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Summary:

A host of factors — including electronic trading and the dominance of hedge funds — have skewed the system to incentivize short-term focus. Company CEOs need to take back control of the aftermarket.

nasdaq logo ipo
photo: NASDAQ

It’s been 12 years since the internet bubble burst, and in the ensuing fallout, it has become apparent that the IPO market has been fundamentally damaged. Thanks to a lack of national confidence and lingering fears and confusion about the potential risks of IPOs, far too many good companies – ones that could supply much needed jobs to the U.S. economy – are unnecessarily paying the price. While addressing the fouled IPO market certainly  isn’t a cure-all for our ailing economy, there’s no doubt that some of America’s missing growth and lost jobs over the past decade are certainly to be found locked away in this hidden treasure chest.

Breaking the IPO market

We can look back now and see that permanent structural changes that were prompted as a result of the dot-bomb crisis– many initially subtle and gradual – shifted our markets so that we frogs didn’t realize that our cold-water world was slowly coming to a boil. And we got cooked.

In fact, a host of factors have contributed to the process. Electronic trading, decimalization, consolidation of the ‘Four Horsemen’ boutique banks into the bulge bracket banks, and the dominance of hedge funds — all these factors helped transform our investment focused public markets into a high-velocity, high-volume trading world. And that has choked the ability of young companies to get the long-term growth support they need to create more jobs for the rest of us.

New regulations to control the underlying corrupt financial practices that helped create and burst the bubble also hindered the growth of legitimate companies with IPO potential. Sarbanes Oxley and analyst regulations added costs while removing critical support. The result has been that the number of years to IPO has been shifted from an average of under five years, to over 10 today. These structural changes in the financial markets have stunted capital formation and in essence broken the IPO process.

Accepting and promoting our new economy

President Obama stated in his recent State of the Union Address that America’s future will come from rebuilding a strong middle class. However, the belief that the solution to moving forward is to resort to the old manufacturing economy is wrong. If we look back over the past 20 years to where the greatest number of jobs have come from, the answer is new-economy companies like Apple, Google, Amazon and Starbucks, which each employ about 300,000 people.

We are now in an “innovation economy” growth phase cycle, and because it is specifically dependent on IPOs – with 92 percent of job growth for companies occurring post-IPO– one can easily connect the lack of growth and jobs over the past decade right back to when IPOs became blocked.

To deliver middle class jobs in the U.S., Mr. Obama needs to focus on creating more tech jobs – which, according to Moretti’s multiplier of five, spawn three middle-class jobs and two professional jobs each.

Preparing CEOs for today’s market realities

What is most wrong with the system is that it is skewed to incentivize short-term focus. Today’s high frequency trading benefits from volatility and in effect creates pump-and-dump scenarios. For IPOs, that translates to often wild price fluctuations, with from 300 to 500 percent of IPO allocations usually trading within the first 48 hours of a company’s offering.

The solution is for company CEOs to take back the reins and factor in aftermarket trading. Managing your shareholder base composition is a basic investor relations function that companies need to begin developing years prior to IPO, including inviting key shareholders into late-stage private rounds. A good rule of thumb is to aim for 60 to 70percent long-term holding base for stability, and 30 to 40 percent short-term holders for liquidity. This yin-yang balance will support a perception that matches reality (fundamental performance).

Without a core of growing companies (that are appropriately valued), the economy will simply keep generating more uncertainty and distrust, further limiting good, young companies’ ability to hire and grow.

Mona DeFrawi is founder and CEO of Equidity, a firm that matches investors with private companies. Follow her on Twitter @MonaDeFrawi.

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  1. Nice summary of some of the issues facing the IPO market.

    I imagine there should be significant interest from VCs and company execs on “shareholder management” as a strategy to improve odds of a successful IPO.

  2. mona-defrawi Sunday, March 3, 2013

    Don,
    Thank you for your astute assessment. That was exactly my intention in writing this contribution — to help VCs and CXOx realize the value of IR that they can hold in-house. IR provides the reins to empower their interests of long-term growth maximization, by helping them manage better their own velocity of trading in the aftermarket, which directly influences valuation. Very few realize the true value of IR – which can offer an internal version of much of what the boutique banks and old market infrastructure used to provide – in addition to the disclosure functions required by the SEC – where most people’s understanding stops. IR is the sales and marketing function for equity-generating products and must be managed and invested in equally to the revenue-generating products of companies.
    And we now have a cloud-based platform to improve VCs & CXOs IR efficiency & results by leveraging the network effect, technology & scale. For more info: http://equidity.com/infographic/

