The Long-Term Harm of SOX and Other Regs, Part 2: Innovation and Motivation

Part 1 covered the dearth of initial public offerings (IPOs) caused by Sarbanes-Oxley.

This part will talk about the short- and long-term effects of not having the IPO realistically available as an exit strategy for entrepreneurs.

I don’t think anyone seriously doubts that in the legal and regulatory environment of 1998, YouTube would have done an IPO instead of selling out to a bigger company. But today? Forget it.

Further, if YouTube’s goal had been an IPO, they might have extended their service beyond something that currently isn’t much more than a very convenient database of video content. But because selling out to one of The Big Guys was clearly the more viable option, YouTube can be seen as exemplifying an entrepreneurial community engaged in shorter-term (and by inference, less innovative) thinking, as Michael Malone described in the latter portions of his Wall Street Journal op-ed (”The Pump-and-Dump Economy”) last week:

The entrepreneurs who’ve started those companies know the situation better than anyone — and right now you’d be hard-pressed to find a Silicon Valley start-up that is building itself for the long haul.

….. Meanwhile, the one traditional force that might have propelled these companies forward to an eventual IPO is gone as well, also thanks to recent regulations. The Financial Accounting Standards Board, which advises the SEC, has been itching for years to force tech companies to put a value on their stock options — despite the fact that most such options end up valueless.

The result, as anyone but an accountant would have known, is that start-ups are far less willing to throw options like monopoly money to everyone from the chief scientist to the guy who waters the office plants. If that sounds good in principle, keep in mind that easy options were probably the most effective form of wealth distribution in modern life. The great stories are not about a Steve Jobs becoming a billionaire, but about his secretary becoming a millionaire.

Under the new options rules there will still be new T-shirt tycoons like Mr. Jobs, but a whole lot fewer of his secretaries will be able to retire young. And it will be interesting to see just how many of those secretaries (and code writers and marketing specialists) will be willing to put up with the long hours in a job that could disappear overnight — merely for wages. That is yet another argument for keeping your start-up to little more than the coterie of founders, and then selling out quickly to Google. No wonder big tech companies like Microsoft and Intel jumped on the stock option reporting bandwagon so quickly.

Don’t kid yourself — motivating employees through stock options in anticipation of going public is not just a tech-company phenomenon. Plenty of non-tech start-ups (pre-SOX) have used them to motivate employees in their earlier stages.

And don’t forget this point: It isn’t just that techs aren’t going public; almost no one is. In previous times, some of the smaller non-techs that went public, even if they didn’t use pre-IPO options as a motivator, were able to achieve explosive post-IPO growth (e.g., Wal-Mart, Home Depot) that almost certainly would not have occurred if the IPO had not taken place. These companies were able to motivate their workers, and especially key employees, by offering rapidly appreciating company stock through their 401(k), stock ownership, and executive-bonus plans. A company choosing to stay private, getting bought by another company, or for that matter, going private after having been public, won’t have that motivator in its toolkit.

Here’s Malone’s chilling wrap:

….. Let’s do our own accounting: Thanks to this troika (SOX, stock options treatment, and what are known as “Fair-Disclosure” regs — Ed), fewer new companies are going public; economic power is being concentrated in the hands of fewer companies; competition is reduced; new wealth is less widely distributed; the rich are getting richer; fewer talented people want to join entrepreneurial ventures; and corporate boards are getting stupider and more paranoid. And, please note, one of the crucial triggers for economic booms — a burst of young tech company IPOs — has now largely evaporated.

Just curious, but is this really what federal regulators, Congress and shareholder rights activists had in mind?

Answering Malone’s final question — It may not be what they had in mind, but each of the three groups identified will become comfortable with it now that it’s here. All three have a vested interest in creating their own version of an “orderly” environment with a smaller number of larger players, free of the potential “chaos” and upheaval that feisty start-ups who can’t be bought off can cause. 50 years after John Kenneth Galbraith wrongly predicted that a few large corporations would become ever more dominant, SOX and the other poxes, if allowed to run their nefarious courses, may accomplish that very thing.

Imagine this — How different (i.e., NOT better) would the world be today if Apple’s or Microsoft’s exit strategy in the early 1980s had been to be acquired by IBM? What kind of computer would you be looking at (or would you even BE looking at one)? Or what if Yahoo’s founders or Amazon’s Jeff Bezos had planned only to sell out to Microsoft? (Or even Wal-Mart or Home Depot to Sears or K-Mart?)

Everything I have covered in the this post and the previous one explains why I’m rooting for Ken Starr in this instance — and you should be too.