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What Are the Challenges and Hurdles to Research?

Notwithstanding the workshop participants’ considerable interest in better understanding the investor exit trends, their causes, and implications, they raised a number of points that make interpretation of recent history problematic and complicate any effort to isolate causal determinants and develop evidence-based policy recommendations. In addition to the difficulty of distinguishing trend from cycle in the IPO versus acquisition time series, these considerations include the role of technology and industry differences and changes in these characteristics over time; the importance of considering “demand” as well as “supply” side factors; the difficulty of determining causal linkages, especially when moving beyond innovation effects to implications for job creation, productivity, and economic growth; and finally, the difficulty of discerning policy influences, not only from other factors but also from one policy instrument to another.

ACCOUNTING FOR TECHNOLOGY AND SECTORAL DIFFERENCES

IPO exits are not uniformly pro- and acquisition exits uniformly anti-innovation. Rather, different kinds of firm organization tend to be associated with different kinds of innovation. Innovations may be categorized in a number of ways; but several participants, following Schumpeter, distinguished between improvements that prolong the life of existing technologies or products—“incremental” innovations—and those that compete with or supplant existing methods—“disruptive” innovations. Incremental innovations tend to be associated with existing firms even when absorbing one or more entrepreneurial firms. The entrepreneurial growth company, on the other hand, is associated with disruptive innovation.

Rosemarie Ziedonis, University of Michigan Ross School of Business, suggested that technology advances may follow a cycle that tends to favor one exit strategy over the other in a particular phase of development. For example, the development of semiconductor technology according to Moore’s law of doubling



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3 What Are the Challenges and Hurdles to Research? Notwithstanding the workshop participants’ considerable interest in better understanding the investor exit trends, their causes, and implications, they raised a number of points that make interpretation of recent history problematic and complicate any effort to isolate causal determinants and develop evidence-based policy recommendations. In addition to the difficulty of distinguishing trend from cycle in the IPO versus acquisition time series, these considerations include the role of technology and industry differences and changes in these characteristics over time; the importance of considering “demand” as well as “supply” side factors; the difficulty of determining causal linkages, especially when moving beyond innovation effects to implications for job creation, productivity, and economic growth; and finally, the difficulty of discerning policy influences, not only from other factors but also from one policy instrument to another. ACCOUNTING FOR TECHNOLOGY AND SECTORAL DIFFERENCES IPO exits are not uniformly pro- and acquisition exits uniformly anti- innovation. Rather, different kinds of firm organization tend to be associated with different kinds of innovation. Innovations may be categorized in a number of ways; but several participants, following Schumpeter, distinguished between improvements that prolong the life of existing technologies or products—“incremental” innovations—and those that compete with or supplant existing methods— “disruptive” innovations. Incremental innovations tend to be associated with existing firms even when absorbing one or more entrepreneurial firms. The entrepreneurial growth company, on the other hand, is associated with disruptive innovation. Rosemarie Ziedonis, University of Michigan Ross School of Business, suggested that technology advances may follow a cycle that tends to favor one exit strategy over the other in a particular phase of development. For example, the development of semiconductor technology according to Moore’s law of doubling 13

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14 INVESTOR EXITS capacity every 18 months, together with increases in magnetic storage and fiber optic transmission capacity led to rapid strides in increasing computing power and reducing its cost, in turn setting the stage for the Internet. Given the opportunities opened up by the new platform, it may have been natural for entrepreneurs to focus on software applications for the new medium, while continued progress in microelectronics followed a predictable course within the capacity of large established firms such as Intel, AMD, and their equipment suppliers. Thus, following a few early independent commercial successes in Internet applications, it could be expected that acquisitions would dominate in information technology during this period rather than IPOs. The drug discovery and development field exhibits other, perhaps more permanent, characteristics that favor acquisition over going public, according to David Morgenthaler of Morgenthaler Ventures, Leighton Read of Alloy Ventures, and Ed Penhoet of Alta Partners. 8 The high cost of extended mandated clinical trials and the prolonged uncertainty regarding reimbursement by medical care payers means that only large pharmaceutical houses have the resources and risk tolerance to take innovative products all the way to market. Thus, exit via acquisition is a more common pattern in biotechnology than exit via IPO notwithstanding the well-known exceptions of Genentech and Amgen. Of course, public policy changes could ameliorate these disincentives for entrepreneurial biopharmaceutical firms to go public and remain independent but probably not enough to make a substantial difference. Besides, other factors such as high pharmaceutical marketing costs and the premiums on having brand recognition and extensive sales forces reinforce the acquisition route. Others pointed out it is worth asking whether technological progress across a range of fields has for the time being ceased to offer as many opportunities for building major, stand-alone technology firms. Apart from what some perceive as a slowdown in information technology and remaining high scientific hurdles in biopharmaceuticals, there is uncertainty about the future of nanoscale science and engineering applications and about “green” technologies. Focusing solely on financial markets is one-sided. TAKING INTO ACCOUNT “DEMAND” SIDE FACTORS Several participants pointed out that exit strategies are determined not only by influences on investors’ and entrepreneurs’ behavior but also by characteristics of the market, including characteristics of established firms. For acquisition to be an attractive option there must be willing buyers. Perhaps a good example is again from the pharmaceutical industry. For whatever reasons, the productivity of the R&D operations of a number of major pharmaceutical houses seems to have declined in recent years. Fewer new molecular entities are being filed with the Food and Drug Administration as candidates for clinical trials. Thus young entrepreneurial firms, especially those engaged in the development of biologic therapeutics, are more attractive candidates for acquisition to replenish drug development pipelines. David Morgenthaler characterized most biotechnology companies as “farm clubs” for pharmaceutical companies. 8 At the time of the workshop, Penhoet was president of the Gordon and Betty Moore Foundation.

