Federal Regs Causing IPO Drought

Published October 10, 2008

Weakness in financial markets and expenses brought on by Sarbanes-Oxley rules have led to a dearth of initial public offerings (IPOs) in the United States, hitting the information technology sector particularly hard.

A six-month drought in IPOs ended in August when San Antonio-based Rackspace Hosting went public, but experts don’t foresee many public filings in the near future.

The primary reason market and policy experts see the lid remaining on IPOs is that in today’s economic conditions, and especially considering new regulatory expenses, it doesn’t make financial sense to take private companies public.

Weak Market Confidence

“There’s a lack of confidence in the markets,” said Jim Watson, managing director for CMEA Management in San Francisco, a venture capital firm that specializes in technology, renewable energy, and life sciences. “Investors have become very conservative, and IPOs by their very nature are high-risk.”

Michael Tew, cofounder of SPAC Research Partners, a Palo Alto, California firm that follows the venture capital market, agrees. He points to the failure of Bear Stearns and weakness in other brokerages and investment companies as making it more difficult for private firms to raise the capital needed to go public.

IPOs were popular with investors earlier in the decade as numerous fast-growing companies enjoyed quick increases in pricing and valuations the day of the offering and shortly thereafter. But those days are long gone.

“There’s no reward for fast growth. It’s all about earnings,” Watson said.

Rackspace provides IT systems and computing to about 33,000 customers worldwide. Rackspace’s offerings include hosting Web sites, e-mail, and cloud computing services. The firm also recently launched a cloud storage service called CloudFS.

Not Worth the Risk

Technology firms have historically had little or no earnings when going public, but high price-earnings (PE) ratios—as much as 30 percent for many tech companies only a few years ago—made IPOs attractive to investors, Watson said. These days, however, those same firms are commanding PE ratios of only 10 percent, which is too low to entice investors.

“It’s just not worth the risk,” Watson said. “You’re better off [staying private] and continuing to build the company.”

Investors agreed with Watson on the day of Rackspace’s debut. The company’s stock closed at $10.01 a share on the New York Stock Exchange, down from its offering price of $12.50. A total of 15 million shares were sold at the low end of its expected $12 to $16 price range.

Market conditions could improve in a few months to the point where IPOs start to be more attractive again, Tew said: “Capital will pick back up, the question is when.”

New Regs Are Culprit

But regulatory requirements—especially those included in the 2002 Sarbanes-Oxley (SOX) law passed in the wake of the Enron and WorldCom scandals—will still cause some firms to stay private, Watson and other policy experts say.

The new rules have led to sharply higher expenses for all public companies and gave rise to new rules at the New York Stock Exchange and Securities and Exchange Commission that affect real estate investment trusts (REITs) and all other public companies.

SOX established new standards for financial literacy, disclosures, and board member rules. The law requires strict auditing and monitoring measures that add to the cost of operating a public company.

Watson estimates SOX costs companies $3 million to $4 million in the first year of going public and at least $1 million annually in ongoing expenses.

Expensive Reporting Requirements

Much of the expense is due to the increased reporting and monitoring required under the law. Publicly traded companies must include in their annual reports an internal control disclosure stating the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.

The report also must contain an assessment of the effectiveness of the internal control structure and procedures of the issuer for financial reporting at the end of each fiscal year. Automated financial reporting systems, including any automated bookkeeping and accounting systems, must be tested for accuracy under SOX to ensure accurate financial reports.

The rule is designed to ensure capital and operating expenses remain properly categorized—and each report must include extensive details

Board Membership Specified

SOX also affects a company financially before it actually goes public, Watson said. In just preparing for an IPO, a firm typically needs to find a new board of directors, with the members screened for fitness to serve on audit committees and other executive committees.

The new board members have to be in place about two years before a firm goes public, Watson said.

“Before Sarbanes-Oxley, you didn’t have to actively recruit for board members to serve on audit committees. Now you have to offer incentives in order to get qualified people. The [SOX-required] qualifications are in high demand, so now you need executive recruiters to find qualified people.”

Those recruiters can cost up to $150,000, Watson said.

More Attractive Alternatives

Steve Titch, a telecom policy analyst for the Reason Foundation in Los Angeles, said venture capital money is still going into Internet and tech ventures. But IPOs in the United States will continue to be limited unless some of the more onerous provisions of SOX are rolled back, at least for new offerings, he said.

Titch, Watson, and Tew all note SOX has made the London Stock Exchange a more attractive venue for going public than U.S. stock exchanges.

Instead of going through an IPO or staying with venture capital funds, another option privately held start-ups are pursuing now is selling themselves to other private and public firms, according to Titch.

Phil Britt ([email protected]) writes from South Holland, Illinois.