Regulatory Litmus Test: Can the “Four Horsemen” Ride Again?

As noted in my recent post with Matt Harris, the venture industry has massive problems of scale. Large investments from even larger funds are weighted down by a dark feature of the past decade: limited opportunity for exits. Venture-backed companies, if they go public at all, do so at much greater scale than they used to, necessitating many rounds of venture investment. It used to be that companies could go public on the NASDAQ much earlier, often brought by a host of middle-market investment banks like the “Four Horsemen” (Alex.Brown, Hambrecht & Quist, Robertson Stephens and Montgomery). Young growth companies could raise $20, $30, $50 million, at valuations in the $100 million range. It set the stage for subsequent share offerings as growth opportunities warranted, and the investment banks provided research on the young companies to keep investors informed of their progress. While many parts of Wall Street and our financial markets are broken, this was one area that functioned quite well and fueled the engine of innovation that led to the technology revolution. Yet in a classic case of unintended consequences, onerous regulations such as Sarbanes-Oxley have served to squelch the fires of creativity and capital formation to the detriment of our economy, our environment and our society.

Our regulators, Congress and yes, President Obama, need to take a big step back and ask the following question: what re we trying to accomplish with our regulatory framework? As with most things, regulations involve a trade-off: impose too many, stifle growth and innovation; impose too few, provide the basis for fraud and mismanagement. My fear is that our regulations have gotten both more strict and less effective, causing the venture business itself to be on life-support. Is this what regulators set out to do? I’m sure not. But here we are. Even a $250 million venture fund has a hard time returning carry – remember, you need $250 million in exits just to break even on a nominal basis, $500 million if you want a decent track record and return for your investors. Tallying up a cool half-billion in exits is no mean feat. Think about the $500 million fund that needs to return $1 billion: where is that coming from without an IPO market or corporate acquirers with huge financial capacity? This is why we need a vibrant middle-market investment banking function to help bridge the gap between A/B round investment and later-stage investment.

The only other way around the problem: later-stage venture funds becoming a proxy for the IPO process, providing outside investors with an exit, letting the founders take a little off the table and re-incentivizing them to take the business to the next level. This way, the original outside investors don’t have a massive layer of preferences on top of them, the founders are happy for partial liquidity, greater financial stability and a nice incentive package, and the later-stage fund gets to put big dollars to work efficiently. While this is fine, it is not a substitute for financial markets and structures that support the kind of growth needed to prepare this country, and the world, for the challenges of the 21st century.

Let’s accept the fact that it is impossible to eradicate fraud. Some degree of fraud has to be acceptable, because the costs of 100% regulatory effectiveness would be to stop commerce altogether. The question is, how much bad behavior can we live with to support flexible and inclusive capital markets?And what kinds of policies do we need to support an active growth-company financing environment? Here are a few observations:

• Tax policy must be simplified, with incentives provided for start-up investment and R&D spending. Corporate taxes should be kept low and easy to compute. Tax shelters should be wiped away except for explicit policies geared towards investment. Forget about Sarbox: the cost of tax compliance (and tax “optimization”) for public companies is a massive and rising expense due to increasingly labyrinthine tax rules. This is wasteful and has to stop. 

• The theory behind separation of banking and research needs to be revisited. In middle-market growth company underwriting, it is very hard to get third-parties to publish research on nascent companies. It is generally the role of the underwriter to keep investors current on the company’s business and prospects. While conflicts of interest can certainly exist, and principles-based regulations should be applied (e.g., if you are “talking your book,” you can get fined, censured, etc.), this is a model that can and does work for financing and supporting trading of growth company stocks.

These are four of perhaps ten or more steps that need to be taken to address this issue. Bottom line: without the ability to take younger companies public as was done for decades, the large-scale venture business is not a viable business model. Too few exits. Not returning carry. Disenchanted LPs. Period.