Sarbox and Venture Capital
The Sarbanes-Oaxley act is driving up the costs of being a public company. Its driving up both direct costs, in terms of investing in assurance technologies, audit, and new processes to produce (slightly) more reliable accounting. But much more important, it imposes a highly risky cost on CEOs and financial officers who must sign off on their company’s periodic reports to the SEC. If they “should have known” that their statements were inaccurate, they can go to jail. This is new, and much more expansive than the fraud which Enron, Worldcom, Sunbeam and others engaged in. (Such fraud was already criminal.) This new set of risks, being highly personal, is causing companies to both over-invest in “Sarbox” compliance, and to go private. That is, to de-list themselves from the public stock markets.
That choice may or may not be rational based on compliance costs. It may not be rational for the company’s shareholders. But it sure is rational for the CEO and CFO, who don’t want to spend time in jail. (This is an example of the principal agent problem, where you hire someone to do something for you, and their motivations are different from yours. For example, Alice hires Bob to sell her car. Bob sells the car to Charlie. How does Alice know that Bob isn’t buddies with Charlie, and they’re conspiring to rip her off?) This acts as a drag on the company; there are probably companies for whom it’s rational to go private, but there are probably also edge cases where management’s interests are overriding those of the shareholders.
I’d like to look at another class of companies, one near and dear to my heart, which is startups. The most prominent mental model of startup is where two guys have an idea and start building it in their garage in Silicon Valley. They struggle for years, and finally IPO, making bazillions of dollars. Despite being the most prominent, these are relatively rare. Of funded startups, more go bust than get bought, and more get bought than go public. But venture investors really like the economics of going public: They tend to get a higher return on their investment that way.
Now lets return to those increasing costs of being a public company. Going public, traditionally, has cost 7% of a firm’s market capitalization, between the bankers, lawyers, accountants, and everyone else. Google managed to keep that at around 1 or 2%, but they were an exception. I expect this number to increase, as accountants go backwards in more and more depth to redo the books from day 1. Because these costs increase, as well as the increased cost of staying public, the “bar” which a company needs to reach to go public will move upwards. In particular going public being appropriate will mean more revenues and more consecutive quarters of predictable and increasing profits. (Not that bankers won’t try to take companies out early. After all, there are those fees, and Sarbox doesn’t send bankers to jail for poor underwriting judgment.) All of this means that fewer companies will IPO as an exit strategy. Now, that’s going to make venture investors sad. It changes their model of what sort of investments they need in their portfolio. If they’re clever, it may also change the way they look for returns.
I’m now going to speculate on what might happen. What we’d like is a way that investors, founders, and maybe even employees are compensated for the value they’ve created. (Not the risk they’ve taken.) Given the US tax relief on dividend payments, special one time dividends may be appropriate. The structure of Venture partnerships becomes important here, and I don’t know enough about that to compare one time dividends to ongoing large payments to certain shareholders, or the interaction of specific bits of law, like the special, poor treatment of dividends paid into Employee Stock Plans. Perhaps stock buy-backs would be useful?
The company may take on substantial debt, with the expectation that future revenues will cover them. This is similar to a leveraged buy out of existing investors. In any event, I’m confident that investors and startups will work out new exit strategies. I’m less confident that they’ll be fair to all parties involved, and as efficient as the ways that have evolved over the past 50 years.