Rebecca Buckman

The Wall Street Journal
January 25, 2006

Regulatory reforms and other changes in the stock market are making it harder for start-up companies to launch initial public offerings of their shares, depriving Wall Street firms and venture-capital firms of lucrative IPO fees and profits.

Last year, 41 start-ups backed by venture-capital investors became publicly traded U.S. companies, down from 67 in 2004 and 250 in the boom year of 1999, according to research firm VentureOne. Overall IPOs of U.S. companies also declined last year, but not as sharply, to 215, from 237 in 2004.

The drop in venture-backed IPOs isn't just a hangover from the technology-stock bust early this decade, when bankers became gun-shy about taking small companies public. In 1995, 144 venture-backed companies went public, and 168 did so in 1992.

Venture-backed start-ups now also need more time to take the IPO plunge -- more than 5½ years, on average, from the time of their first venture-capital investment, up from less than three years in 1998, says VentureOne, a unit of Dow Jones & Co., publisher of The Wall Street Journal.

A few years ago, Omneon Video Networks, a privately held broadcast-video company in Sunnyvale, Calif., would have been a strong IPO candidate. It's a profitable, eight-year-old enterprise with prominent investors, 175 employees and big customers, including Viacom Inc.'s MTV and Time Warner Inc.'s Turner Broadcasting. But Omneon Chief Executive Joe Kennedy says the company can't yet offer enough shares to attract the attention of big-name research analysts to publicize the stock and cash-rich mutual-fund investors to buy it.

"If you don't attract the big funds, you're not going to attract the research analysts," Mr. Kennedy says. "And if you can't attract the analysts, you're just sort of in a backwater." He figures his company won't be big enough to go public for at least another year. "By historic standards," he says, "we probably would be right on the verge of a public offering today."

For companies like Omneon, the trend limits their ability to grow. Public companies can use their own shares to buy other businesses. Without shares, private companies have to tap their own often-limited supply of cash to grow -- or persuade their venture-capital backers to cough up more money.

Venture-capital firms, which invest in young businesses in hopes of profiting when they go public or are acquired by other companies, are awash in cash for investments these days, but the trend toward fewer IPOs also is crimping their returns. Though some venture-backed firms have fetched lofty prices from acquirers -- eBay Inc. last year paid $2.5 billion for Internet-phone firm Skype Technologies SA -- IPOs traditionally have been more lucrative. And the longer venture capitalists hold investments, the more money they tend to sink into them, potentially lowering returns.

"When we're making an investment now, we're really assuming [a merger or sale] would be the exit," says Bob Grady, head of U.S. venture investing for Carlyle Group in San Francisco.

Investment banks that earn fees for overseeing stock offerings are feeling the pinch, too. Some of that hit is offset by money they make advising companies on acquiring start-ups, but the number of venture-backed acquisition deals declined last year as well, to 356 from 407.

The predicament may be temporary, but experts say the slowdown stems in part from shifts on Wall Street. One big issue is that Wall Street firms employ fewer stock analysts these days. Publicly traded companies thrive on analysts' attention because their reports trigger buying and selling, creating robust marketplaces for their shares. That makes coverage by analysts crucial for start-ups considering stock offerings.

The relative dearth of analysts stems from a regulatory crackdown on biased stock research in 2003. Authorities concluded that some analysts had been touting companies' shares to drum up investment-banking-advice business from the companies for the analysts' Wall Street employers. So regulators barred firms from compensating analysts based on investment-banking business. Now firms have less incentive to employ as many analysts or to pay them as much.

The result: According to the National Research Exchange, a new company offering independent stock analysis, the number of research analysts at 10 major Wall Street firms declined to 995 at the end of 2005, down 30% from 1,420 in 2001.

The remaining analysts mostly focus on larger companies' stocks because they are of interest to most big investors, including mutual funds that do lots of trading business with Wall Street firms. Moreover, the firms make money on stock-trading commissions, so they also have an interest in encouraging buying and selling in bigger companies that have more shares available to trade.

Wall Street firms also have an interest in lavishing research attention on their most lucrative clients -- the bigger companies.

If a company is small, "it's very difficult...to justify putting an analyst on the stock," says Promod Haque, a managing partner at Norwest Venture Partners of Palo Alto, Calif., an Omneon investor.

The industry's switch in 2000 to trading stocks in penny increments, instead of eighths of a dollar, cut trading profits for Wall Street firms, slashing another source of revenue available to pay analysts. That switch also discouraged analyst coverage of smaller companies with fewer shares to trade. Wall Street firms profit by putting stock traders together, pocketing the difference between what buyers will pay and what sellers will accept. The smaller the increments, the smaller the profits.

"Research creates order flow in that stock," says David Weild IV, National Research Exchange's chief executive. "The question is, is that order flow profitable? At a penny, unless you have huge volumes, it's largely unprofitable." [for small companies]

Small companies considering going public also must contend with new auditing and reporting requirements, including the 2002 Sarbanes-Oxley law. The law makes it more expensive to be a public company, requires top executives to vouch for the accuracy of their books and includes stiff penalties for violations, all of which makes start-ups think twice about going public, small-company executives and venture capitalists say.

Ironically, the recent flood of cash into mutual funds and hedge funds also is working against small would-be public companies: As funds grow bigger, each of their investments tends to grow, lest managers get overwhelmed trying to oversee too many stocks.

"If you were to have a portfolio with $10 billion in it and you wanted to have 100 investments, then the average investment would have to be $100 million," says Mr. Weild. That rules out investing in smaller companies, because mutual funds usually don't hold more than 10% of a company's shares.

"The overwhelming growth in mutual funds, in 401(k) plans, in all asset categories has meant that to be a public company, you need to [operate on] a bigger scale to attract investors," says Mark Zanoli, managing director for tech banking at J.P. Morgan Securities.

According to VentureOne, the median stock-market value of venture-backed start-ups going public last year was $216 million, up from $138 million in 1997 and just under $80 million in 1992. The bubble years of 1999-2001 were an aberration: The median value of start-up IPOs hit $449 million in 2000.

To stage a successful IPO today, Mr. Zanoli says, companies need close to $100 million in annual revenue and a potential stock-market value of at least $250 million -- and preferably much more.

Some mutual funds still invest in smaller stocks, but newly public companies have to work harder to get their attention. Website Pros Inc., a Jacksonville, Fla., provider of Internet services for small businesses, went public last year, and Chief Executive David Brown estimates that he spends up to 20% of his time courting investors.

"It's not easy," he says. "We're in a tough business cycle for IPOs right now."