  3. Vinod Shintre Sunday, March 3, 2013

    interesting perspective & thanks for sharing

  4. There are plenty of accurate observations here, but they don’t correspond with the recommendations. Let’s start with Amazon. Yes, Amazon’s IPO pre-dates SOX. And yes, Amazon has a large labor force. In fact, Amazon’s employee count increased by 58% in the past year, which is impressive. However, that is global employee count. Like many companies, I don’t think Amazon discloses how many are overseas employees and how many are U.S. employees. IBM stopped disclosing that fact for the first time last year, though it was easy to back out that less than 50% were in the U.S. I have no idea what the data is for Apple, nor Google. So I would hesitate before praising these companies for creating so many jobs in the U.S. They are innovators, and have done much good, but more of such companies won’t necessarily help our economy! Consider Germany. Germany has a manufacturing economy. Germany has low unemployment. I wouldn’t fault our U.S. President for encouraging a more balanced mix of manufacturing and e-commerce/ services!

    Next, I don’t understand how “company CEOs [should] take back the reins and factor in aftermarket trading.” Start-up CEO’s run start-up’s. They have their hands full with operational concerns. “Managing your shareholder base composition is a basic investor relations function” is applicable to a mature privately held company such as say, Palantir. Or Gallo.

    You’re correct, that there are major problems with our IPO process. But I wouldn’t blame Sarbanes-Oxley or excessive regulation for that. If there were more regulation, or maybe just less greed, we wouldn’t have wild proliferation of non-GAAP financial statements and bete noire such as the travesty that is Groupon. As for Facebook, that was a mess all around.

    I’d be curious what Peter Thiel might recommend for the IPO market. He knows what’s worked in the past, he’s managed to get his own company going, and going well, and he’s willing to acknowledge when he’s wrong, all of which I respect.

    1. The key takeaway is that CEOs need to plan better for their IPOs by focusing on long term investors and that the financial markets need to be better structured in a way to reward long term success.

      1. Structuring the financial markets in a way to reward long term success would likely include major change in trading practices, e.g. less high frequency trading, fractional share prices, backing away from dark pools.

        Problem 1: Resistance because change like this appears to be fallback to older technology. Problem 2: Those who enjoy HFT profits will fight tooth-and-nail to keep it, unless they are convinced that rewarding long term success for innovative U.S. companies is in their own interests (which it is, but how to convince…?)

      2. Bingo!
        …and that much of the control is actually in THEIR hands, not just their bankers or “the market” at large.

      3. Bingo!
        …and that much of the control is actually in THEIR hands — and their activities can create counter balances for the market structures to properly re-align results. They don’t need regulation to fix this for them. And everyone wins with long-term success!

    2. Thanks for your thoughtful and informative comments Ellie. Please allow me to respond and correct any misunderstandings, perhaps created by the 600 word limitation.

      – Please keep in mind that global job growth also channels back greater profits to the US based companies which directly improves economic growth here. Many US jobs have also been created, and they tend to be the higher paying jobs that have three times the multiplier effect of manufacturing jobs (per Dr. Moretti’s The New Geography of Jobs, 2012.)

      – The US economy has evolved from being primarily manufacturing driven into an Innovation Economy. If you look back 20 years to see where most of the jobs have come from in America, it is from these entrepreneurial companies, including Starbuck’s 700K jobs, which innovated coffee or in the words of their mission “To inspire and nurture the human spirit”. America doesn’t yet realize that its economy has matured and in its next evolution cycle, and our regulations and awareness are sorely lacking the ability to nurture our future growth as clearly evidenced by our flat numbers for over 12 years now (minus the artificial real estate bubble and chasm).

      – I am not faulting our President, whom I support in his efforts, but wish that he could realize manufacturing could grow at a much higher rate, when the core part of the economy grows first – through the high growth innovative companies capable of delivering 3 times the middle class jobs he seeks.

      – You are correct that I was referring to late-stage, pre-IPO company CEOs who would be the ones concerned with IPO aftermarket trading. And yes, Palantir is one of the terrific companies nominated for the GrowthSTARS Awards my company has sponsored to help America become aware of where it’s next growth jobs and growth is coming from. Studies have shown that 92% of job growth occurs post-IPO, so to grow jobs, we must ensure strong IPOs again.

      -And I agree with you wholeheartedly that greed is the greater culprit, and don’t blame Sarbox or excessive regulation or even argue that they should be removed in the least. However, I am trying to inform late-stage CEOs that due to the regulations and many other structural changes in the markets, they cannot believe that they can use the traditional IPO process and expect different results from the poor ones we’ve seen over the past decade. We must apply new strategies and evolve the IPO process. IR strategies are commonsensical, powerful and work.

