of its preliminary comments suggest that it may ease some of the restrictions on private company trading, such as the 500 shareholder rule to retain private status.

While this will allow greater participation on the secondary exchanges, the private, secondary market is not a viable substitute for a robust U.S. IPO market.

First of all, the private market excludes large numbers of investors from participating, as trading private shares is limited to qualified institutional buyers and accredited investors. This smaller investor pool fails to deliver the same rationalization of the stock price that public market trading delivers.

Shares in demand within the private markets can easily inflate in this constrained environment, while lesser known issues trade at deep illiquidity discounts. A smaller investor base also undermines the motivation behind a regulated marketplace, which is to encourage the broadest possible participation.

Second, lack of regulation in this market leaves it vulnerable to transparency issues. Once the first dentist loses his shirt on a social media company whose valuation plummets unexpectedly, a litany of lawsuits will certainly ensue.

Last but perhaps most important, there’s no evidence that trading in the private markets can generate the same economic growth that an IPO can. The public markets, when they are thriving, have systematically proven to create jobs and support innovation. Private market trading hasn’t.

Treating the Problem

For these reasons, private companies, investors, regulators and policymakers alike must keep the focus squarely on how to revive the U.S. IPO market.

If we fail in this regard, a markedly different public market will begin to take shape. In it, investors could have as few as half the number of public companies to invest in as they do today, a number that is already down 39% from just a decade ago when the major U.S. exchanges where still American owned.

Venture-backed startups that formerly aspired to launch onto the capital markets growth trajectory will instead solicit acquisitions, allowing their innovations and jobs to be absorbed by larger corporations, with many perhaps based overseas. Or they’ll settle for smaller capital infusions and remain private indefinitely, trading among a small group of elite investors.

Furthermore, the lack of thriving public companies turning out innovations could transform the U.S. into an also-ran in the global technology race. And that 92% post-IPO job growth would apply to only a fraction of the companies it has in the past – meaning fewer homegrown jobs for all Americans.

Sadly, these are the likely consequences of a permanently hobbled U.S. IPO market. Fortunately, the alternative to this vision requires less imagination than it does common sense.

By shifting our attention away from the hype of the secondary market—which is a temporary fix—and right-sizing the regulatory regime for small, emerging growth companies, we can revive the U.S. IPO market and re-harness one of the mechanisms that has generated U.S. jobs and economic growth for decades.

Paul Maeder is a co-founder and general partner of Highland Capital Partners and chairman of the National Venture Capital Association. He can be reached at pmaeder@hcp.com.