Reengineering IPOs so the system works

IPOs are out of reach for many good companies today. In fact, the lack of IPO exits is at the root of many of the current unicorn devaluations. Shortly before the Internet bubble burst, electronic trading, decimalization (stocks moving in pennies instead of fractional dollars), and the new economics of large investment banks and clients has dominated and disrupted this watershed event for companies and investors. The disruption continues 15 years later and is reshaping the venture industry.

Yet we continue to conduct IPOs just as we did before, as if nothing has changed, despite obvious shortcomings and fewer successes. If any of our portfolio companies posted such poor results, we long ago would have reengineered, pivoted, or disrupted right back.

Today, nearly all companies follow a standard pop-and-drop IPO curve, regardless of industry, product or performance – indicating that this is a market or process phenomenon and not a result of individual company quality.

The highest stock price is nearly always in the first days of trading, when the first slew of buyers sell quickly to bank the 25 percent discount off the IPO price.

Prices then decline by the end of the first month, since market-making economics today don’t encourage long-term support. With the beginning of decimalization in 1997, trading commissions plunged to tenths of a penny a share from $0.25 a share, giving these early holders incentive to take high-volume, short-term profits instead of long-term-holding gains.

At six months, when lockups expire, short-sellers anticipate insiders’ liquidation of their holdings and prices drop to their lowest. Only at this point, after the early IPO arbitragers are finished, do long-term investors begin to fill the void, reattaching the stock price to actual company performance vs. stock trading logistics.

By this time, however, great damage to the company’s brand often had been done under the false belief that the IPO’s price performance indicated actual company fundamentals and prospects.

If it’s lucky, about 10 to 18 months after a company goes public, the shareholder base finally reaches a long-term holding majority that enables it to trade on fundamentals, minus a discount for brand damage incurred. While Facebook was able to overcome its IPO brand damage, many smaller companies carry scars.

Innovation is still strong, but much value is lost in the transition from the private markets’ long-term value-creation structure – building companies – to public markets’ short-term value-extraction structure, and deciding how much those companies are worth at a given moment and trading accordingly.

Caught in between is the U.S. economy, for which venture-backed companies are its growth edge, delivering 21 percent of its GDP and creating 92 percent of their jobs after their IPOs, a formerly seminal event in harvesting the venture-investment crops. Economic growth was crippled when the ground below IPOs shifted, and it hasn’t fully come back since.

It’s been seven years since I came to Silicon Valley to help “fix the IPO crisis” and pioneered the first private-market platform. Our original vision was reshaped by the valley, first into secondary liquidity, then into primary unicorn ($1-billion-plus-valuation) activity, both without seeking a long-term resolution for IPO exits upon which valuations depend. The real problem remains unaddressed.

Keeping in mind that stocks are derivative instruments that enable us to trade ahead of dividends and capital gains – expanding access to equity participation and accelerating liquidity and wealth creation – we can redesign IPO instruments to fit today’s evolved market structures to deliver intended goals.

Instead of staying stuck in the old IPO process or seeking secondary liquidity in lieu of primary exits, why doesn’t the industry reengineer a new process/product that encourages a long-term value alignment in the transition to public shareholders?

Wall Street regularly creates new products, and Silicon Valley can help it innovate some new “algorithms” to encourage long-term value creation and economic growth through an “evolved IPO” product.

A number of reforms can be considered when designing the new IPO-product algorithm, and here are a few early brainstorms to help get the ball rolling:

• Create long-term-holding incentives (e.g. capital-gains-tax advantages);
• Add new restrictions (e.g., lockup periods for IPO buyers, or rolling expirations) to discourage short-term predatory trading immediately after an IPO;
• Remove or reengineer price discounts;
• Offer late-stage rounds to qualified institutional buyers as convertible securities with controlled conversion points and liquidity for the eventual transition to less sophisticated public buyers who require greater protection; and
• Apply new crowd-funding legislation to give retail buyers greater participation in IPO issues, which may also have some trading and pricing benefits for companies.

Under Dixon Doll’s leadership as chairman of the National Venture Capital Association from 2008-2009, industrywide research addressed the IPO crisis. Further progression of his excellent work can help IPOs evolve toward better results. We know what happens to those who fail to adapt to changing environments. Such a lack of product/market fit will continue the loss of value and erosion of confidence in our industry.

Mona DeFrawi served as vice president of corporate development and director of investor relations at four companies managing their IPOs, communications, and shareholder activities over 10 years. She also was the founder and CEO of InsideVenture, the first private market platform (acquired by Second Market). She can be reached at mona@growthstars.com.

Photo of outside the NYSE building courtesy of Reuters/Lucas Jackson