      – I too, would be thrilled to hear what Peter Thiel thinks about evolving the IPO process, and perhaps he can comment on my “IPO Evolution” available on my website, http://www.equidity.com/infographic

      1. Ellie – Thanks for your thoughtful comments — and please allow me to correct any misperceptions:

        1. In no way am I requesting changes in trading practices or calling for more regulations. In fact the very opposite: I am trying to make company CEOs aware that they can control much in their IPO process. They can “structure the financial markets to reward long-term success” by ensuring that the majority of their shareholder base (60-70%) are long-term growth investors with that style of investing. They will price the company based on its ability to create this growth. At this ratio, both stability in valuation and liquidity in trading are promoted in a way that offers a price attached to fundamentals. Free markets…No requested regulations.

        2. There is no falling back to the old order, but we also don’t have to be victims of the new order simply because we don’t understand how our own stocks trade and allow those controlling the transactions to align it towards their own incentives above our own. CEOs must take back their control over their own transactions. I spent 10 years helping 4 companies go public and trade in the aftermarkets. There is a ton companies can do to market their opportunities, but stocks are complex and long-term investors cannot invest in that which they do not understand – so financial communications and marketing are key to managing your stock’s trading especially in today’s HFT markets which are allogrithm driven and often fundamentals-agnostic.

        3. In my vision, having more strong companies on the public exchanges will give even HFT managers more to trade and a stronger economy giving birth to more opportunities. Everyone should win.

  5. The IPO market isn’t broken companies continually go public at hyped valuations. What is the secret sauce for determining who a long term holder is, the buyers themselves tend to lie?

    1. Going public at hyped valuations and lying are “Broken” in my book!
      The real crime is that these corrupt and greedy practices have our new Innovation economy held hostage, not able to grow or create jobs, while we try to figure out this mess. Most don’t even realize this is the problem…Time for an evolved IPO process that brings rationality, truth through transparency, and growth for all of us again.

      1. You last sentence sounds great. How do you propose we get there?

      2. 1. Create an IPO on-Ramp by getting to know your long-term growth investors years pre-IPO, and then doing a PIPO round (Public Investors in Private Offerings) a year or two pre-IPO. This vets and values the company by conservative investors aligned with long-term value creation for our companies — and creates more trust in the valuation than current practices. (see: equidity.com/infographic)

        2. Offer a platform that mimics SEC regulated disclosure for private market transactions to facilitate the above: allows visibility broadly across industries; transparencies through virtual data room controlled information sharing; and direct access to management. Screen and select the best companies and investors only for participation, to increase confidence and stimulate research and deal making. (see equidity.com)

        3. Educate the public – And our legislators who are the guardians of our economic growth — to understand that we are in a new economic growth cycle for our Entrepreneurship Economy, and this growth depends on IPOs to bring the next great job creators to the public markets. 92% of job growth occurs post-IPO. If we don’t address these issues, we will continue to have flat or very slow growth and unemployment for another 10 years. If we understand how we are evolving economically, then we can create the proper regulations, taxation, etc. to promote the best growth and opportunities for our country.

        How’s that for a start?

  6. I’ve been studying this for over 10 years and can say that the IPO market is not the problem. It’s fairly easy for a company to do an IPO today for less than $100,000.

    It’s true that understanding and managing the outside investor process is critical and hard to find good *institutional quality* solutions to get the job done. (I agree that the primary job of the CEO is to build the company and create returns for equity holders.)

    Recently there’s been some decent traction for companies on platforms like CircleUp and some other founding platforms and I suspect there will be more.

    What’s missing is long-term investing. The public markets are totally dominated by short-term trading. For many reasons most people with money seem to shun any investment that will take 3, 4, 5 or even 10 years to pay off but then may offer 10x or 100x returns.

    Incentives like tax benefits could be a big spur for these types of long-term investments in smaller, innovative companies. That’s a big economic driver that should be used now. A few tax incentives could shift a few percent of investable assets to this investment class and companies could get funded and grow then the successful ones trade on a platform like SecondMarket or SharesPost/Nasdaq before moving on to larger more liquid markets if they continue to grow.

    The last factor to realize is that many of these companies will fail. Just as we already see on Kickstarter. It’s hard to build products and services, ship them, support them and grow. Investors in these companies lose 100% of their money. Like casinos people should be allowed in but the risks need to be understood and the market monitored for fraud.

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