People Need to Think Outside the Box Again

We see the creative destruction going on in the media space as blogs, iTunes and so on restructure the markets. What about equity capital? The overall structure market today is much like it was a decade ago when we were raising equity for firms in the public markets. However, the machine has been gunked up with far more regulation and the threshold for being able to raise money has gone up quite a bit.

For a while we thought that maybe new exchanges like the AIM in London might thrive and become what some might think of as the "new NASDAQ." Despite being reasonably successful it hasn’t really done so and we don’t have any conviction that it will. Part of the reason is that it’s just too UK-centric but it also faces the same hurdles any new market will as we describe below.

Just last week some fresh dust was kicked up by Fred Wilson (a noted NYC VC) on an interesting concept that Goldman Sachs (GS) put out there called "GS Tradable Unregistered Equity OTC Market" or GSTrUE for short. (Obviously someone will need to come up with a better name for it at some point.) We first heard about this a year ago via a post over at Information Arbitrage. At the time I really wondered if this would catch on but until Fred’s post I didn’t hear much about it.

There’s a huge gap in the capital markets. In theory there is supposed to be a middle market for companies and capital but there basically isn’t. The big have just gotten bigger - look at Oracle (ORCL), Microsoft (MSFT), eBay (EBAY). Small innovative firms are the source of our technology advances but have no path to remain independent companies once they reach a certain size. You can hear a collective groan from users when these companies get acquired. That said we do find smallish companies that can shoot the gap and become successful public companies. There were actually several last year. Companies like Data Domain (DDUP), Netezza (NZ) and NetSuite (N) made it out and did fairly well.

In theory, venture capital/private equity firms might have jumped in to fill this gap. The problem seems to be that they are themselves so large that for them to earn a return that matters to their portfolio, the company they invest in has to have the ability to become a very large company. It’s hard to prove that even terrific small companies like Flickr can become $1B businesses. And given the way the VC/PE market works, you’d spend months on the road in meetings trying. So when Yahoo (YHOO) comes along with their $400M you just hit the bid and end the story.

So what about this potential new market that could evolve to serve the small to middle tier companies? There are a few critical pieces missing from our perspective. We’re admittedly biased here but we think research coverage and company visibility makes a difference.

As onerous as the traditional IPO process is, it provides some things that investors have come to rely on. There is a well-defined due diligence process which goes into creating the prospectus and it’s a valuable discipline. Investors also know that once the deal is done they can count on the company participating in the various investor conferences that are out there, analysts will cover the company and write reports, the underwriters will make markets and trade the stock.

We think this is part of the reason the AIM market only works so well for US companies and investors. Getting analyst research coverage beyond UK brokers is next to impossible. Google Finance may eventually help with basic company information but that’s pretty scarce right now.

Everyone knows that independent research is in short supply these days and the business models to support it are still tenuous. Today the best return on research capital is to invest the money directly to create superior returns rather than offer it for sale. If there were to be a vibrant new market like GSTrUE or something else, there would need to be some strong independent research on the companies listed there. For it to really happen people would again need to think outside the box.

Maybe independent analysts would get paid a fixed fee and then be rewarded financially based on the accuracy of their research predictions and estimates. This way they would be leveraged to the success of the *company* rather than the success of the *deal*. (BTW this is the way it was at SoundView Technology back in the old days when we had research-driven investment banking and not the other way around.)

So maybe it’s a question of making old things new again. But in a modern structure maybe we can leverage some new technologies and concepts this time. This is a great topic. We’d encourage everyone to follow the links above and take time to read the comments and the back posts.

Comments

[Whidbey]

Nothing new here, VC have written contracts with all sort of kickers available. But if you want to trade them, and I sense you do, you must do a registration or stay private with lettered stock, a la 1244. What exacting, if anything, were you hoping to start?