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WHAT ARE THE CHALLENGES AND HURDLES TO RESEARCH? 15 DIFFICULTY OF DISTINGUISHING POLICY INFLUENCES One hypothesis consistent with the decline in IPO activity is that the costs and difficulties of pursuing the public company route to turning an entrepreneurial firm into a successful large-scale firm are rising. An increase in the cost of taking a young company public or an increase in the cost of operating a small public company would help explain a shift in the direction of those seeking to sell entrepreneurial-origin firms to established companies. As noted above and many workshop participants reiterated, it is frequently argued that changes in securities regulation—especially the Sarbanes-Oxley Act of 2002, which was intended to reduce the risk to outside investors of purchasing stock in public companies through greater uniformity, verification, and transparency in accounting—have disproportionately raised the costs of small, publicly traded firms. The Sarbanes-Oxley reporting requirements have a number of fixed cost elements relating to external auditing and certification by senior management that do not vary a great deal by firm size and are ongoing after an IPO. Lawrence Calcano, formerly of Goldman Sachs, elaborated that in addition to the financial costs of legal and accounting services are opportunity costs that weigh especially heavily on entrepreneurial firm management attention, a scarce resource. It means diverting the attention of senior managers from developing the young firm’s operational systems to financial compliance. Bill Raduchel, independent investor, described an example of regulatory compliance costs from personal experience. He claimed that the new requirements had increased demand for and thus significantly raised the price of recruiting chief financial officers (CFOs) and legal counsel for small publicly traded firms and larger ones alike. But this is adding disproportionately to the administrative costs of the former. Likewise, the consolidation of firms in the market for accounting services— from the “Big 8” to the current “Big 4”—was having the same effect in raising auditing costs. As Bill Janeway and other workshop participants observed, the problem with testing this fairly well developed, plausible set of hypotheses is that a number of other contemporary policy and market changes also appear to be working in the direction of raising the costs of the IPO option. The following examples were mentioned but not discussed as extensively: • Investment analyst coverage. Arms length investors in public firms need information about those firms to make informed investment decisions. In 2003, the Securities and Exchange Commission, New York Stock Exchange, National Association of Securities Dealers, and New York Attorney General Eliot Spitzer reached a litigation settlement forcing the largest securities firms to insulate their research and investment banking operations to reduce conflicts of interest. The result was to erode the economics of equity research and especially to curtail analyst coverage of small public companies and new issues including IPOs. According to David Morgenthaler, this forced IPOs to bear more of the cost of equity research while making them less attractive investment opportunities, especially for institutional investors.

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16 INVESTOR EXITS • Managers’ and directors’ liability. In the same period public company managers and directors became more vulnerable to stockholder lawsuits and related enforcement actions by the SEC and state attorneys general. Litigation is expensive and, again, a distraction for senior management focused on firm growth. • IP litigation. Intellectual property represents another example of increased litigation. The rising number of lawsuits claiming patent infringement was leading to more defensive patenting to fend off litigation. Some participants hypothesized that acquisitions may be fueled in part by the motivation of both sellers and buyers to build patent portfolios that would discourage would-be plaintiffs. Unable to suggest any countervailing market or policy changes making an IPO a more rather than less attractive exit strategy for investors, some workshop participants thought it would be difficult to disentangle the effects of reinforcing trends in order to identify what policy changes might be warranted and effective in restoring the traditional role of IPOs in high technology firm development. Others, however, considered changes in transaction costs a prime area for study. DIFFICULTY OF ESTABLISHING CAUSAL LINKAGES GENERALLY Having considered the cyclical versus secular or structural changes in patterns of investor exits from young entrepreneurial firms and the difficulty of establishing the causes of such changes, several workshop participants expressed the opinion that the most challenging research task, and one critical to bringing about any public policy changes, would be to link exit patterns to macroeconomic effects such as job creation, productivity advances, economic growth, and competitiveness or to stagnation or under-performance in any of those measures of economic performance. Ed Penhoet observed, “There are many correlations, but causality is a challenge.”