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.

15 Comments

  1. Pingback: Obama administration to tighten regulation on VCs? » VentureBeat

  2. Ross Dakin March 26, 2009

    I am a proponent of deregulation in general, and while I agree with the majority of your view, I’m not sold.

    Your comparison of this proposition to SOX seems a bit unfair. While SOX directly impacts all companies (detracting from their bottom line), this legislation would never touch the companies; rather, it only concerns the investors, and in an seemingly inexpensive way.

    Also, the issue of privacy does seem addressed in the testimony:

    “The regulatory reporting requirements for such funds should require reporting, on a confidential basis, information necessary…”

    Finally, I worry about the reputation of venture capital, should it be the sole group exempt from this legislation. I would hate for VC firms to become known as the “safe havens” of companies looking to avoid audits.

    Reply
  3. fiveyearstoolate March 27, 2009

    Sarbanes-Oxley has fallen into the category of solutions that are worse than the problems they purport to solve. There was little disagreement post-Enron/WCOM/etc… that there needed to be regulatory reform around accounting practices, but as is so frequently the case, in their rush to show people (read: voters) that they were *doing something*, they put in place a heavy, onerous system whose unintended consequences are arguably more damaging than the original problem being addressed.

    Sadly, it appears that history will repeat itself yet again. As Bill notes, despite having no involvement with the current market failures, we are likely to see the venture ecosystem saddled with unnecessary regulatory overhead as lawmakers overreact to today’s crises.

    Eric Wiesen
    RRE Ventures

    Reply
  4. Stephen Bove March 27, 2009

    Bill,

    This was great. The first substantive defense of VC in the current milieu by ANYONE from a top firm in the valley.

    Which brings up a major issue: Why doesn’t VC have a lobby in DC that’s worth a damn? And why don’t more top VCs take a public stand for their political points of view?

    VC is one of the most important asset classes in the US. The capital allocation efficiency of VC is extremely fine tuned and the un-leveraged returns of top firms are envied around the world. Good VCs are some of the best appraisers of risk and business formation on the planet. Their experience could be a major factor in steering national financial and regulatory policy.

    Yet VC’s representation in DC is negligible (esp. compared to the other top asset classes: Investment Banking [equities, fixed income, etc.], Real Estate, Insurance). And VCs on a personal level are by and large “sotto voce” on the Hill.

    This apolitical “don’t piss off the limited partners” stance may have been appropriate in the past, but given the gigantic concentration of financial power we are witnessing, how can VC NOT be more visible at the table going forward?? The National Association of Venture Capital needs to quintuple its influence and the top VCs in the Valley need to come out from behind the curtain to i) defend the turf they more-or-less invented (private equity funds with management fees and carried interests), ii) prevent more insane anti-innovation legislation & regulation in DC, and iii) vector more of the government’s capital into early stage enterprises that need major expansion capital.

    Stephen Bove

    Reply
    • bgurley March 29, 2009

      This is a great question, and one I have been asked many times. I suppose the biggest reason is the extreme fragmentation of the VC industry. Most industries with large lobbying groups are highly consolidated (in the real estate case with a monopolistic organization called NAR). If you own 40-95% of an industry, the ROI from lobbying is fairly obvious. if you own 1.3%, its harder to rationalize the spend.

  5. davidwlocke March 27, 2009

    SOX was legislated as a one sentence regulation “We establish the intent….”, which has gone on to be the full-employment act for accountants. Those accountants now own the standards through which all companies are SOXed.

    Accounting is supposed to provide managment with actionable information, or it it supposed to provide investors with actionable information. But, what we get with SOX is management by accountants.

    Even if you pay the SOX tax, your startup cannot survive management by accountants. Stop it!

    Ross, I’ve done SOX. It is a very expensive proposition within the firm. That is widely known. Read the regulation. There are no reporting requirements. What happens is the CEO is held responsible for the veracity of the numbers in the annual report. A vast network has to be established to vet the numbers. And, typically, controls are dumped into committees where no one is responsible. The SOX audits vet these networks of process documentation and consolidating internal reporting to the CEO, so he can sign off.

    VCs are alreay immune, because the companies are private. SOX, however is required to become public, essential to the VC’s exit through IPO or M&A. As accounting costs climb, capital efficency is lost. At some point there is no win, so there would be no reason for VCs to invest.

    The real safe haven is not going public. And, there are plenty of private companies that have not been funded by VCs or other financial insitutions. Bootstrap avoid the ….

    Reply
  6. Jordan March 28, 2009

    Did I miss something, or doesn’t a company with $50MM in revenue and a 10% operating margin have $5MM in EBIT, leaving it with only $3-4MM in after-tax earnings? (unless you are counting tax credits from the years of losses). I don’t mean to pick on the math but to point out that the real cost is more line 75% or more of net income?

