CHAPTER 8
THE LAST GASP OF THE IPO MARKET

THE RANGE OF activities for which the most economical format is to organize as a corporation and sell shares to the public is rapidly diminishing. The parts needed to create an enterprise are often available off the shelf, which allows creating pop-up ventures that are cheaper and nimbler than established corporations. Yet some companies are still doing initial public offerings (IPOs), that is, selling shares to the public in what used to be called a “capital raising.” Why?

IPOs offer founders of companies and their financial backers an opportunity to cash in. Going public allows venture capitalists to recoup their investment, lets early employees capture the rewards they were offered, and creates a currency for the company to make acquisitions. There is great appeal in selling shares to the public.

Yet the attraction for buyers is less obvious. Firms that have gone public since the dot-com collapse of 2000 often flout standards of corporate governance (for example, by giving founders permanent control through super-voting shares). Their rationale for going public—to pay off employees and early investors, rather than to raise capital to invest in long-lived assets—suggests that such firms are not sustainable as public companies for the long term, although demand for returns by investors may sustain them for some time.

Three magic words

BY SOME ACCOUNTS, the goal of entrepreneurs everywhere is to sell shares in their business to the public through an initial public offering, or IPO. The IPO offers a chance to pay back early investors and reward employees while also validating the vision of the founders. Going public is a considerable achievement, a major milestone in the life of the entrepreneur and the enterprise. It can also make founders very rich. Not every entrepreneur values going public, however, because of the potential loss of control. Ford Motor Company, an icon of American capitalism, did not go public until 1956, nine years after its founder had died and a half-century after its founding. Henry Ford’s mania for control, realized in end-to-end vertical integration, was not compatible with selling shares to the public during his lifetime. Henry allegedly told his son, who advocated going public, “I’ll take every factory down brick by brick before I let any of those Jew speculators get stock in the company.”¹ (Henry was in the vanguard of industry; not so much when it came to morality.) When the company did eventually go public, the Ford family retained a class of shares that gave it 40% of the voting rights, guaranteeing effective family control in perpetuity.

For much of the 20th century, corporations did an IPO when they had a history of doing business and a plan for profitability in the future. The IPO could raise capital to grow the business, by buying plants and equipment, or stores, or rolling stock. Building giant and efficient factories cost money; so did coast-to-coast distribution networks and department stores. Companies that proposed to go public explained to potential investors how they would use the funds, and why they expected future profits to justify buying their shares.

During the 1990s, however, the IPO became an almost inevitable step in the life of any tech startup, whether or not it had a history of profits, or even revenues. Data from Professor Jay Ritter at the University of Florida show that there were almost 4,500 IPOs from 1990 to 2000.² Hundreds of biotech and dot-com companies went public, with limited prospects at best for growing into a real business. It seemed that a great concept—say, selling pet supplies online—was enough to justify an IPO, even in the absence of any revenues or credible plans to make profits. Wall Street firms earned large commissions from IPOs, and early investors looked forward to the one-day pop in price, which some regarded as free money. Going public creates business for a large phalanx of service providers, from lawyers and bankers to accountants and consultants. With the surging stock market of the 1990s, there was plenty of business to go around. IPOs drew in millions of investors around the world, creating a virtuous circle that encouraged entrepreneurship, or at least a lot of vaguely plausible business ideas.

Some months saw scores of IPOs. On November 23, 1999, the following companies were recorded as going public:

Agency.com (interactive marketing)

Cartesian, Inc. (consulting to the communications industry)

Deltathree, Inc. (voice-over-IP telephone services)

Digital Impact, Inc. (Internet marketing)

DrugMax, Inc. (distributor of pharmaceuticals and beauty products)

GetThere, Inc. (web-based travel reservations)

Official Payments, Inc. (electronic payments for the IRS)

SmarterKids.com, Inc. (online retailer of children’s educational books and games)

TeleCorp PCS, Inc. (wireless services)

Teledyne Technologies, Inc. (spinoff of conglomerate Allegheny Teledyne)

Water Pik Technologies, Inc. (another spinoff of Allegheny Teledyne)

The next day saw three more: Axesstel, Inc. (wireless broadband), KnowledgeMax, Inc. (e-business supply chain management), and PNV, Inc. (“the leading provider of bundled telecommunications, cable television and Internet access services to truck drivers in the privacy and convenience of their truck cabs”).³

The mania for public offerings was unprecedented. It seemed that almost any vague business concept with a “dot-com” in its name was able to raise millions of dollars from eager investors, many of whom were new to the market. The excesses of the dot-com era are well documented. The rapaciousness of Wall Street and the credulity of investors inflated a bubble that left sophisticated investors dumbfounded. Warren Buffet and other value investors anxiously sat out the frenzy rather than adopting new valuation techniques that were far removed from any reasonable theory of expected profits. The market could not stay this crazy forever.

