Unintended consequences

It is now apparent that the ramifications, the ripple effects if you will, of the Enron bankruptcy, are likely to extend well into the future. My interest, as a venture capital devotee, has little do with the issues being hotly debated in the press, i.e., the guilt or innocence of certain individuals or institutions, or such macro-issues as, for example, how the accounting profession should be regulated by the government, if at all. I am focused in this piece on a couple of narrow questions, narrow at least compared with the all-encompassing 'reforms' being promoted by the loudest voices in this debate.

The first item of note is prompted by a sign of the times: the ATT-Comcast proxy statement is over 800 pages long and approximately half of that, a little under 400 pages, is taken up with financial disclosures. Now, the SEC's original charter, as perceived by the Agency and endorsed by successive administrations over the years, has been on making public company disclosures accessible and understandable to the 'average investor.' The most recent example of the SEC's focus is the promulgation of 'plain English' requirements. The Enron affair, to be sure, may in fact enhance comprehensibility by insisting on road maps to the financial statements at some point in the proxy materials, plus the annual and quarterly reports.

However, I will leave it up to you whether an 800 page document is a step in the right direction on that score … or, whether a document of that length is inherently unreadable, no matter what its content consists of. My point is that the sheer length of the disclosures is a direct outgrowth of the Enron furor. However the prose is phrased and the numbers aligned, lawyers and accountants, plus the managements they represent, are now scared to death of allegations of non-disclosure. Some of the more truculent members of Congress have been talking about criminal penalties. Hence, the disclosure statements accompanying a complex structure or transaction are going to go on and on ad infinitum, at least if one of the companies is public. Simply preparing a document of that size is a monumental task…and, obviously, monumentally expensive. But, it is hard to see what choice the principals have. You have to 'kitchen sink' the materials, if you don't feel like testifying before a Congressional committee.

Thus, one of the necessary effects on emerging growth finance (paling, perhaps, in comparison with the ripple effects on corporate finance generally) is to call into question the value of public registration in the first instance. There is already a cloud on that status for emerging growth companies. Any company with a market capitalization of, say, less than $500m necessarily has to wonder whether being 'public' is worth it, since its stock (as likely as not) is in what is called the Orphanage. That is to say, of the 12,500 (+/-) public companies in this country, at least 7500 are too small or too indistinct to command coverage by professional analysts. As a consequence, institutional interest is sparse and the stock price floats down into single digits, regardless of how well the company might be doing. The asset-managing institutions have merged in recent years; and, a given asset manager (now managing, say, five times the assets in his or her prior portfolio) needs an enormous amount of liquidity in many cases in order to get in and out of a stock without disrupting the market.

Thus, without analytical coverage, the small cap stocks (unless they are extremely fast growing) inexorably settle down into the Orphanage. There is gloomy data to the effect that, once a stock slips into single digits, it rarely (if ever) escapes that venue. And, with the stock price depressed, the stock as currency is useless for acquisitions, employee incentive awards and the like.

All these conditions existed pre-Enron. Now, post-Enron, the simple cost of public registration (the expense and risk of preparing the documents) is likely to go up by at least one order of magnitude. Moreover, the threat of liability from the professional securities bar, particularly if there are politically driven amendments to the Private Securities Litigation Reform Act, is magnified. All in all, it is not a pretty picture for Orphanage companies.

Therefore, my forecast (and I am working on such transactions intensively in my law firm), is that 'going private' transactions will accelerate. Why be a public company if the costs have gone out of sight, the stock price is artificially depressed (in management's view anyway) and all you are doing is providing a road map for your competitors and customers to understand your strategy and pricing, all to your competitive detriment?

In fact, the hue and cry concerning analyst compensation is likely to enlarge the Orphanage. Investments banks recover the costs of employing all star analysts in two ways. First, analytical coverage generates commission income; but, for an analyst to get paid by a major league investment bank, his or her coverage is necessarily restricted to stocks with heroic trading volumes. The commissions are not large enough in the small cap market to make it worthwhile for an analyst to spend his or her time in understanding the story.

The second way (at least up to now) analysts had generated revenues was by supporting the corporate finance group and being paid bonus dollars from underwriting and M&A revenues. The analyst was an integral part of the team selecting IPOs and secondary offerings…a logical notion since, if the analyst did not like the stock, why would the investment bank underwrite it in the first place? However, the current accusation is that analysts recommending stocks underwritten by their employer are simply shills for the house, abandoning their independent and objective judgment. And, it is likely that that source of revenue for the analysts will be curtailed, if not eliminated. This throws us back again to focus on the large cap issuers … 20 analysts following Microsoft and none at all following the next Microsoft.

The second result of Enron, I think, will be an impact on the IPO market generally. Traditionally when venture investors went into a company, their investment model was built on a preferred exit mechanism, being the IPO. That's where the big bucks are, or at least were, in this business. The big payoff for the VCs has been historically driven by their success in racking up a 'portfolio maker' exit event. And, since those enormous payoffs were generally IPOs versus company sales, the VC preference was to invest in companies with IPO potential. Their valuation methodologies worked backwards from that event, running the risk and reward calculations off the IPO model.

The question post-Enron is whether the IPO model makes sense any more. Indeed, there were signs pre-Enron that the IPO as a liquidity event had problems, including but not limited to the successful candidates winding in the Orphanage; by the time the lockup had expired, the Orphanage effect may have dragged the stock down into that single digit bottomless pit and many insiders, the ones who elected the IPO in the first place, never saw much of a return.

Secondly, it has been cogently argued that the 'cost' of equity capital in an IPO is somewhere around 25 per cent, compounded. This seems counterintuitive: IPO equity is not debt. At first blush, it is not apparent why any cost would be applied to that element of a company's financial structure. However, if one assumes (as is the case, I believe) that the expectation of the market place vis-à-vis most IPOs is that the company will achieve a 25 per cent (more or less) growth curve, the rationale becomes apparent. If the company fails to 'pay' the 'interest' on the IPO investors' capital by meeting or exceeding their expectations, then the stock gets killed. Again, as far as the insiders are concerned, they still own the stock; but their wealth is as effectively diminished as if the bank had foreclosed on the mortgage.

Now comes the Enron (as I call it) necktie party, which necessarily will encourage litigation against the company, its directors, controlling shareholders and management when and if an IPO turns out not to meet expectations. If plaintiffs' counsel can get to the jury, then the issue of liability post-Enron may be a foregone conclusion. Moreover, the Enron D&O carriers are disclaiming coverage…a chilling precedent if successful. Once you factor those risks in, coupled with the lockup and the market's cruel reaction to one hiccup in the growth curve, you have to wonder whether an IPO is worth it.

Enron, in short, may be one of the signal events in the history of the Principle of Unintended Consequences.