In Defense of SOX
It is fashionable in the venture capital business to hate Sarbanes Oxley, aka SOX.
Most every VC I know of thinks it is bad for the VC business. Maybe it is. It certainly makes it harder to take companies public. And there is so much work that has to be done by a company to become "SOX compliant", particularly section 404 compliant, that many companies can’t even think about taking that on while trying to grow their business.
I believe that before SOX, way too many companies went public before they were ready to be public companies. They didn’t have profits, they didn’t have financial organizations capable of building and mantaining internal controls, they didn’t have complete management teams, and they often didn’t even have reality tested business models.
And once one company in a sector went public, they all went public, driven by a desire to maintain a level playing field with their competition. Chapter Two of Hackoff.com has a good description of those days.
I recall the late 90s when companies would hire the CFO weeks before the IPO road show. I recall that happening with a few CEOs as well. It was crazy. And it’s no wonder that so many of those companies ended up being bad public companies.
With SOX, that really can’t happen. It takes a year or longer to prepare to become a public company. We have several companies in the Flatiron portfolio that are going through this process now. And as much as I hate seeing them spend the money on SOX consultants and staffing up their finance departments, I see it as an important test of whether the company really wants to be a public company or not.
There are plenty of ways to raise capital privately so the public markets aren’t always the best option for raising capital, particularly for young companies.
And the M&A market is very healthy, so going public isn’t necessarily the best way for the insiders to get liquid on their investment.
The investment banks are supposed to be the gatekeepers of the IPO process, deciding which companies are ready to go public and which are not. Back in the day when they really "underwrote" the public offerings and took the risk on whether the deals got done or not, maybe they did provide some kind of readiness filter, but I don’t think that investment banks can be relied upon to be the quality filters anymore. They make too much money on the IPOs, regardless of whether they are successful public companies, to be truly objective about the process.
So I think its a great thing that SOX has put a high hurdle that companies need to jump over to become public. In the past four years, we have seen that good companies can go public, but it takes a lot of work and preparation to do that.
My friends at Broadview (now part of Jeffries & Company) used to have a chart of the performance of venture backed IPOs six and twelve months post IPO. A sizable majority of them were trading below their offering price by the time that the VCs could get out. They made a persuasive, if somewhat self serving, argument that selling venture backed companies provided better exits than IPOs.
I’ve often felt that was true for all but the very best portfolio companies. Now with SOX we have a hurdle that forces entrepreneurs and VCs to be patient and prepared for the IPO process. I’d be interested to see that Broadview chart pre and post SOX. I bet it looks better now.