The high-water mark of this rush of IPOs was March 2000, when the Nasdaq index topped 5,000. Within a few months of reaching this peak, the index had dropped by almost 70%, and it would not pass 5,000 again for almost 15 years. Hundreds of companies disappeared during the burst of the dot-com bubble, and related business scandals emerged, such as the Enron fraud. A series of financial reforms were adopted to limit just how ludicrous firms proposing to raise capital on the public markets would seem, how egregious the misrepresentations of their investment banks, and how extreme the conflicts of interest facing financial analysts. The Sarbanes-Oxley Act of 2002 was the most consequential, creating more rigorous standards for corporate boards of directors, accountants, and financial analysts, and requiring top executives to personally attest to the truthfulness of the company’s financial disclosures.

In part as a result of these reforms, the number of IPOs has never returned to the level of the 1990s. Yet they still hold a fascination for outside observers, who see IPOs as a sign of the ruddy health of American business. To this day, entrepreneurial business plans almost inevitably include an “exit strategy” that entails dumping shares on an unwary public.

IPOs in the 21st century

THE NUMBER OF IPOs dropped dramatically after 2000, and they have never recovered their old allure (see Figure 8.1). In the 14 years since 2000, there have been roughly 1,600 IPOs in the United States. Many of these were not new businesses, but companies that had gone bankrupt (Northwest Airlines, General Motors), been taken private (Dominos Pizza, Celanese), or were being spun off.

FIGURE 8.1 US initial public offerings (IPOs) by year, 1980–2014

Source: Data from Professor Jay Ritter, University of Florida, http://site.warrington.ufl.edu/ritter/ipo-data/

Commentators have offered many reasons for the IPO drought, with “overregulation” being one of the most prominent. Marc Andreessen, a founder of Netscape—whose 1995 market debut was the starting gun for the dot-com race—stated that after 2000:

A whole set of “closing the barn door after the horse had run out” kind of things happened. Sarbanes-Oxley happened. The irony of Sarbanes-Oxley was that it was intended to prevent more Enrons and WorldComs but it ended up being a gigantic tax on small companies. . . . The compliance and reporting requirements are extremely burdensome for a small company. It requires fleets of lawyers and accountants who come in and do years of work. It’s this idea that if you control everything down to the nth detail, nothing will go wrong. It’s this bizarre, bureaucratic, top-down mentality that if only we could make everything predictable, then everything would be magic, everything would be wonderful. It has the opposite effect. It’s biased enormously toward companies that are big enough to hire fleets of lawyers and accountants, biased against companies that are very young and for whom there’s still a lot of variability.⁴

Andreessen, now a venture capitalist, also notes that the composition of the market has shifted from individual investors and mutual funds to hedge funds, short sellers, and other short-term traders who are highly attuned to moment-by-moment price fluctuations. This can make the market more volatile and thus more hazardous for newer ventures. “[F]or young companies, everything is connected: stock price, employee morale, ability to recruit new employees, ability to retain employees, ability to sign customer contracts, ability to raise debt financing, ability to deal with regulators. Every single part of your business ends up being connected and it ends up being tied back to your stock price”—which can be whipsawed by short-term investors. He concludes: “The result of all that is the effective death of the IPO”—that is, for at least small-cap firms.

Although blaming regulation for economic woes is a reflexive response for some, one reason for the shortage of IPOs that has received less attention is that companies simply don’t need the money. We saw in Chapter 7 that it had become much, much cheaper to launch a company these days. It is not surprising that venture capitalists want to blame regulation, because the alternative is an existential threat to their industry. One venture capitalist noted the implications of this new system of low-cost startups:

“The model that has existed for the past fifty years, with people such as ourselves being the gatekeepers of money between big institutions and entrepreneurs, is going to at least decline as a percentage of the dollars that get invested in startups,” he said. Instead of raising investment cash, V.C. firms could start investing their own capital; the rest would come from crowd-funding. They’d be traffic directors instead of gatekeepers. . . . What we’re seeing now is literally a shift in the way that people do business—a shift from hierarchical architectures to networked architectures.⁵

If regulations make going public costly, short-term traders make it risky, and the low cost of entry makes it unnecessary, then why do companies still do IPOs? This is not an idle question. A company’s IPO prospectus includes a required section titled “Use of proceeds.” Consider what Facebook has said about how it would use your investment dollars:

The principal purposes of our initial public offering are to create a public market for our Class A common stock and thereby enable future access to the public equity markets by us and our employees, obtain additional capital, and facilitate an orderly distribution of shares for the selling stockholders. We intend to use the net proceeds to us from our initial public offering for working capital and other general corporate purposes; however, we do not currently have any specific uses of the net proceeds planned. . . .

