Why Sarbanes-Oxley Was the Best Thing to Happen to the Internet

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DUE DIGITAL DILIGENCE – In the next year or two, we’ll likely see the following companies go public with an initial market value over $10 billion:

  • Facebook
  • Groupon
  • LivingSocial
  • DropBox
  • Zynga

Many of these are companies that, in a world without Sarbanes-Oxley, could already be public. That would probably be good for investors; if average people could have gotten Facebook stock at the same $500 million valuation their Series C had, it would have been a spectacular investment, indeed.

Or would it have been? Counterfactuals are notoriously tricky, but it still seems that most of the companies listed above are incredibly ambitious. Whereas today’s mid-tier dot-coms are all fairly boring. Stamps.com, Ancestry.com, and Quinstreet are all pretty good businesses, but they’re also pretty boring. Good, boring businesses are great at hitting their quarterly numbers, but they’re not so great at providing an incredible user experience or transforming an entire market.

When companies are restricted to accredited investors—and big accredited investors, at that—they think differently. They care less about the next quarter, and more about getting a 10X return for their early backers, or a 3X return for funds providing growth capital. Illiquidity isn’t a net positive, but it does force investors to think about the bigger picture, which also forces entrepreneurs to think that way.

This trickles down to consumers, too. Publicly traded Internet companies innovate much more slowly, at least as far as users can see. (Public companies that invest heavily in R&D — Microsoft, IBM, Google and the like — also tend to invest disproportionately in the “research” side. It pays off, but over a very long time.) Projects like the News Feed and Groupon Now are harder to imagine from a public company.

Sarbox has also dampened acquisitions by removing the public market as a competing bidder. The biggest effect here might be that investment banks have less of an incentive to build relationships with early-stage startups in the hope that they can take those startups public years later.

This gives startups less access to acquisition offers and less negotiating leverage. All that might lead to more total acquisitions (since acquisitions are a good substitute for an IPO when someone really wants to cash out), but fewer exits.

Sarbox was bad for entrepreneurs. But it was bad for entrepreneurs in a way that’s good for consumers and late-stage investors: it forced founders of great companies to double-down on world domination instead of settling for life as a boring public company or a subsidiary of Microsoft.

And now it’s finally paying off. We’re getting a new crop of actively fascinating Internet IPOs—the first time we’ve had so many since the last bubble.

(Mark Suster has related thoughts on VCs responded to public markets. Naturally, this piece about VCs responding to a down market was published the morning of a 5% rally.)

Cross-published at Digital Due Diligence’s website.

3 COMMENTS

  1. I hope you meant this article as satire. SOX is not good for start-ups or consumers. In the first case it restricts access to capital, which has depressed the number of technology start-ups. This has significantly reduced the new technologies being created. Since increase in our level of technology are the only way to increase real per capita income, this has been bad forever one – with the possible exception of gov. bureaucrats and accountants. This means it was bad for the average consumer and average producer.

  2. The stock market is just one means of accessing capital, and I doubt that accounting regulations, however annoying, have any real dampening effect on real innovation. SOX did not cause the world to end. Of course investment bankers want everyone to think that the stock market is the true measure of all value, but it simply isn’t so. Yes, the stock market is a highly efficient means of determining/allocating value and providing companies with access to capital, but the markets can be distorted and manipulated in a mind-bending number of ways. The stock bubble of the late 90s was a massive transfer of wealth out of the pockets of everyday shareholders (i.e., millions of Americans with their meager savings invested in 401k accounts) and into the pockets of investment bankers, market makers, and early-stage investors who left the world with little to show for all the billions of dollars they chewed through. Many companies were outright scams (err…Enron). If SOX had some actual dampening effect on innovation, wouldn’t it have shown up in patent filing statistics? I don’t see a drop after SOX was enacted: http://www.uspto.gov/web/offices/ac/ido/oeip/taf/us_stat.htm. On the contrary, looks like a pretty steady increase to me. So I caution confusing true value creation with the paper wealth conjured up by investment bankers, derivatives, Ponzi schemes, leverage, asset bubbles, off-balance-sheet trickery, and such. I know this sounds like a rant against “those fat cats on Wall Street,” but my point is that true innovation will happen with or without SOX; it’s more a question of how much phony-baloney bubble crap you want happening along with it. And as a society, wouldn’t we rather have capital directed to REAL value creation rather than the over-inflated “group buying for retired rodeo clowns” startups?

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