Follow-up on the IPO conveyor belt disconnect

We certainly don't agree with Mark Cuban on everything, but we give him credit for continuing to hammer on a subject of great importance to the economy at large: the lack of IPOs.

We wrote a post last week entitled "Disconnect in the IPO conveyor belt" discussing some of the ramifications of this problem, ramifications which extend far beyond the somewhat rarified and (to many investors) unfamiliar world of start-ups and venture funding -- ramifications which impact employment, prices, innovation, and the quality of all kinds of goods and services used in business and in daily life.

This morning, Mark Cuban was on CNBC again talking about this subject, and made the point that the dysfunctional IPO landscape also has a negative impact on equity markets in general.

Specifically, he said (beginning at about 00:45 seconds in the above-linked clip):
If we have a problem, it's not that there's frothy valuations for tech companies in the public markets: it's that there's no tech companies that have high growth rates, that are in a position to get frothy valuations -- that's the problem. I mean, if you look at, you know . . . tell me who the high-growth-rate companies are today that have under a hundred billion dollar market caps -- Netflix? You know, how many of them are  there? And that's the real problem in this market. And what's happening is, you've got -- because companies are refusing to go public -- it's just, you know, if you want to talk about the Valley, the whole ethos is now: "Don't go public." It's crushing our stock market.
This is a huge issue, for all of the reasons we discussed in the earlier post (here's that link again) and in our post from 2013 on this same subject, as well as the reasons discussed in Mark Cuban's blog post from February on this topic, and the even more in-depth discussion in the excellent article from Julie Segal from 2010 which we linked in the previous post as well.

Despite what Mark Cuban appears to be saying at the very beginning of the clip above, we don't actually agree that the solution is to "write down to zero" any investment in a private company that is not yet profitable -- one reason start-up companies raise venture capital is because they are not yet profitable, despite having a new or innovative idea which could be profitable in the future.

For that matter, many innovative public companies may not yet be profitable, but this does not mean that investors should "write their stock down to zero." We actually do believe that there are innovative and worthwhile companies for investors to analyze whose market capitalizations are well below $100 billion (some of which may not yet be profitable), but we definitely agree with Mark Cuban that there are a lot fewer of them than there might be if the funding and IPO landscape were not as dysfunctional as it has been for the past fifteen years.

Of course, there are many other contributing factors to this present environment, including the increasingly convoluted regulatory landscape and the additional costs which have been added to the burden of being public in the past fifteen years (or more -- the process has been going on for quite some time).

We commend Mark Cuban for his efforts to bring this situation to the attention of a wider audience.

At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Netflix (NFLX). For the record, the market cap of Netflix at time of publication was approximately $38 billion.

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Disconnect in the IPO conveyor belt

image: Wikimedia commons (link).

Entrepreneur and investor Mark Cuban was on CNBC's "Squawk on the Street" this morning discussing what he sees as a "disconnect" in the progression from company formation ("start-ups") to growth and access to the capital markets through public listing. In a response to a question about the lackluster economic growth in recent years, he replied:
There's a disconnect right now because so few companies are going public. That gives an incentive for any S&P company, any major public corporation, to just wait and see rather than investing -- making capital investment in their own company, the things that make them competitively strong -- just waiting to make an acquisition. 
And so if you are not investing in yourself -- look, there's hundreds of billions of dollars being invested in start-ups of all kinds, whether it's retail start-ups, technology start-ups, biotech start-ups -- and so, rather than big companies having to invest in their own R&D, they just sit back and wait because now the culture of start-ups is you don't go public: you look for an exit. [based on the unofficial transcript posted by CNBC here].
In other words, he notes that very few start-ups are trying to make it all the way to public viability as a new competitor on the scene, and instead their founders and investors are just looking for "an exit" by selling to a large company. One effect of this situation, he points out, is that the big companies can outsource the research and development that they would normally undertake, and just watch for interesting or innovative start-up companies, and buy the ones that look promising -- absorbing their technology.

Mark Cuban casts this situation as a negative development -- and we agree with him.

We would argue that the reason so many entrepreneurs have a culture of (in Mark Cuban's words) "You don't go public: you look for an exit" is not that they wouldn't want to go public and compete as an independent entity, but because the path to doing so has become much more constricted over the past twenty years, for a variety of reasons, leading to an unhealthy situation which has ramifications far beyond the world of venture investing and which ties in to the health of the economy at large. 

The "conveyor belt" connecting innovative ideas with access to capital that entrepreneurs require in order to grow and compete on their own in the economy is broken, to the point that many companies which could become viable players never even get funded, and those who do end up getting bought by big, existing companies. It is a problem that signals unhealthy developments involving the capital market landscape, although it may manifest itself more noticeably in the world of start-ups.

It is a topic that many experienced investors in the venture capital landscape have been writing about for the past few years. Mark Cuban published a more detailed discussion of some of the issues he expressed in today's interview in a blog post he wrote this past February, entitled "The Pre-cognitive Anti-trust Violation: How the decimation of the IPO market has hurt the economy and worse." 

The title may at first seem a little whimsical, but it actually conveys an extremely important idea, albeit in a somewhat obscure metaphor that takes a little thinking in order to unpack. 

It appears to be a reference to the "pre-cogs" in the famous movie Minority Report, which depicts a dystopian future in which three psychic beings known as "pre-cogs" are able to see crimes before they happen, and then law enforcement officers can go take down the criminals before they even carry out the future crime (a situation which is obviously ripe for horrific abuse, as the movie dramatizes quite effectively, and as the brilliant author Philip K. Dick was trying to warn society when he wrote the story upon which the movie was later based).

Mark Cuban implies that unhealthy constriction in the pathway to public viability is enabling established competitors to do a kind of "pre-crime" take-down of their future competitors, before the competitor even has an opportunity to get out into the world and become a competitor. Thus, it is a situation in which competition is killed off in much the same way that the anti-trust advocates of a hundred years ago were worried about, but in an even more sinister way -- before the competition even happens (hence the reference to the "pre-cogs" of Minority Report fame).

The negative effects of such a situation are obvious: less opportunity and incentive for companies to innovate;  less opportunity for investors to invest in small public companies before their real growth kicks in; less capital available for entrepreneurs to create a viable business; less ability for employees to benefit financially from the added work and risk they take by working at a startup; and ultimately fewer jobs, fewer opportunities, and less innovation for the economy at large.

And those are just the more obvious negative effects of the problem that Mark Cuban is describing!

We ourselves also wrote about this phenomenon back in May of 2013, in a post entitled "Crossing the chasm to IPO becomes even more difficult."

Perhaps the deepest and most thorough analysis of the historical causes of this phenomenon could be an article written by veteran investment journalist Julie Segal, published in 2010 in Institutional Investor entitled "Death of the IPO." Even more wide-ranging consequences that she traces back to this problem include a reduction in the volume, availability, and ultimately quality of equity research. 

The most telling of the ramifications she points to is the widening divide between "Main Street" and "Wall Street," as the connecting link between the two is narrowed, constricted, or obstructed completely.

This is a very serious subject, and one we commend Mark Cuban and others for discussing candidly. The solutions to the problem are not easy or obvious -- as Julie Segal points out in her article, some of the contributing factors go back to decisions made decades earlier. But it is one that we believe investors should think about and understand.

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