Alibaba is in the news – running an IPO aimed at raising $21 billion. Oculus, the once darling of crowd funding fans, sold to Facebook for $2 billion after raising $2.4 million on Kickstarter. The Alibaba IPO won’t fund Alibaba’s growth or create employment, and the Oculus deal snuffed out an independent company and does nothing for its early supporters.
Let’s start with first principles – what is the purpose of the capital market? Cynically, and with some reason, we can say it exists to enrich a very small segment of our society, but a better answer is the capital market exists to fund the nation’s enterprises and generate prosperity. Clearly this is not what they are doing. To our mind, prosperity comes from distributed wealth, and today’s market serves to concentrate wealth.
I have a background in financial markets and tech startups. I’d like to be able to fund my current company in the public market, and I’d like small investors to have the chance to buy our stock. We would have a better chance to pursue our strategy without a dominant investor, and if we succeed as we intend, small investors would be able to come along with us. The market I have in mind financed the creation and growth of the tech sector from the 1970s through the late 90′s. That market no longer exists, IPOs are now reserved for exits, not beginnings, and crowd funding is no substitute.
Crowd funding websites have been hailed as the answer for small companies and individuals trying to bring a product to market. There are many things to like about this new trend, and while crowd funding has had problems with projects that didn’t deliver, on balance crowd funding is a positive addition to the options for small business.
Crowd funding has some limitations for companies trying to raise money:
- It works for products – it is not effective without the promise of a product delivered to the supporter at the end of the project;
- It doesn’t work for commercial or enterprise products – we conducted a review of several hundred projects and couldn’t find a successful enterprise focused project; and,
- It absolutely does not work for anything involving fundamental research, materials, or technology.
While there have been some wild successes on crowd funding sites, it only works to fund a very limited part of the innovation community.
As a supporter, at best you get an early version of a product, or you might get a t-shirt, ball cap, or some other memento. Oculus is a good example of this, and it is a good example of the misunderstanding of the crowd funding proposition amongst its supporters. In effect, you are offering a donation, and you may get a copy of the product. You don’t get to participate in the wealth you helped create.
As currently practiced, crowd funding is not the answer to the problems of funding innovation and growth. That it has been so enthusiastically adopted should trouble political and business leaders, regulators, and small investors. It is a symptom of the failure of our markets to finance our industries.
Only a tiny number of IPOs in the U.S. in the past decade have had raising capital as their purpose. The goal of most IPOs is a profitable exit for funds and their wealthy investors. The technology and information revolution that transformed our world came out of a very different market than the one that exists today. The one that exists today is choking growth and employment, and excluding small investors from investing in promising early stage companies.
For example in the early 1970s both Intel and MCI were able to raise capital in the public market at an early stage, they remained independent and executed on their bold visions. Because they were public, small investors could buy and hold their stock and ride the resulting growth into personal wealth that today is the preserve of wealthy investors. By comparison – participants in crowd funding don’t benefit from the success they fund; at most they get an early copy of the product and a good feeling.
It is worth noting that the Intel or MCI of the 1970s would find crowd funding problematic – their products were not suitable.
MCI, which had a small IPO in 1972, and Intel went on to change the life of almost every person on the planet. MCI used the funds from their IPO to break the monopoly on American telecommunications held by AT&T. MCI’s success made the inexpensive and ubiquitous Internet possible. Intel powered the devices. Your life is different as a result.
Compared to today where Oculus supporters will get a headset, a lot of small investors owned MCI and Intel, and put their kids through college with the proceeds. The Alibaba IPO won’t create a single new job.
By the Numbers
From the 1970s through the 1990s, the astonishing growth of the U.S. technology sector and the transformation of telecommunications were largely financed by companies finding capital for growth through IPOs on NASDAQ. This market was enormously successful in providing access to capital for issuers, and allowing the small investors to participate in this unprecedented creation of prosperity.
Chart from: Rebuilding the IPO on Ramp, page 8, the IPO Task Force, October 20, 2011.
Unintended consequences from poor regulation, consolidation of investment banks and commercial banks, and changes in market structure are the reason small IPOs have declined by more than 90%, and the time to IPO has doubled from 4.8 to 9.4 years.
This affects all of us:
- Access to public capital (IPOs) for small and medium enterprises (SMEs) has been stifled; and,
- Small investors, the middle class, are frozen out of investing in SMEs because they are not financed in the public market. Today only accredited investors can play in the private equity space.
Think about what this means to employment and wealth creation – 99% of all enterprises in the United States employ fewer than 500 people but account for 52% of all U.S. workers[i]. By contrast, only 24.7 million Americans work for firms with 500 or more employees[ii].
Financing a Startup or SME
SME financing has shifted to private equity and acquisitions and away from IPOs. A sale to a larger competitor or partner can provide a good exit for early stage investors and founders, but it generally means that a solid small company doesn’t have the chance to become a great large one. Consider Oculus – from a company with many paths open to it, Oculus now follows the existing strategy of Facebook. I don’t pretend to know anything about Mark Zuckerberg, but he already has a company to direct. We will never find out what Oculus might have become led by CEO and founder Brendan Iribe because even if he had wanted to remain independent, the private equity behind him was going to take the deal. Mergers and acquisitions suppress innovation and slow job creation.
These changes collectively mean that only accredited investors and qualified investment buyers can participate in the economic opportunity of new ventures, effectively precluding the average investor from participating in new ideas and innovation as investments. It also means that enterprises seeking growth capital are limited to more expensive private equity and venture capital.
We like crowd funding – it is a creative response to a real problem, but it is not the answer. We have considered using crowd funding to launch one of our products this year but it is not an easy fit for us; we have a strong enterprise and industrial focus not well suited to the current crowd funding processes.
Alibaba and Oculus are examples of the failure of our markets to serve the interests of the greater community of businesses and investors. Capital markets matter, and ours is broken.
[i]Table 758. Establishments, Employees, and Payroll by Employment-Size Class: 1990 to 2008 – U.S. Census Bureau, Statistical Abstract of the United States: 2012
[ii]Table 758. Establishments, Employees, and Payroll by Employment-Size Class: 1990 to 2008 – U.S. Census Bureau, Statistical Abstract of the United States: 2012
Author: Paul Hanson
Paul is the Founder & CEO of bbotx. He has developed and marketed software products in different market segments in North America, Europe, Asia, Africa and the Middle East over the past 20 years – doing business and working in 40 countries.