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Ease Regulations to Revive Venture Capital

The venture capital industry is in poor shape. When measured in inflation-adjusted terms, the amount of venture capital under management is now down to levels not seen since the 1990s, data from the National Venture Capital Assn. reveal. Almost three and a half times as many venture capital-backed companies went public from 1989 through 1998 as from 2001 through 2010, data compiled by finance professor Jay Ritter at the University of Florida show. (Note that I’ve deliberately removed the bubble years 1999 and 2000.) And since 2000, 55 percent fewer firms are actively investing.

Weakness in the venture capital industry hurts job creation and economic growth. According to a 2010 study by IHS Global Insight (click on the first PDF on the page), companies that once received venture capital account for 21 percent of U.S. GDP and 11 percent of private sector employment. As the venture capital industry contracts, we’re out the jobs and economic growth that would have been created by startups that now aren’t funded. While there’s no good way to quantify the missing economic impact, it will hurt if this generation’s Steve Jobs and Bill Gates can’t get venture capital to turn their ideas into the next Apple (AAPL) and Microsoft (MSFT).

The heart of the industry’s problems is the low rate at which companies now go public. Since the venture capital-backed IPO market began to decline in 2001, the industry has been shrinking. While the industry experienced a bubble at the turn of the millennium that required a shakeout, we’ve probably passed the point of cutting fat. In real dollar terms, the amount of venture capital under management and the number of firms actively investing are back to pre-Internet-bubble levels.

Unfortunately, there’s no good alternative to a vibrant venture capital industry. Banks can’t fill the gap left by a shrinking venture capital industry because the rates of return demanded for these high-risk investments exceed the limit on what interest rate lenders can charge. Nor can business angels make up the difference. With the median venture capital investment at $7 million and the median angel group investment at $250,000, it would take a massive increase in the number of angel groups, let alone individual angel investors, to fill this gap. And the fact that we have had congressional hearings over the loan to failed solar panel maker Solyndra shows why government funding isn’t the answer.

Regulation Costs

The venture capital industry’s central problem is the increase in securities regulations that started in the early 2000s. According to the IPO Task Force, a self-nominated group of investors, entrepreneurs, attorneys, and academics involved in the financing of high-potential new ventures, these regulations have raised the cost of building the compliance infrastructure a public company needs to approximately $2.5 million, and the legal, accounting, and compliance costs to $1.5 million annually. Moreover, it now takes as many as two years to get a young company ready to meet these compliance requirements. All of this makes startups reluctant to go public, notes the task force’s Oct. 20 report presented to the U.S. Treasury.

The task force offers a good first step to fixing the problem, recommending that companies tapping public markets for the first time with sales of less than $1 billion at the time of IPO be permitted five years to completely adhere to public company securities legislation. This adjustment period includes compliance with the Sarbanes-Oxley Act, which increased the standards for the actions of the boards of directors, management, and auditors of public companies.

These changes are needed. Right now, four out of five CEOs of pre-IPO companies view “the costs and risks of [Sarbanes-Oxley] and other accounting and compliance requirements” as a concern about going public, the report explains.

There’s also no surprise in the task force’s assertion that approximately 85 percent of pre-IPO company CEOs think that going public now is less attractive than in 1995. That date is telling. If the venture capital industry is to survive, we need to get venture capital-backed startups going public at a rate similar to what they achieved back in the mid-1990s. Making it possible for young, high-growth companies to ease into complying with securities regulations designed to mitigate fraud at giant corporations will help us get there.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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