Every entrepreneur used to dream of selling shares in an initial public offering, or IPO, and listing those shares for trading on a national stock exchange. Now many strive to avoid that fate. The number of public companies has shrunk by more than one-third during a time when the U.S. economy has more than doubled in size. In 1997, there were 9,113 public companies in the U.S. At the end of 2016, there were fewer than 6,000.
The real action is no longer in public offerings but in private deals, and the best opportunities increasingly are open only to big investors, such as sovereign wealth funds and private equity firms. It’s not an exaggeration to say that the IPO market is in the beginning of a death spiral as observers assume that any company that resorts to raising money in an IPO must already have been rejected by the more sophisticated investors in the private capital markets. This is a stark reversal, since IPOs long were the funding mechanism of choice for the best corporations.
A tragedy of the new normal is that the public equity markets are fast becoming a suckers’ game. Small investors never see the better investment opportunities because they are open only to institutions. As a result, our markets are no longer democratic, they are elitist.
It may seem as though the demise of the public company is no big deal. After all, capital is only money, and since companies that once got funding from IPOs can now tap private sources, there are no losers — other than a few traders, investment bankers and, of course, the stock exchanges. But this view fails to account for the fact that investing in public companies long has been the principal way that individuals saved for retirement. The trend away from IPOs has dire consequences for regular people as investment opportunities for mutual fund managers as well as individuals shrink.
The IPO allowed small investors to share in the upside potential of the company.
One drawback to going public is shareholders’ sometimes excessive focus on short-term stock price fluctuations. Although investors in private deals care as much about performance as investors in IPOs, IPO investors tend to have a less sophisticated understanding of the challenges facing the companies whose shares they own. This knowledge deficit often leads public company investors to be excessively concerned about quarterly earnings reports.
But litigation and regulation are the real pathologies driving IPOs to the brink of extinction. Public companies invite lawsuits because opportunistic plaintiffs’ lawyers can round up a couple of investors as clients and bring lucrative class action suits against companies, boards and top managers ostensibly on behalf of all investors. Despite evidence of the frivolous nature of many of these suits, judges have proven unwilling to impose sanctions on meritless complaints or even to refrain from awarding generous attorneys’ fees and costs with shareholders’ money.
It is much more costly for investors to sue privately held companies because private company investors generally have to pay their lawyers’ fees out of their own pockets. They must also obtain a payout from the defendants in order to recoup the costs of litigating.
Regulation is another big problem for public companies. The Securities Act of 1933 prohibits not only actual sales of securities but even the offering of securities to investors until the SEC’s Division of Corporation Finance signs off on hundreds of pages of disclosures and accounting information. After a company has gone public, company officials are barred from interacting with stock market analysts to explain what their company is doing unless these conversations are made public. This makes it hard for new issuers to explain their businesses in any detail, particularly since competitors are among those most acutely interested in these disclosures. Errors in disclosure, regardless of how innocent or inadvertent, are severely punished.
The Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010 both greatly increased the risks of being an officer of a public company. Sarbanes-Oxley added to the criminal code provisions that require CEOs and chief financial officers to certify every three months that their companies’ SEC filings, including audited financial statements, fully comply with myriad reporting requirements, and that the information in the complex filings “fairly” presents the company’s financial position. Public company officers are subject to penalties of up to 10 years in prison for getting the certifications wrong.
The “say on pay” provisions of Dodd-Frank require that companies submit the compensation packages of their top officers to their shareholders for an advisory vote. This may be a good practice for poor managers to follow, but good managers who are navigating a public company through tough times often find themselves targeted for making unpopular decisions.
There was a time when the entire venture capital industry was based on the strategy of investing in a young company and then “cashing out” by taking them public a few years later. The IPO allowed small investors to share in the upside potential of the company.
As IPO’s fade in importance, so too will individual and small institutional investors. Wealth will be created less democratically with vast swathes of investment opportunities closed to the public. This, in turn, will exacerbate the increasingly acute problem of economic inequality that already is chipping away at the fabric of American society.
Jonathan Macey is Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School.