. . . Pending other uses, we intend to invest the proceeds to us in investment-grade, interest-bearing securities such as money market funds, certificates of deposit, or direct or guaranteed obligations of the U.S. government, or hold as cash. We cannot predict whether the proceeds invested will yield a favorable return. Our management will have broad discretion in the application of the net proceeds we receive from our initial public offering, and investors will be relying on the judgment of our management regarding the application of the net proceeds.⁶ [emphasis added]

In other words: We are selling shares to create a market to sell our shares. We have no use for the funds we are raising, and will put them in the bank until we have a good idea. Trust us. Also, we might make some acquisitions.

This is not unique to Facebook. Of course, there are good reasons for companies to want to be vague about how they will use your money, but there are also very good reasons for buyers of their shares to demand more information about where their money is going.

The two most obvious reasons that companies want to go public are to pay off their early investors, and to give employees who have been compensated with shares a chance to cash in. While this may be a good reason for the company to want to sell its shares, it is hardly a good reason to buy. There are entire categories of bad investments premised on the idea that later investors pay off the early investors (for example, Bernie Madoff).

A third reason to go public is to be able to use the company’s shares to make acquisitions. Facebook famously bought WhatsApp, a phone app for sending instant messages, for $19 billion, even though some found WhatsApp to be largely indistinguishable from a half-dozen other instant message apps. An acquisition like this would have been much harder without going public. As Google, Facebook, and Amazon expand into varied unrelated industries (virtual reality goggles, self-driving cars, smartphones), often via acquisitions, they seem to be following the same course as the conglomerates of the 1960s, becoming mutual funds with high overhead.

A fourth rationale for going public is that the proceeds will be used to hire really smart people who will come up with highly profitable ideas in the future. This is comparable to the mission of one company founded during the South Sea Bubble of 1720: “a company for carrying on an undertaking of great advantage, but nobody to know what it is.”

It is easy to see why companies might want to go public, in a world full of investment capital seeking an outlet. It is much harder to conceive why investors would hand their money over to such companies.

IPOs and the death of corporate governance

THE DROUGHT OF IPOs since 2000 is often blamed on regulations intended to rein in reckless corporate behavior by enhancing “corporate governance.” Corporate governance refers to all the things that shape how corporations make decisions and are held accountable, such as who is on the board of directors and how it is structured; how shareholders influence corporate decisions through annual elections or activism; the actions of accountants, bankers, financial analysts, and other gatekeepers; the stock market itself and how it prices shares; and the “market for corporate control” that allows outsiders to take over a company whose internal management has failed.⁷

There are certain widely shared standards of what good corporate governance entails. “Good” in this case usually means “good at ensuring that the company does what’s best for the long-term interests of the company and its shareholders.” Some basics include having a well-qualified board of directors composed primarily of outside directors who are independent of management; incorporating in a state with high legal standards; using a reputable accounting firm to audit the company’s books; and avoiding measures that protect the company from outside oversight (such as takeover defenses). A bedrock principle is that control of public corporations should be “contestable,” that is, that the decisions of management and the board of directors are not insulated from outside oversight (for example, by activist shareholders or potential takeovers).

Yet IPO firms in recent years have often violated one of the most basic principles of corporate governance: that each share should be entitled to one vote, so that voting rights correspond to how much a shareholder has invested in the company. “Unequal voting rights” or “dual class capitalization” has a long history, and many household names have classes of stock that give founders or their families voting rights that ensure their control. For instance, Phillip Knight controls a substantial amount of Nike’s voting stock and has the rights to appoint board members.

This kind of structure is most common in the newspaper business. The New York Times, the Wall Street Journal, News Corporation, and many others guaranteed their founders effective control through super-voting classes of stock. The rationale was noble: For the press to serve its essential functions in a democracy, it cannot be subject to undue commercial pressures. If the New York Times is not earning enough profits, or alienates a major advertiser through its reporting, activist hedge funds cannot pressure it to sell out its principles merely for cash. Research suggests that structures like this can lower shareholder returns, but investors know that going in. If you are going to invest in a newspaper, you have to accept the risk that it will not always do what is most profitable.

