Washington Is Killing Silicon Valley
sec.online.wsj.com
sec.online.wsj.com
"FASB's "mark-to-market" accounting rules helped drive AIG and Bear Stearns into bankruptcy, even though they were cash-positive."
Claiming that mark-to-market accounting killed Bear and AIG is a bit like claiming that seat-belt laws kill people who drive drunk.
AIG and Bear were engaged in a fatal game, regardless of the accounting rules. Mark-to-market accounting may have accelerated the crash (by forcing them to account for bad investments today, instead of hiding them on the balance sheet for some indefinite time), but the fundamentals of their crappy investments didn't change as a result of the rule.
We were trying to raise money for a fixed rate subprime mortgage company in 2007. They had remarkably good underwriting and very low defaults. But the value of their assets kept on plummeting, and they were forced to meet margin calls by their creditors. That firm no longer exists.
However, the cash coming in from their assets could have paid their debt and operating expenses indefinitely. If there was no mark-to-market, then I would know a hundred or so extra people in New York with jobs.
I realize that there's a bit of begging-the-question here, but even so, if you've borrowed a ton of money and secured it with "assets" of questionable value, then you're taking a risky bet. The accounting regulations didn't make the bet better or worse -- they just kicked the losers out of the game before they wanted to quit.
But the real issue is the flawed risk ratings on the MBSs. If your asset is AAA then it really shouldn't matter whether you are marking it to market or not, as it's supposed to be quite liquid, by definition, as there is supposed to be extremely little risk that its price will fall.
The reason the MBSs weren't liquid is because the ratings were incorrect and the market knew that -- perverse incentives from ratings agencies had led to this, as had the widespread belief (taken as an assumption by many foolish risk-managers and codified into pricing formulae) that housing prices could not fall.
If the MBSs had been properly rated, then mark-to-market would not have caused the firms holding them on their books to become insolvent, as capital adequacy requirements are based on the riskiness of the assets.
So while mark-to-market may have sped up the failure of those firms, the firms were already weakened due to their treatment (thanks to bad ratings) of risky debt as AAA.
In fact, a few months before things got really bad the SEC sent out a memo advising that the fire-sale provisions of the FASB rule regarding mark-to-market were not to be used, a decision which suggests either that the SEC was OK with some firms failing in the near future (unlikely) or that it believed that the ratings were generally accurate (even more unlikely). I've been told by some Wall Street experts that everybody knew that the ratings were BS. Hence the SEC's decision to send the memo was probably just intended not to telegraph the possibility of a future problem to avoid spooking the market in hopes that the problem would go away.
A few things to note: The regulatory trend is moving toward BASEL II which relies heavily on both mark-to-market accounting and third party ratings agency ratings. So the big regulatory question is, how can the perverse incentives that arose and led to the inaccurate ratings of MBSs be restrained? So far everyone is talking about banning the trading of x, y, and z and of limiting bonus pay, executive salaries, etc., but nobody is talking about the actual concrete perverse incentives (pressure on ratings firms to issue inaccurate ratings) that fed the whole mess.
The situation in the banks is similar: there are collateral requirements that have to be met, trades with other banks that have to be honored, etc. A bank can cover its day-to-day operational expenses and be cash-flow positive, but if it suddenly has to pay someone else a big chunk of money that it doesn't have the liquid assets to provide, then it's still insolvent.
Say that you take out a mortgage on a new house. The bank lets you borrow up to a certain percentage of the house's value, say 90%. The other 10% is a down payment that you must meet with your own money.
Now lets say the value of your house falls from $100,000 to $90,000. The way your mortgage is written, you probably still owe the bank $90,000 (90% of the original purchase price). However, the way debt contracts are written in the financial world, you would have to PAY the bank $9,000 to reduce your total borrowing to 90% of the CURRENT value of the property, or $81,000. That $9,000 payment is a "margin call" in financial market terminology.
So, financial firms borrow up to a certain amount of the assets that they lend, say 90%. If the value of those assets drops in half, and the value of mortgages plummeted on the open market, they owe their lenders enormous sums (45% of the value of the assets, for a 50% drop in value on 90% leverage).
Those margin calls forced a lot of firms out of business, even though their assets were still performing and still paying enough to meet their debt payments and operating expenses. If the firms could call their mortgages, they would be fine, but they can't because the mortgage money is spent on a house which is a non-liquid asset. The financial firms likely thought that their assets were undervalued on the market because of the panic that set in, but no matter. That's not the way their contracts were written.
