Above the Crowd

Note To Timothy Geithner: Do Startups & Venture Capitalists Really Need More Regulation?

March 26, 2009:

Mr. Geithner:

In the late 1990’s, in response to the obvious financial shenanigans of large companies like Enron, Tyco, and WorldCom, Washington handed us the Sarbanes-Oxley Act.  I have no idea how effective Sarbanes has been at reducing fraud (it obviously did not prevent our current economic malaise), but I do know one thing.  Sarbox created a significant burden and tax on small companies that desired to tap into America’s public capital markets, and one that could have long-lasting negative impact on the long-term success of startups and innovation in America.  It’s pretty simple, Sarbanes-Oxley can costs $2-3mm to implement, and also is a huge burden on your IT and development staff (taking away from feature expansion and product improvement).  For a company doing $50mm in revenue with a 10% pre-tax operating margin, you only have say $3mm in after-tax earnings to report.  These new Sarbox costs effectively eliminate your profitability, which has a huge impact on valuation.  Of course, what this in fact causes is companies to feel the need to be much, much larger before they even try to go public.  Notably, IPOs have been systematically reduced post-Sarbox, and we are still significantly below 1991-1992 pre-bubble levels.  As David Weild notes for PEHub, “I submit that there is no question that accounting costs and Sarbanes-Oxley costs are a primary (maybe not the only) factor in the diminution of initial public offerings in the United States.”

So today we get news that in light of the recent financial crisis, you want to impose new regulations on hedge funds that will also sweep in venture capitalists (and by association their private companies). Depending on the regulation, this could require VCs to disclose specific metrics about the private companies in which they have invested, robbing these companies of one of the key benefits of being private.  Now it is fairly obvious that venture capitalists and the small venture backed companies in which they invest had nothing to do with the mortgage crisis, Fannie Mae, Fredie Mac, AIG, or anyone of the 8 major TARP recipients.   Yet despite this, your sweeping recommended legislation will impose more undue costs and disclosures on entities that had absolutely nothing to do with the problem you are solving.  

Washington already has given us one overly burdensome legislation (in Sarbox) for a previous problem we did not create.  Please do not do it to us again.  And remember that the largest companies in America that were created in the last 35 years (MSFT, GOOG, AAPL, CSCO, INTC) were all small venture-backed companies at one point in time.  Do we really want to inappropriately restrain or throttle the future pipeline of such companies in America?

I am all for you solving the problems you need to solve, but please be careful of the effects of unintended consequences for others.

Bill Gurley, Benchmark Capital
www.twitter.com/bgurley

Added note:  Some have pointed out that VCs should not be the only class “exempted” from the regulation.  First and foremost, why would they be included?  What did they do to contribute to the current situation? However, if you insist on this viewpoint, then let us instead focus on the specific instruments that caused the harm – leverage and derivatives.  If any limited partnership uses these instruments, they are subject to the regulation.  If not, no regulation.  That is pretty simple and clean.

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