When Google went public in 2004, it gave its founders 10 votes per share, while the public got only one vote per share. As Google’s IPO prospectus pointed out:

Larry, Sergey, and Eric will therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets, for the foreseeable future. In addition, because of this dual class structure, our founders, directors, executives and employees will continue to be able to control all matters submitted to our stockholders for approval even if they come to own less than 50% of the outstanding shares of our common stock. This concentrated control will limit your ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock could be adversely affected.⁸

In short, if Google’s founders decided to sell the company to the government of China, with Tibet thrown in as a sweetener, they could do so. Outside shareholders were willing to take this deal, and thus far they have not been too disappointed. (Although in 2014 there was a shareholder proposal seeking to switch to one-share, one-vote, with a predictable outcome.) Certainly, Google might reasonably invoke the precedent of the New York Times: What if hedge funds wanted Google to be evil, in spite of its motto?

But since the 2008 market crash, an unprecedented number of IPO companies have given their founders and other insiders voting rights that guarantee their control in perpetuity—a feature that typically lowers shareholder returns. One study found that more than 10% of IPO companies from January 2010 to March 2012 had dual-class voting structures that gave their founders super-voting rights (which has come to be called the “Zuckerberg grip”). These include LinkedIn (10 votes per share), Zillow (10 votes per share), Yelp (10 votes per share), Zynga (a B class with 7 votes per share and a C class with 70 votes per share), and Groupon (which awarded its founders an astounding 150 votes per share).⁹ In other words, far from being bullied by their shareholders, the founders of these firms have found a way, in effect, to maintain uncontestable and eternal control. And while Google might have a plausible First Amendment case, it’s hard to see how an online coupon vendor or videogame producer can justify such structures.

Once again, Facebook stands out for its distinctive governance structure. Its Class B shares enjoyed 10 votes per share. They were two-thirds owned by Mark Zuckerberg, giving one person over 50% of the company’s total voting power. From the prospectus:

Because we qualify as a “controlled company” under the corporate governance rules for publicly listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function. In light of our status as a controlled company, our board of directors has determined not to have an independent nominating function and has chosen to have the full board of directors be directly responsible for nominating members of our board, and in the future we could elect not to have a majority of our board of directors be independent or not to have a compensation committee.¹⁰

When Facebook went public in 2012, it erected a fortress against outside shareholders and gave dictatorial powers to one 28-year-old. It is perhaps not surprising that its share price dropped by half on its first day of trading. What is more surprising is that it not only recovered, but showed impressive returns. With revenues of only $12.5 billion in 2014, it is nonetheless able to make multibillion dollar acquisitions on the whim of its CEO.

Fifteen years after the dot-com bubble burst, and along with it all of the reforms in corporate governance that followed, the most high-visibility entrepreneurial companies of the high-tech economy have abandoned basic shareholder protections. It is possible that Google, Facebook, Zynga, Groupon, and the rest are intended as benevolent dictatorships, with their visionary founders protecting the vital missions of their enterprise from the depredations of short-term shareholders. Perhaps Mark Zuckerberg is the Web’s Lee Kuan Yew. But a betting man might think of this as a great opportunity to short in anticipation of the next bubble burst.

The disappointing job creation of IPO firms since 2000

ONE OF THE great fears about the decline in the IPO market is that potential high-growth companies would not be able to raise capital to build facilities and hire people. No IPOs, no jobs. The JOBS Act of 2012 was premised on the idea that access to the public markets was key for job-creating new ventures. Companies with less than $1 billion in revenues would be defined as “emerging growth companies” and exempted from some of the requirements of the Sarbanes-Oxley Act, and would make it easier for companies to raise capital through crowdfunding (for example, by using websites). As we have seen, there is reason to be skeptical about whether access to capital was the reason the economy was not creating many jobs in new companies. Some of the “biggest” tech companies, with multibillion dollar valuations, have surprisingly few actual employees.

So do companies create jobs after they go public? To address this question, I assembled annual employment data for every company that went public in the US beginning in 2001 using the Wharton Research Data Services. It is, unfortunately, not as easy to answer the question about job creation as you might guess. One approach is to measure direct employment. American public corporations are required to report the size of their global workforce every year on the Securities and Exchange Commission’s Form 10-K. I examined these figures for every company from the first year they reported after their IPO to the last year they were in the dataset (usually 2014), taking the difference to represent job creation.¹¹

Of the roughly 1,600 companies in this group over 14 years, the median IPO firm grew its employment by 51 jobs. One thing that stands out is how many companies actually shrank after going public. KBR, an engineering company spun off from Halliburton, reported 56,000 employees in 2006 (its IPO year) and only 25,000 in 2014, shrinking by 31,000. Ally Financial (formerly GMAC) had 28,000 employees in 2000 but only 7,000 in 2014, after its bankruptcy and IPO. Armstrong World Industries shrank from 14,500 to 7,400 after its IPO; BearingPoint shrank from 10,000 to 2,500; and so on.