With M&A as the only exit available, the pay out for any employee other than perhaps the first-five isn't going to be a "home run". Thus there would be nothing for them to justify giving up a higher salary, stability and working longer hours: their options won't be worth much.
Trying to grow the company to post-SOX IPO size would also mean a much greater gamble and much greater time investment. Now the options wouldn't account for anything for possibly as long as ten years (which isn't much shorter than climbing the ladder at a big company).
This means that smart hacker's most economically rational choice is either working for a big company (which issues RSUs or options for publicly tradeable stock) or co-founding or being employee# 1-5 in a less ambitious venture (which usually isn't going to provide very much of a technical challenge).
Not all is bleak, however: it's unlikely that SOX will go (but perhaps I am a pessimist when it comes to govt. getting smaller) but we could see mid-size private companies providing revenue sharing/bonuses (in lieu of options), smarter M&A strategies (e.g. acquirers letting the companies they bought maintain their culture and grow, while offering employees additional upside or even spinning the ventures off for an IPO - but with big co's resources, most notable example of this is EMC + VMWARE acquisition and IPO) and finally markets where smaller players could still have interesting technologies to play with (vs. general database driven websites, which don't really involve much "hard core" tech).
It could be happening via investors, though. It could be that e.g. Google decided to go for the big time partly because there was so much funding available in 1998, which in turn was true because investors were hoping for IPOs.
You haven't seen them say it directly, but how many applications do you get that are for fairly ambitious and big projects? What percentage are front-end heavy web-apps/aggregators? What percentage are fairly ambitious and require a serious research, development and have a huge potential for growth? That's a question you may be able to answer better than anyone else (although I'd imagine most YC applicants are a self-selected crowd and those hoping for an exit other than M&A and to hire a great deal of talent may not even apply to YC).
I also didn't think about the investment angle at all. I wonder how much investors are pushing for companies to sell quickly vs. grow.
I'd say many if not most of the startups YC funds have the potential to go public, if the founders were sufficiently driven. (In saying that I'm relying on the fact that practically no companies that go public look like they will at the start. Apple started out as a company that was going to sell plans for computers.)
Wow that's something I haven't entirely considered, despite knowing it to be true. Somewhat adds to my argument, however, without the chilling effects of regulation we may have seen a more interesting and diverse market -- but now I am in purely speculative realm.
Wrong, wrong, and wrong.
1. SOX has killed the IPO; IPOs have plummeted since SOX, due to the ridiculously draconian laws that make compliance expensive and time-consuming. Startups and small companies just can't afford the costs, closing one of the two viable exits for founders and investors.
2. "Raising the bar" for IPOs makes it sound like we're just going to get higher quality. The reality is that most companies can't afford to IPO, and even if they can, they're now hampered by greater costs and the distractions of compliance. If the bar needs to be raised, let the market raise it.
3. IPOs are not about consistent revenue generation: they're about raising capital. There's absolutely no reason why a growth business like Facebook that is not profitable shouldn't be able to IPO. If the market likes their odds of succeeding in the long run, their IPO will be a success. If not, it won't. In your model, someone apparently gets to decide who "deserves" to IPO. This kind of thing has never worked and almost always has the opposite effect of that desired.
Wikipedia has some useful information, as useful, see the 'Criticism' and 'Praise' sections:
http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act#Criticism
My guess is that it's one of those technical things where reworking it to keep what's good about it (making the CEO and CFO sign off on stuff sounds sensible), and dumping some of the bad bits is the best course of action.
I also have a suspicion that perhaps lack of regulations wasn't the biggest problem, but lack of regulatory enforcement with some teeth to it.
Great points Ryan...just wanted to add a few things:
1. This is mostly true. Going public can add 5 MM - 20 MM in overhead easy...let alone all the additional TPS reports and devoted man hours to bureaucracy. Also, it's significantly harder for companies that are bleeding money to go public; it didn't used to be, which is good and bad.
2. Agreed. Seriously, fuck going public. Going public is for companies who are not profitable, desperately need liquidity (e.g. Google) or capital. You can issue dividends, institute profit sharing programs and even have internal company stock exchanges without being a public company.
3. Just wanted to add that raising capital includes making the company liquid so people can cash out. Private equity firms and some tech shops that went public are a good example.
http://bear.cba.ufl.edu/ritter/IPOs2008VC.pdf
(The question is what the heck is going on in 2008?)
