Wednesday, February 1, 2012

RIP IPO?

Here's my column from today's USA Today op-ed page:

The news that Facebook is preparing its initial public offering offers investors a bracing tonic after 2011, which The Wall Street Journal summarized as "another year of IPO blahs." At a minimum, Facebook's announcement will raise Wall Street's spirits.

But more important in today's economy, it raises fundamental questions.

What's the purpose of an IPO today -- compared with its original business rationale? Whose interests do IPOs serve -- and does going public actually harm a company's future prospects? Perhaps most important, have IPOs outlived their usefulness -- and will we see American business in the future that looks a lot more like American business in the past? Is it time to say RIP to IPOs?

One of the most vocal and well-informed critics of today's IPO market is Roger Martin, dean of the Rotman School of Management in Toronto. Martin is the author of Fixing the Game, a critical look at the pervasive problems with corporate finance today. I called Martin to get his take on Facebook's announcement, and on the role of IPOs in general.

"It's nice to have a liquidity event that will show just how rich Mark Zuckerberg is," Martin says. "But Facebook doesn't really need the money."

And that's the first big problem with today's IPO market. A company's decision to go public used to be based on its strategic needs: an IPO gave it much-needed growth capital.

Today, the IPO serves financial ends. "Private equity funds usually have three to five years to demonstrate to their limited partners what returns the fund has achieved," Martin explains. "They can't give their investors back their money or hand over stock in a non-IPO company. They need a "liquidity event," which not only rewards early investors but also represents a sizable payday for a company's founders and its initial employees.

Which poses another set of problems. "As soon as a company goes public, you often see a 'founder motivation problem,'" Martin says. "To make the company successful, the founder will work long hours and give the business almost all his or her attention. After the IPO, the motivation changes. The founder has had a big payday. You often see a founder gradually losing interest." To be fair to Zuckerberg, who has already turned down a king's ransom to sell Facebook, his passion for the business is likely to remain after the IPO; other founders, however, may lose focus.

As for attracting talent, Martin says, going public poses a similar challenge. "If employees got their options before the company went public, they face the same loss of motivation as the founder. And when it comes to attracting new employees after the IPO, if the stock doesn't perform as expected, attracting employees with the promise of stock options isn't going to work. Employees know their stock will be underwater."

Why wouldn't the stock go up? In a June column for The Washington Post, shortly after LinkedIn's IPO, Martin explained the problem: an almost unbridgeable gap between what the stock market expects a company to deliver and the reality of what it actually can deliver. Given LinkedIn's market capitalization of $8 billion, Martin calculated that investors would expect LinkedIn to generate about $560 million of value in the year ahead. But LinkedIn's profit in 2010 was $16 million. After doing the math, Martin concluded, "LinkedIn could grow net income 27 times over three years and still massively disappoint the market. To meet current expectations, it would have to generate 82 times profit growth in the same period."

And, says Martin, speaking about business in general, that gap between expectations and reality is what is preventing the U.S. from building great, enduring companies.

All too often, he says, what happens after a company goes public -- and then inevitably fails to reward its investors with the returns they expect -- is a spiral of disappointment. The stock goes sideways, the company is viewed as a failure, and sooner or later disappears or is acquired -- even though the company has sound fundamentals and a good competitive position.

Its IPO, which gave a few people a "liquidity event," has undermined the company's long-term ability to endure.

So what's the answer? RIP IPO.

The IPO has become such a standard feature in our culture of casino capitalism that we tend to take it for granted. But as Martin points out, the first 30 years of U.S. business in the 20th century were dominated by semi-public or privately held companies run by entrepreneurs or owner-managers.

"We're in an odd period right now," he says. "We thought that being publicly traded was the way to go. But it turns out not to be right: You can't build a company and its value over the long term given how the expectations market jerks companies around. I see us coming back to the days of privately held companies because of all the problems associated with being publicly traded."

It could turn out that this period of IPOs and publicly traded companies isn't the norm -- it's actually a passing fad, a financial anomaly.

If so, the real question won't be, when is your company's IPO?

It will be, when are you taking your company private?

All Rights Reserved 2009 (c) Alan Webber, Rules Of Thumb