At the other extreme, there were a handful of companies that saw substantial growth in their job rolls, but on closer inspection this growth often turned out to represent acquisitions rather than organic job creation. Moreover, many of the jobs created were part-time, seasonal, and low-wage. Those companies that ranked in the highest job growth (with number 1 as the highest below) include:

1. Brookdale Senior Living, which went public in 2005, grew from 16,000 to 82,000 jobs in 2014 (52,500 full-time, 29,500 part-time), but this was almost entirely through roll-up acquisitions in the fragmented senior care industry.

2. Synnex, leaping from 1,664 to 64,000 jobs. But the vast majority of those jobs came from its 2013 acquisition of IBM’s global business process outsourcing unit. This was job shuffling rather than growth.

3. GameStop, a strip-mall videogame retailer that operates 6,700 stores around the world and employs at each “on average, one manager, one assistant manager and between two and ten sales associates, many of whom are part-time employees. . . . We have approximately 18,000 full-time salaried and hourly employees and between 29,000 and 55,000 part-time hourly employees worldwide, depending on the time of year.”

4. Google, which grew from 3,000 at its IPO in 2004 to 53,000 in 2014, through a mix of organic growth and acquisitions.

5. Chipotle Mexican Grill, which grew from 13,000 in 2006 to 53,000, “including about 4,590 salaried employees and about 48,500 hourly employees.”

6. CBRE Group, a commercial real estate holding company, which expanded from 13,500 to 52,000—again, through roll-up acquisitions in a fragmented industry.

7. Texas Roadhouse, a restaurant chain, which grew from 9,700 to 43,300, of which many are part-time.

The number of full-time US jobs created by the top 10 IPO companies this century has been quite modest. For comparison purposes, GM added 150,000 people to its payroll in 1942 and 1943, and the US economy created 257,000 jobs in January 2015 alone. Wherever these jobs are coming from, it is not driven by IPOs. With the notable exception of Google, the jobs that are created by IPO companies are often part-time and in low-wage occupations in food service and retail. Google’s job growth, averaging 5,000 per year since its IPO, is a bright spot, but it is almost utterly unique in the tech sector.

There is some evidence that the JOBS Act has increased the number of IPOs slightly—one study estimates that 21 more firms per year went public after the Act than would have been expected. Many of these are biotech companies (SIC code 2836), which benefit from the reduced disclosure requirements under the JOBS Act. But the median biotech firms that went public after 2000 had only 49 employees in 2013, and all 100 of these companies put together had fewer than 8,000 employees.¹² (Notably, over 90% had no profits.) Biotech IPOs will not create a surge in employment, revenues, or profits in the foreseeable future.

IPOs may also be bad for innovation: According to a study by Shai Bernstein at Stanford, companies that become IPOs subsequently see a decline in the quality of their patents, a loss of innovative employees, and a decline in the productivity of remaining employees, relative to firms that filed for an IPO but then withdrew.¹³

It seems that the stock market is largely irrelevant for creating new jobs in the US, and making it easier to go public is unlikely to change things. IPOs no longer provide much information about the health of the real economy, particularly the part involving employment.

IPOcalypse now?

POLICYMAKERS AND PUNDITS have placed a great deal of faith in the power of entrepreneurship to create new job-generating enterprises. Their creed is that unleashing entrepreneurs and providing them with financial capital will give them the incentives and the ability to build enterprises to take the place of the Eastman Kodaks and Westinghouses of old. But this faith-based economic policy is rooted in an outdated view of how the economy works. Entrepreneurs today, guided by their investors, avoid buying equipment or hiring employees that might tie them down. Going public is unnecessary and perhaps even dangerous; those who do it often go out well armed with defenses against their shareholders. Many firms that go public don’t need the capital they are raising, or they use it to make acquisitions, not to build capacity. In this way they mirror established companies, which today use much or most of their profit to buy back their own stock rather than investing in new factories or stores.

At the time of this writing, IPOs have experienced a modest resurgence. But given that the large majority of companies going public have no profits and create little employment, it is unclear how this will drive the economy forward. Moreover, the governance practices of the most visible technology firms suggest that eventually the market will turn against them.