2) Yes, we are getting better quality. If you were around for the fluff IPOs of the late 90s you'd agree. For every Kana Communications there were at least 9 other immature flops like pets.com, etoys.com, flooz.com that died within 3 years.
3) Companies get to choose their own destiny. If they're ready to IPO they'll swallow the $5million overhead of SOX and head out to the market. Those that can't swallow the cost or time will either have to wait or find alternate means.
That said, SOX is still a beast born of a knee-jerk reaction and I'd love to see it streamlined. But there's some good in there.
Of course, they don't have a financial PATRIOT act to contend with (our Sarbox).
The people really hurt by SOX are:
1.) Early startup employees. These people don't get rich unless the company gets really big - like, public-company big. Acquisitions tend to cut their growth potential and fold them into a larger corporation just as they're hitting their stride. And if the company just stays private, they never see liquidity on their stock options, and might as well not have them (in fact, many companies that intend to stay private just don't give out equity, because it complicates financial reporting). They're screwed either way.
2.) Customers. Because exits are smaller, capital costs are lower, and it's very difficult to convince someone to join your startup, recent startups tend to be less ambitious. That's why there're all these complaints about "frivolous" Web2.0 companies. Building an ambitious company, like another Google, after SOX would require convincing investors that the company can get big enough to justify the SOX reporting costs, convincing employees that it'll succeed in that, and then actually executing on that while shunning acquisition offers. It's much easier just to pick off the low-hanging fruit.
3.) The investing public. They're shut out of investing in promising growth companies. Instead, they have to put money into large existing companies, which blow shareholder wealth on overpriced acquisitions. The managers get rich, the entrepreneurs get rich, the retail shareholders get screwed.
It's telling that in Web1.0, most people dreamed about joining a successful startup. In Web2.0, most people dream about starting a successful startup. The incentives are not there for people to sign onto an existing company.
Yes! I wish more people talked about this. Especially with the tax benefits, issuing dividends is the way to go.
Actually it has. It introduced a qualitative change in liability for corporate executives. Selling now has way, way less downside. The reason that's not "ok" is that a higher hurdle doesn't merely cause companies to wait before IPOing. They get bought instead. Result: no new public companies.
What's wrong with having fewer public companies?
There's really nothing wrong with it from most entrepreneurs' POV: they build something people want, they get paid for it.
The problems occur at the margins: the businesses that could be started with enough outside capital but can't be bootstrapped off initial cash flows, or the small investors that are perfectly capable of doing due diligence on companies but are banned from investing because all the attractive investment targets are private. It's really an opportunity cost issue: things work okay, nobody gets visibly screwed over, but all sorts of little transactions that would make life better for everyone never take place.
This is basically the story behind investment trusts, mutual funds, and hedge funds. Back in the 20s, everybody put their money into investment trusts. They got screwed by the Great Crash, so the government put all these restrictions on public investment vehicles (can only invest in stocks & bonds, can have no more than 1.5% of assets in any one security, etc.) and the trusts were reborn as regulated mutual funds.
Then people realized that because mutual funds were so regulated, they were leaving money on the table, and all these alternative asset classes like commodities, timber, derivatives, venture capital, etc. were ripe for the taking. So they created a new class of investment vehicle, hedge funds, without the regulations but only open to people who supposedly know what they're doing.
Now ordinary people are investing in hedge funds indirectly, through funds-of-funds and pensions, and they're getting screwed. So there're calls to regulate hedge funds now.
Financial markets treat regulation as damage and route around it. Unfortunately, they sink many suckers in the process and create demand for new regulation, and so on.
It's hilarious because hedge funds are a scam (based on traditional 2 & 20 fees alone). Then someone creates fund of funds, which is a scam of a scam. And people are dumb enough to buy it.
Thanks for answering my implicit question about why an investing member of the general public should care about whether start-ups get bought out by existing companies or go public themselves. It makes sense that over the long haul, a more diverse ecosystem of publicly traded companies makes for a more resilient economy and more opportunities for small investors to make profitable investments.
Of course, the current tanking of the stock market all around the world, by no means only in the United States, might suggest that small investors need to know that the ecosystem does have selection pressure for transparency and accuracy of corporation statements to investors. I appreciate the replies by various participants here on how Sarbanes-Oxley has a different cost burden for new, smallish start-ups as contrasted with established, large public companies. Perhaps adjustment of some rules to take into account the size of a firm is in order.
