Death of the IPO

We all know the IPO has been dying a slow death since the dot-com crash. While the liquidity that IPOs provide startups was seen as providing a major advantage to US startups, all signs point to the 1980s and 1990s as being an aberration in the long-term economy.

Earlier this month, Barry Silbert of SecondMarket spoke at the Stanford Technology Ventures Program on his new vision for capital markets.

A key 5 minute segment of that was about the “long, slow death of the IPO.” During that segment, Silbert asserted that "I don’t think a lot of people realize that over the last 10 years, the IPO market has been dying a slow death”.

(Actually, most of us who study entrepreneurship are at least dimly aware of this, as are entrepreneurs. A year ago I asked if we had seen the “end of the IPO anomaly.”)

Silbert provided specific evidence of this death. He showed a chart with the IPO rate down by 75% during this century, and almost complete disappearance of small IPOs (under $50m).
He attributes the end of the IPO to:

• end of research on small cap companies due to
• end of full-service brokerages (at the hands of Charles Schwab, eTrade etc.)
• shift from fractional to decimal pricing and thus the end of the bid/offer spread
• successful litigation against big 10 brokerages by then-NY AG Elliot Spitzer to end incentive compensation for stock researchers
• Sarbanes-Oxley increase in regulation and costs
• an explosion strike price class action litigation

The net result is increasing the time to IPO from 5 years to 10 years, which (as he notes) doesn’t work for angels, VCs or employees.

Of course, as the CEO of a secondary financial market Silbert has a stake in all this. The IPO traditionally achieved four goals for young companies.

1. raise capital
2. provide liquidity to investors (an exit event)
3. allow the stock to be used as a currency for acquisitions and employee compensation
4. and as a branding event

Silbert argues that the secondary markets are providing the first three. Certainly the success of Facebook suggests that this is a route available to highly visible consumer-focused companies.
The rest of the talk is, naturally, why the audience should believe in SecondMarket.

Hat tip: VentureBeat

Building a $50m lifestyle business

One of the more irritating habits of the academic view of entrepreneurship is when people disparage anything other than the next Google as a mere “lifestyle business.” In this view, unless the founders are maximizing their desired exit market cap, they’re just tyros doing it for fun.

I had lunch with a friend today talking about his next startup. He’s going to bootstrap and keep it small, both so he can do tasks that he enjoys and also not spend his whole life chasing after external funding.

For the average entrepreneur, a successful IPO is a fluke in good times and nowadays like being struck twice by lightning. Still, my friend’s plan would be disparaged in many classrooms as a “lifestyle” business, because he’s planning something that he wants to do rather than purely utility maximizing.

One argument is that job creation and wealth creation comes only from these IPO-bound high growth companies. So society — whether it be academic researchers, MBA teachers or government bureaucrats — ought to focus on these IPO-bound companies.

But what if my friend grows his new firm to a $50 million/year business? Is that still a lifestyle business? Over three decades, John Beyster built SAIC into a $7 billion/year Fortune 500 company with 42,000 employees before he finally decided to IPO.

Of course, many of the “lifestyle” businesses stay small. But the majority of the venture-funded rockets crash and burn. The chances of creating the next Google are even less than achieving an IPO that allows the VCs to sell their loser to an unsuspecting public.

And is market cap the only measure of venture success? About a year ago, I got to hear fellow MIT alumnus Sal Khan talk about his nonprofit startup, the Khan Academy. Sal is going to change how we think about education — either at the margins, or perhaps the standard K-16 modality for all of North America. Is this just a “lifestyle” business?

Finally, there are the inherent efficiency and effectiveness advantages of the owner-manager business. Investors, banks, the government, even academic theoreticians go to great lengths to solve the inherent principal-agent problem of having one party provide the capital and another manage that capital. As Enron and Worldcom and Government Motors demonstrate, sometimes these controls fail miserably.

If the owners are the managers, then all that effort is no longer necessary, because there are no abuses to prevent. Who has the most incentive to run a business for its long term success? The “lifestyle” business owner. Of course, success may not be as defined by some external economist or finance professor — but does that make it any less successful?