    Reply
    • bgurley March 29, 2009

      Yes — you are correct, an I erred on my math.

  7. Jordan March 28, 2009

    Sorry, that last comment was meant to have a period at the end, not a question mark.

    Reply
  8. BoomTownBiloxi March 31, 2009

    Very good post, I like this blog.

    Reply
  9. ChukChansigOldCasino April 2, 2009

    Very good article.

    Reply
  10. Shaddow Bill April 3, 2009

    stop whining and just IPO on another Exchange outside of the US. if you want to stay in North America, list on the TSX. AIM in Euopre, etc. plenty of options and investrs are not usually limited on the exchanges they can invest on. the real complaint should be the lack of good investmetn judgement by VC’s over the past decade.

    My bet, Bill, is that if markets were better and the IPO window was open, you wouldn’t be complaining about Sarbox. You would be flushing companies out into the market as quickly as you could.

    Yes, sarbox is a requirement. it is a cost of doing business, and understanding your business.

    all of you VC’s love to blame someone else for something. how many of your companies are profitable? oh, wait, sorry, none and its all because of Sarbox, right.

    perhaps the focus should be on building profitable long lasting franchises. the rest will follow.

    Reply
    • bgurley April 3, 2009

      To each of your points:
      1. Exchanges outside of the US – in practice this isn’t actually feasible. if your HQs are in the US, and you have employees in the U.S., and you have over 500 shreholders (which you will if you are public), then you are required to adhere to sarbox regardless of the exchange. I will assume you didn’t know that.
      2. I believe the IPO window is open. ChangeYou went out yesterday. Rosetta Stone coming.
      3. $3mm in sarbox costs does raise the revenue level needed to be profitable — this is the whole point of the article
      4. Building profitable-lasting companies is always the goal.

  11. William Carleton April 5, 2009

    Well argued post. But I didn’t see anything in Geithner’s prepared remarks that indicated any steps toward regulating the private companies in which venture funds invest. Rather, the thrust of his concern, and the themes of his remarks, had to do with lack of oversight and recourse over institutions that pool and traffic in other people’s money (and yes “people” meaning not just individual 401(k) contributors but also other sophisticated institutions and investors). The argument that the VC industry did not use leverage or otherwise do anything bad to precipitate the current crisis is I think to miss at least part of the point: as I said recently in a post on my blog, good reform might do well to anticipate where (excessively-)creative financial types may migrate when all other avenues are rendered more transparent.

    Geithner put it better in his remarks: “We can’t allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints. . . . [O]ur regulatory system must be comprehensive and eliminate gaps in coverage. “

    What would be so wrong with investment pools having to register in the same manner that individual investment advisors do? No one wants innovative, small private companies to have to reveal competitively sensitive information, but we probably do want a financial eco-system that is fully accountable to investors as to how money is managed, and by whom. This information might also be useful to private companies, too, when assessing the suitability of their prospective investors.

    Reply
  12. TheSoak May 15, 2009

    At what point does government stop regulations of commerce? What additional oversight does government require to provide for our financial ‘safety’. The legislation of additional regulations will not improve safety, but only impair the enforcement of what already exists.

    Sarbox was a knee jerk reaction to blatant accounting fraud. Fraud that was covered by existing regulations and ignored by the accounting firms tasked with the audits. Unfortunately, the Sarbox solution was dictated by the accounting lobby in what could best be described as a CYA effort.

    The cost of Sarbox never ends. The accounting lobby made sure that they were well positioned to pickup the pieces and force their way deeper in to companies. They now dictate technology requirements proclaiming greater support of Sarbox. They venture far outside of the financial systems realm and work to dictate standards that are not applicable. Sarbox gave the accounting firms a self-fulfilling prophecy; they know something is wrong and they are going to find it and you will continue to pay because something will always be wrong.

    Now we have the Fed, Treasury and SEC trying to deflect blame for the current crisis to the players on Wall Street and now SHR. This is not an issue of inheritance. Geithner was the President of the NY Fed and presided over a miserable failure of his office’s primary role, the regulation of Wall Street. He did not need broader powers, he needed to enforce the regulations in place and ask questions.

    Do venture capitalist need additional regulations? Absolutely not! We need the Fed, Treasury and SEC to enforce the existing regulations where applicable regardless of the organizational type.

    To my first question; at what point does government stop regulations of commerce? I have no idea, but hope we all survive the conflicted contradictions in the interim.

    Reply

Leave a Comment

Your email address will not be published. Required fields are marked *

Prove that you're a human *