It's important to note the section when reading Journal's articles online, lest one treat an opinion of Mumbalumba's propaganda minister as WSJ front page news.
It's very unfortunate that they brought down a lot of other people along with them.
SOX is bad for statups, but not for those reasons. The cost of compliance for smaller companies is too great in comparison to their income. The entire SOX shouldn't be brought down, it should be made more friendly for smaller corporations and an effort is already being made (see wikipedia under heading SOX 404 and smaller public companies)
The computer boom came about because of capital gains tax cuts, huh? What a joke.
Cuban talks about this point here:
http://blogmaverick.com/2008/10/23/the-cure-to-our-economic-...
(if taxes don't matter to investment decisions, then why not raise them to 99%?)
If you believe current taxes are right at the "sweet spot", why do you believe that?
It's just political propaganda that China is oppressive and thwarts entrepreneurship. Sure there are some problems, but China's human rights issues are about on par with Gitmo.
of course, there will be an impact if a company wants to IPO, but that comes much later on. However, even in that case, it's more about revenue/income generation.
i'm interested in seeing what's going to be the liquidation route for startups now since the M&A market is quiet now.
In a similar vein, if my video game character gets -10% to speed (or +10%), I typically shrug it off as nothing, but it all too often is the difference between life and death.
It was actually a comment similar to this one a few weeks ago on HN that made me recognize this as a bias. I wonder if there's any literature on it.
"One grain of sand is not a heap. Adding a grain of sand to something that is not a heap will not make it a heap. By induction, then, heaps cannot exist."
The conclusion, of course, is obviously false, because heaps of sand do exist. But you can't state at what point something that's not-a-heap becomes a heap.
AFAIK, this was still an open question when we covered it in class (2001). I don't know of anyone that's provided a convincing argument for why two premises that seem true result in a conclusion that's obviously false.
Achilles is in a footrace with the tortoise. Achilles allows the tortoise a head start of 100 feet. If we suppose that each racer starts running at some constant speed (one very fast and one very slow), then after some finite time, Achilles will have run 100 feet, bringing him to the tortoise's starting point. During this time, the tortoise has run a much shorter distance, for example 10 feet. It will then take Achilles some further time to run that distance, in which time the tortoise will have advanced farther; and then more time still to reach this third point, while the tortoise moves ahead. Thus, whenever Achilles reaches somewhere the tortoise has been, he still has farther to go. Therefore, because there are an infinite number of points Achilles must reach where the tortoise has already been--he can never overtake the tortoise.
Treating a pile of sand as an accumulation of individual grains which can be precisely abstracted through induction is an unnatural mode of thinking. Without focusing our attention on it, it will remain a single, fuzzy abstraction. That we see no clear distinction between these two modes seems more a neurological phenomenon than a philosophical one.
A while ago, when thinking about the boundary between long and short, decided that the problem was that we use discrete labels for continuous phenomena.
I suppose this may be related to the Anchor Bias (http://www.overcomingbias.com/2007/09/anchoring-and-a.html). Something that is not a heap, after a grain of sand is added, is still a heap. Something that is a heap, after a grain of sand is removed, is still a heap.
An interesting instance of this arose when determining how numbers are described in the Piraha language, a language with only three words for quantities. Seeing one battery, the Piraha called it "ho'i". When they added one more (a large increase percentage-wise), they immediately switched to another word, so therefore "ho'i" means "one." But when they started with ten batteries and started removing them, one of them started calling it "ho'i" at six batteries, so therefore "ho'i" really means "few." (http://en.wikipedia.org/wiki/Pirah%C3%A3_language#Numerals_a...) I'd explain that as: when deciding whether to call something "few" or "many," they anchored off the initial judgement, and looked at the percentage change. So one politician could convince voters a 10% tax increase will have no effect by starting off "Well, what would a 0% increase do? How about 1%?", while another could convince them it would be devestating by starting off at 20%.
Perhaps you have something against me personally? For that, I have no remedy, but to tweet for help: http://twitter.com/indiejade/status/1072506322
yes.
"We hold that all individuals have the right to exercise sole dominion over their own lives, and have the right to live in whatever manner they choose, so long as they do not forcibly interfere with the equal right of others to live in whatever manner they choose.
Governments throughout history have regularly operated on the opposite principle, that the State has the right to dispose of the lives of individuals and the fruits of their labor. Even within the United States, all political parties other than our own grant to government the right to regulate the lives of individuals and seize the fruits of their labor without their consent."
