1
Background of the Workshop

The year the Internet economy bubble burst, 2001, marked an abrupt change in private equity markets involving young, entrepreneurial firms. Along with a sharp drop in venture capital placements, according to data reported by Thomson Financial, the number of U.S. initial public offerings (IPOs) plunged 85 percent to 41 from 264 the previous year. Throughout the previous decade the number of IPOs averaged 247 and never fell below 70. In 2004 the market recovered somewhat, but in the following three years the number of IPOs averaged only 52.1 Further, some U.S. corporate IPO activity gravitated to foreign exchanges, especially to the London AIM market but also to Singapore and elsewhere (Bartlett, 2006).2 Meanwhile, the number of investor exits by sale of venture-backed companies to established firms—acquisitions—grew correspondingly. Venture investors now routinely expect to sell out to existing firms rather than to take their companies public.3

Why is this of interest and possibly concern? Schumpeter’s theory of creative destruction, which has had a dominant influence on contemporary entrepreneurship literature (Audretsch, 2002),4 suggests that new firms with entrepreneurial spirit displace less innovative incumbents, ultimately leading to higher productivity and a higher economic growth rate. Other research suggests that large established corporations are inclined to resist radical change; and when absorbing younger,

1

Since the workshop was held, the number of IPOs by venture-backed firms has dropped even further, to merely 6 in all of 2008 and 5 in the first half of 2009, according to the National Venture Capital Association and Thomson Reuters. Meanwhile, there were 260 acquisitions in 2008 and 121 in the first half of 2009.

2

Concern about international competition in the IPO market has, of course, receded with the current financial crisis. The AIM market suffered a far more serious fall than did the NASDAQ exchange.

3

Of course, the number of venture-backed firms is small compared with the total number of technology-based start-ups in existence in the United States. Branscomb and Auerswald (2002) estimate that there may be as many as 200,000, of the latter, one-third of them with employees. For empirical analysis of the choice between IPOs and acquisitions, see Brau, Francis & Kohers (2003) and Poulsen & Stegemoller (2008).

4

For a contemporary statement of the thesis by a former R&D executive of a major firm, IBM, see McGroddy, 2001.



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1 Background of the Workshop The year the Internet economy bubble burst, 2001, marked an abrupt change in private equity markets involving young, entrepreneurial firms. Along with a sharp drop in venture capital placements, according to data reported by Thomson Financial, the number of U.S. initial public offerings (IPOs) plunged 85 percent to 41 from 264 the previous year. Throughout the previous decade the number of IPOs averaged 247 and never fell below 70. In 2004 the market recovered somewhat, but in the following three years the number of IPOs averaged only 52. 1 Further, some U.S. corporate IPO activity gravitated to foreign exchanges, especially to the London AIM market but also to Singapore and elsewhere (Bartlett, 2006). 2 Meanwhile, the number of investor exits by sale of venture-backed companies to established firms— acquisitions—grew correspondingly. Venture investors now routinely expect to sell out to existing firms rather than to take their companies public. 3 Why is this of interest and possibly concern? Schumpeter’s theory of creative destruction, which has had a dominant influence on contemporary entrepreneurship literature (Audretsch, 2002), 4 suggests that new firms with entrepreneurial spirit displace less innovative incumbents, ultimately leading to higher productivity and a higher economic growth rate. Other research suggests that large established corporations are inclined to resist radical change; and when absorbing younger, 1 Since the workshop was held, the number of IPOs by venture-backed firms has dropped even further, to merely 6 in all of 2008 and 5 in the first half of 2009, according to the National Venture Capital Association and Thomson Reuters. Meanwhile, there were 260 acquisitions in 2008 and 121 in the first half of 2009. 2 Concern about international competition in the IPO market has, of course, receded with the current financial crisis. The AIM market suffered a far more serious fall than did the NASDAQ exchange. 3 Of course, the number of venture-backed firms is small compared with the total number of technology-based start-ups in existence in the United States. Branscomb and Auerswald (2002) estimate that there may be as many as 200,000, of the latter, one-third of them with employees. For empirical analysis of the choice between IPOs and acquisitions, see Brau, Francis & Kohers (2003) and Poulsen & Stegemoller (2008). 4 For a contemporary statement of the thesis by a former R&D executive of a major firm, IBM, see McGroddy, 2001. 3

