The Death of the IPO

As many of you know, Goldman Sachs recently invested $500 million in Facebook at a $50 billion valuation. Goldman is also reportedly raising $1.5 billion from those special, lucky investors in a special-purpose vehicle that will invest alongside the firm. It's gonna be super special. All kidding aside, this is kind of a BFD. Speculation has been swirling for years around if and when Zuckerberg would take the social networking behemoth public. As you probably know, Zuckerberg has largely resisted, saying time and time again that he had no near-term plans for an IPO and would be taking his sweet time about going public, thank you very much ... and that you can go back to obsessively checking status updates for all he cares. (The Onion, as per usual, pegs The Zuck perfectly.)

Thus, when Goldman poured millions in this week, many in the press were seemingly elated, as its investment would give elite investors the opportunity to invest in Facebook stock and was therefore a clever little private IPO indeed that would save Facebook from having to ACTUALLY go public. Not so fast, Zuckerblurg. It seems an arcane securities law requires a company with over 499 shareholders to begin disclosing financial information -- which is typically followed shortly thereafter by a full-scale IPO. Considering that Facebook has said their number of shareholders will break 500 by the end of the year, it looks like the Goldman deal will force Zuckerberg's hand after all, likely pushing Facebook to an IPO by April of 2012.

Goldman Wins Even if Everyone Else Loses

Oh, Goldman. Where there is a fee to be had, Goldman will find a way. Regulatory friction to arbitrage against? Goldman! Of course, to its "credit," Goldman purportedly has given Facebook everything it wanted: typically, the only way to raise $1 billion + was to provide the disclosure and liquidity that comes with an IPO. You put up with the analysts, the quarterly filings, the auditing, all in exchange for that sweet, sweet cash. Goldman gave Facebook all the benefits of goin' public without having to deal with the drawbacks. Of course, if this forces Zuckerberg's hand into an IPO earlier than he had planned, perhaps not a happy camper he will be. But, Goldman, at least in the short-term, is the big winner.

Why? Well, for starters, Goldman will have a top position if Facebook goes public anytime soon, and they will likely be able to pay for investment simply by way of fees, and by demanding that its investors cough up $2 million to invest and hold onto their shares until 2013. There'll be those management fees for institutional investors to get a stake in Facebook through their private equity vehicles, and Goldman will probably make a 4 percent fee and 5 percent carried interest on the deal. So, Goldman is essentially making a low risk investment and, as per usual, they stand to make a shit ton of money. (That's the technical term: shit ton.)

Just Not the Same

But, the reality is that one company every 10 years gets to enjoy protracted, enthusiastic public speculation about their IPO, as they bat around offers and prance around wondering about life as a public company. You may remember Google-palooza in the lead-up to their IPO. But, Facebook's private Goldman exit is not in the realm of possibility for 99 percent of companies and in no way do the specifics of this deal indicate a trend that many others will follow. What DOES seem indicative of a serious, insidious trend over the last decade is that the IPO market -- specifically small and medium sized companies -- continue to be the big losers in deals like this and, well, in general.

Why WOULDN'T You Go Public?

The VC industry has been complaining for years about the death of the IPO, with start-ups being the chief victims. Obviously, there are some unsavory results of going public, like being a slave to quarterly earnings, governance and stock price. And there's the brain drain that comes with going public as top employees inevitably begin an exodus for the next hot, pre-IPO company. Not to mention how the role of the CEO inexorably changes. After IPO, Zuckerberg's role will become one in which he manages Wall Street expectations and manages the press, spending less time on actually building his company. For an awkward, quasi-autistic wunderkind like Zuckerberg his new role will be an anathema. The increased short-term focus for someone who is obsessed with managing, building, and innovating his product will suck.