The article supplies pre- and post-SOX IPO counts, and while that doesn't prove anything in itself, they do smell like fish.
Another point the article makes is that companies can't afford the massive legal costs of going public and SOX, and that is why so many of them are getting bought up (thus no new public companies). I would think by now that the "cost of going public" would be somewhere along the lines with "the cost of starting a startup" and going down as well -- with digitalization of documents, etc.
So, perhaps it's a matter of the regulation that is in place needing to play "catch up" with the reality of the times.
I'm not sure I agree with you, but anyway, that deal fell through because of regulation. But observing that one aspect of regulation works, is hardly an argument that deregulation is bad.
> "cost of going public"
Other comments in this thread (http://news.ycombinator.com/item?id=406433) suggests that going public means slightly more than digitizing documents. No SAAS, no IM, no iTunes, more lawyers, more accountants. But, arguing "regulation is not hurting that much" is hardly an argument that deregulation is hurting more.
He told me that SOX required the company to have auditing/traceability and controls for everything. This meant they quit using any software as a service applications, they shut down IM, they have to keep track of everything on every machine, banned a whole list of applications that would interfere with SOX (iTunes, file sharing, and music app), etc.
They had to hire lawyers, more accountants, consulting firms. He told me they were looking at > 10m to comply. And that doesn't count lost productivity of having to act like a draconian big ass company where they had to have design docs for everything they do, detailed project plans, get rid of the tools they use (as listed above), etc.
In other words to go IPO now you give up agility, spend more money, and become less productive.
PS: There are IM clients that large companies can use so clearly some of what he said was BS.
Or to prevent them from investing in private companies without giving a piece to NY bankers? (Not implying you necessarily disagree)
Cray started illegally with small investors who all ended up making a lot of money. In the Midwest too! Good thing Washington isn't allowing that to happen again.
"According to the National Venture Capital Association, in all of 2008 there have been just six companies that have gone public. Compare that with 269 IPOs in 1999, 272 in 1996, and 365 in 1986."
It's probably more complex than that, or he'd have hammered the point a lot more. I'd love to see a graph, for instance.
http://lawprofessors.typepad.com/securities/2008/02/januarys... : "January [2008] was a slow month for IPOs, with only five that raised a total of $892 million. This compares with ten in January 2007 that raised a total of $2.25 billion." I quickly googled, and there's probably more to look at here, since either 5 of the 6 IPOs did it in January, or there's different counting methodology in action here. Still, it's down even in months that weren't bad. It's not just statistical gaming, even if that's in play. Asking what changed is still fair.
Tufte in The Visual Display of Quantitative Information points out that the Wall Street Journal is one of the least likely newspapers to display anything in a graph. Indeed, it would be a lot easier for visually minded people like me to check the Journal's arguments if they were displayed in bivariate plots more often.
The failure of IPOs isn't going to affect entrepreneurship, but it could well affect VC funding because it eliminates their primary exit strategy.
Malone does have a point about the FSAB. Treating options as an expense does make them less attractive to public companies, but it was an attempt to correct some egregious excesses. As usual, slap the big guys and hurt the little guys. Mark to market is an attempt to keep companies from hiding their investment losses in bookkeeping. The downside is that it makes their net worth much more volatile. AIG was a blivet in any case.
Cutting capital gains was good. Giving Reagan credit for the boom of the 90s is pure BS.
Cut the WSJ some slack. This was an op ed piece from an outsider. Malone used to be a San Jose Mercury News Reporter. He usually has something useful to say and he has the interests of the developer/entrepreneurial community at heart.
I do think its interesting that, even when Obama was talking about the potential for large cap. gains tax increases, he made a point to exempt "small businesses and startups." I'm not sure how we could draw that line, but it indicates to me that Obama has exactly Malone's general argument in mind.
http://en.wikipedia.org/wiki/Freedom_of_information_in_the_U...
should be exempted from SOX so that they can raise funds through IPO.
Saying that Bear Stearns and AIG were cash positive is absolutely meaningless, as if I just bought $5 million worth of stuff on my credit card, make $40,000 a year and haven't gotten a bill yet, I'm still cash positive.
It's a little different, and much more complex, but I don't think the article writer really cares to understand any of that -- he just wants to beat the dereg drum, no matter how much sense it makes or doesn't.