I hope to play a role in my friend’s new business. Perhaps he (or we) will grow it to a $10m/year business, or even a $50m/year one. I feel better about recommending this model of entrepreneurial development to my entrepreneurship students than gambling on VC and a successful exit.

Experiential entrepreneurial education

I am now just recovering from the weekend I spent with the three SJSU teams at the 47th Annual International Collegiate Business Strategy Competition. Our teams did very well — two firsts and a second — surpassing the total (if not the batting average) of our two 2008 teams.

The experience of coaching the ICBSC teams for the past six years has made me a true believer in the value of simulation in business education. In fact, I among several strategy faculty this month discussing how to include simulation in SJSU’s planned revision of the undergraduate B.S.B.A. curriculum.

I believe that the ICBSC experience is also a great one for prospective entrepreneurs. It’s hard for me to separate out the intercollegiate competition from the underlying software (the Business Policy Game), but from my own startup days I recognize degrees of realism in the simulation that we don’t otherwise have in the undergraduate or graduate curriculum.

The BPG backstory is not particularly entrepreneurial. The student team (typically 4-6 people) is taking over as the new executive leadership of a 2-year-old publicly traded (!) company, and you have five years (20 quarter) to growth the business and do a better job than your competitors in terms of stock price, net income. profitability ratios and other elements of what looks a lot like the “Balanced Scorecard.”

However, the way the simulation plays out is very entrepreneurial. Despite having revenues of $10 to $30 million a year, the “executives” have no staff: if anything is going to get done, it gets done by the team members.

There are also immovable deadlines: whether a decision is optimal or not, the game follows the maxim of one of my former entrepreneurial mentors: “any decision is better than no decision.” (Would that I’d followed that more often).

On Saturday, members of one of my MBA teams said that their ICBSC final presentation reminded them of working in a startup — editing the slides for their presentation literally as they walked into the room to give their required talk to the judges. (Alas, this approach was not as effective as the other SJSU team that had started their talk earlier).

However, the most important point is one that generalizes to any simulation for entrepreneurship students. I ask my students to write business plans, and I give them feedback on what parts of their plans are good and bad. But they see this as just my opinion, and sometimes they’re right.

In a simulated business competition, the computer is telling them what’s working and not working, at many different levels. Perhaps their new product is selling well, but their margins are too low due to high input costs or limited pricing power.

The simulation comes as close as we can to providing feedback of the market in terms of meeting a payroll and getting to positive cash flow. Believe me, all of the teams have etched into their heads that “cash is king” and the importance of keeping cash inflows ahead of outflows. (One rival did so badly that they had to sell both factories to cover their bills, leaving them only one quarter away from closing operations.)

Some people say that the way to educate prospective entrepreneurs is to have them run actual businesses. There’s a value to that, but I think that’s more something they should do in high school in Junior Achievement than necessarily in college.

The problem is that these student businesses are just that. Yes, you learn how to get customers and cover costs, but unless you’re Michael Dell, they’re just a student business. (Even Ralph Rubio waited five years after graduating to start his fish taco stand.)

For would-be tech entrepreneurs, the challenge is more daunting. yes you can start an iPhone app business or a software consulting business, but most tech business require more capital (and typically some seasoned management) to pull off.

After years of coaching these teams, I think there’s an event more fundamental difference: we learn more from failure than we do from success. Our teams this year made mistakes — a few huge ones — and I suspect those mistakes will stick with them a long time.

I still remember spending $250k of our retained earnings on a product that failed, taking with it the company’s retail software operations. (Fortunately, we refocused the business and got lucky when customers jumped in our lap five years later.)

Are we ready to have lots of student businesses fail, and fail big? Or will we give them so little resources that they fizzle out quietly before they can lose to much money?

In that regard, the simulation competition may distort the lessons that could be gained in a classroom setting. In the ICBSC competition, if two teams grow their company from $10m to $30m/year (with 10% net margins) only one can be a winner. In the real world, both management teams get nice houses, nice vacations and happy investors.

More seriously, the 5th place teams give up because they have no chance of winning, rather than trying to do the best by the employees, managers and investors. So in the classroom setting, I would give a bonus for winning, but in the end grade the students on how well they ran their business rather than how well they did versus competitors.