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4 INVESTOR EXITS smaller enterprises, they tend to retard innovation or at least direct it to incremental changes in existing products, services, and processes. 5 This thesis contributes to the apprehension that in the future there will be fewer Googles, Microsofts, Yahoos, Genetechs, Amgens, Suns, Oracles, and Ciscos. 6 What may matter more than a drop in the number of firms going public and exhibiting average performance is the lower probability of an IPO leading to an exceptional engine of breakthrough technology development and job creation. Another concern is that the shift from IPO to acquisition exits means generally lower returns to venture capital investing and therefore lower venture capital investment, which has played an important role in the development of technology-based firms in the United States since the 1980s. One line of counter-argument asserts that entrepreneurs who are bought out before they would normally exit by taking their firms public frequently go on to launch new start-ups based on other technologies. In theory, moreover, established firms are better positioned to accept higher risks and nurture new enterprises than if they are subject to the expectations of institutional and individual investors focused on quarterly earning reports. Acquisitions can take many forms and are by no means uniformly hostile to all forms of innovation. In any case, exit outcomes are not necessarily dichotomous or permanent. A venture-backed firm may go public and subsequently become a target of acquisition. Or it may be acquired by an established company and later spun off as an independent firm. Less discussed but perhaps equally important is how exit strategies affect venture investor and entrepreneur decisions about firm strategy before the point of sale or IPO. The expectation of acquisition may favor investments in some kinds of technologies and discourage investments in others, depending in part on the field. In the case of biopharmaceutical technology, investment in the development of drugs with very large markets attractive to established pharmaceutical houses may be favored over drugs for niche markets that a medium-size biotechnology firm might profitably pursue were it to remain independent. In information technology, the expectation of an acquisition outcome might favor investment in new applications representing relatively little technological advance. Suppose some of these consequences are real and are judged to be adverse to desirable kinds of technology development and the nation’s long-run economic interests. Then several other questions arise. Is the change in the composition of exit outcomes cyclical and in due course self-adjusting or structural and likely to continue in the absence of intervention? What combination of market forces and public policy decisions account for the change? What public policy instruments if any are available to make the domestic IPO route more attractive? What are the pros and cons of possible actions? To take an example discussed at some length, the IPO recession in the United States and the migration of some IPO activity abroad is sometimes ascribed to changes in securities regulation, in particular the accounting requirements introduced by the Sarbanes-Oxley Act of 2002, passed by Congress in response to the Enron, WorldCom, and Adelphi scandals. This was the most obvious relevant policy change 5 Regarding the impact of acquisition on innovation, see Ahuja and Katila (2001) and Prabhu, Chandy and Ellis (2005). 6 Most but not all of these companies had successful IPOs prior to 2000. Google went public in 2004.

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BACKGROUND OF THE WORKSHOP 5 of the last decade. On the other hand, it is sometimes argued that while the Act raised the cost to existing investors of going public, it has contributed to a higher, more uniform standard of accounting that has the potential to raise the confidence of outside investors purchasing stock in young, often still unprofitable, but promising entrepreneurial firms. 7 The many unanswered questions surrounding these phenomena led the National Academies’ Board on Science, Technology, and Economic Policy (STEP) in 2007 to seek support from the Ewing Marion Kauffman Foundation, the nation’s leading philanthropy focused on illuminating and supporting entrepreneurship, to hold a workshop of investors, entrepreneurs, and academic experts in finance, law, and innovation to discuss these questions. The one-day meeting was held August 2, 2007, at the Academies’ headquarters in Washington. A committee composed of seven STEP Board members and others planned the agenda and helped identify the participants, who are listed in Appendix B. The workshop was organized around four principal questions: • What are the trends in investor exits from venture-backed firms and do these merit attention? • What are the determinants of entrepreneurs’ decisions to take firms public or to pursue acquisition by established firms? • What are the consequences of those alternatives for innovation, employment, and the productivity of the economy? • What public policies strongly influence decisions to build or sell companies? The workshop participants were not asked to reach any collective judgment about the cyclical vs. long-term nature of the shift from IPOs to acquisitions, nor to evaluate the consequences of the change, nor, in short, to arrive at any consensus findings with respect to the questions listed above. Rather, they were asked to outline research efforts that would improve understanding of the phenomena, identify hurdles to or opportunities for undertaking such research, and suggest what past or prospective public policy actions should be investigated as part of a broader research effort. 7 The costs and benefits of financial market regulation are, of course, a much bigger question in the aftermath of the 2008 market meltdown.

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