A Note on Privacy

On a sidenote, albeit an important one I think, some have argued that Zuckerberg doesn't want to disclose financials and what the company has been doing with our precious information and these hoardes of data they're collecting. Many say that Facebook will be less dangerous if it IPOs, because it will be less likely to make risky decisions with our personal info. I think this is largely bullshit ... all the information that's on Facebook, I've voluntarily put there ... there isn't a single image or piece of content that would phase me if anyone in the world could see it. On the other hand, Google has every piece of information that's in my inbox, everything I've ever searched for, and everything I do in my browser (Chrome). Just because Google is a public company doesn't mean I'm any less worried about what the fuck they're doing. Ultimately, we have to trust that Google (and Facebook) won't abuse public trust for short-term gains and so far it's worked out. Mostly.

The Numbers Don't Look Good

But, again, the real untold story is the desiccation of the IPO market over the last decade. Between 1992 and 2000, the percentage of venture-backed IPOs versus M&A exits was favorable for IPOs with 56 percent of deals resulting in IPOs and 44 percent in M&A exits. Between 2000 and 2008, the percentage of IPOs dropped to 13 percent. It's also taking longer for companies to IPO or exit: in 1998, companies were on average 4.5 years old at IPO, today they're 9.5 years old. And, shockingly, in the 1990s, deals under $50 million comprised nearly 80 percent of IPOs, whereas today it's closer to 20 percent. Obviously, it's become clear that a vacuum exists for small and medium-sized IPOs.

Sure, Hulu, Skype, and Demand Media all have announced plans for IPOs in the next year or so. Not to mention that GroupOn just secured the largest funding round in history, with a $950 mill round from about 80 honcho VCs and Angels. But, these are huge companies; IPOs for smaller companies are historically low, and many would agree that capital formation in the U.S. is in a sad state.

BUT WHY?!?!

Some of big contributing factors to the IPO shriveling include compliance requirements and increased regulation due to Sarbanes-Oxley, the increased volatility in the public markets (especially in the aftermath of the financial collapse), I Banking issues, having to have a high rev threshold, and many others. Sure, Soxley's original intent was to protect investors, reduce fraud, and restore confidence in the wake of Enron et al, but it's made it prohibitively expensive for small companies to IPO. Some say Soxley has upped corporate transparency and that may be true, and some argue that regulation is now actually MORE lax as a result, but it also may well be costing the U.S. massive totals in compliance fees and devastating the small business IPO market.

IPOs are a critical part of the capital markets ecosystem that includes entrepreneurs, equity analysts, investment bankers, and VCs -- and they're an essential component in job creation -- something we desperately need at this point in our economic history. But thanks to Eliot Spitzer killing off the last veins of economic support for investment research by shanking firms' ability to use IB revenue to underwrite analysts covering public companies. IPOs depend on quality equity research and the economic incentives for in-depth investment research have virtually vanished.

And it all goes back to the rise of online brokerage, order-handling rules, and decimalization ... changes in trading ... banks couldn't pay for research and went to investment banking, but the conflicts of interest were obvious.

“CEOs of small publicly traded companies feel abandoned,” says Robert Mancuso, founder and managing partner of private equity firm Dellacorte Group. “You might get one research report a year, but that’s not coverage.”

IBs are more focused on the IPO market overseas, which is thriving, and it just seems that Wall Street may be losing its connection to Main Street through the very American process of job creation (who's dream has not been at one point to start a company and take it public?) that is essential to the IPO process. Eliot Spitzer just wanted to put a stop to lying and fraud in the markets, but what he's done, what Sarbanes has done, what private IPOs and gun-shy public market investors, and regulation has done is killing the IPO market and hurting the economy. Big time. VCs have turned their portfolio focus from IPOs to acquisitions...

I Banks might benefit from encouraging new buyers and funds that specialize in Venture-IPOs and accounting firms might want to offer lower-cost services to IPO candidates, amiright?

This is a serious problem, and needs to be addressed, even if it takes The Social Network to make us realize that.

Eliot Spitzer to Institutional Investor:

"If people say that a prohibition on lying in the market is hurting the market for IPOs, there is a deeper problem than I thought."
 

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