This is a guest post by Mona DeFrawi

The entrepreneurship industry is the economic growth engine of the U.S., and it has been blocked from realizing its potential due to the broken IPO markets. The economy stopped growing when good IPO activity disappeared,  and economic and job growth have been flat or declining ever since.

The timing is no coincidence.

The depressed economic growth of the past decade can be traced directly back to the demise of IPOs, showing signs as early as 1996 with the advent of electronic trading. I have often said that high-frequency trading (HFT) doesn’t support long-term investment potential, and has an eroding effect. There is too much liquidity and not enough stability in shareholder base composition for young IPO companies.

This market-wide phenomenon of valuations detached from fundamentals has created downward pressure on valuations, while dramatically increasing uncertainty and lack of confidence in IPOs.

As a result, companies are either stalling their decision to go public, or they are going public to mismatched valuations and disappointing aftermarket results.

So how did we get into this mess?

The Internet Bubble popped

The Internet Bubble popped in a lot of investors’ faces. No one wants or needs another Pets.com. Let’s not kid ourselves — if the IPO markets were better and could handle the traffic, we could easily see 200 IPOs this year from amazing companies grown over the past 10 years, but backlogged at the starting gate.

While many companies are attempting quiet filings in accordance with the Jobs Act, most are failing to complete their IPOs. 15 years ago, all of these growing technology companies would have gone public easily and successfully.

But the high frequency trading world of the bulge bracket banks and their short-term hedge fund clients — who buy most of the IPO allocations today — aren’t designed for growth companies. Traders need highly volatile pops based on hype, so companies like Facebook are perfect targets for their investing needs.

We need fewer Goliaths, and more David’s

The post-bubble 21st century outlook brought a perception that companies need to be very large to have a successful IPO.

What isn’t understood is that creating a long-term shareholder base counterbalances high frequency trading. Companies should take charge of their stock trading activity pre- and post-IPO.

Your bankers are there to support an excellent transaction, but there isn’t sufficient aftermarket support.

The problem with the large banks

It now takes an average of 10 years to IPO vs. less than 5 years prior to the bubble.

At least 300-500 percent of IPO allocations today trade in the first 48 hours of an IPO. As the markets have gotten worse, venture capitalists have are bringing their IPOs to large banks. There is a false perception that only the large banks can get these deals done.

Large banks clearly state that they are not fiduciaries in their IPO agreements. While intermediary “stop gap” measures, such as late stage secondary cash-outs and M&As are offered, it’s dangerous for them to consider long-term options. The long-term markets will collapse under the pressure to cash out now.

The markets must return to supporting economic growth rather than short-term profit extraction, at which they’ve become quite expert. This is a dead end strategy where the parasite eventually kills the host.

What can we do?

We actually have far more power to change IPO activity than perceived. First we must focus collectively on bringing back healthy, functional IPO markets again.

The traditional IPO process hasn’t worked well in our disrupted markets for over a decade. Yet for the past five years, the nation has been experiencing its biggest-ever backlog of great companies, which have already been incubated and funded, hired hundreds and thousands in high-paying jobs, and have excellent potential.

We are facing an issue of a broken IPO infrastructure, not a broken market cycle.

Companies can easily change their IPO prospects, but must invest in preparation. Banding together as an industry, issuers and investors can swiftly re-align transactional and aftermarket activities to actual performance. While everyone has demanded an improved IPO mechanism that provides an on-ramp and full cycle management of IPOs, few realize that they have power to change it.

It is our duty to revitalize the entrepreneurship and venture industries that are critical to America’s economic and job growth. Changing perceptions and actions always requires a transition, but we can most certainly grow healthy IPO markets again.

Mona DeFrawi’s work with Equidity is focused on U.S. capital formation, economic development and job creation. Devoted for 25+ years to supporting the entrepreneurial companies that contribute most to U.S. economic growth, technological leadership and improving our lives, she has delivered results in fundraising, IPOs, corporate development and investor relations.

Broken IPO image via Shutterstock 

Right now, Graham is worried. Worried enough, at least, to send a letter to the companies currently in the YC startup program. And that’s likely to make a lot of other people worried.

What’s the problem? In a word, Facebook:

 … I had dinner recently with a prominent investor. He seemed sure the bad performance of the Facebook IPO will hurt the funding market for earlier stage startups. But no one knows yet how much. Possibly only a little. Possibly a lot, if it becomes a vicious circle.

If funding becomes a problem, startups are forced to raise money at a lower valuation than earlier funding (a “down round”) … or may not be able to raise money at all.

What I do worry about is (a) it may be harder to raise money at all, regardless of price, and (b) that companies that previously raised money at high valuations will now face “down rounds,” which can be damaging.

There is a solution, however: be profitable.

The best solution is not to need money. The less you need investor money, (a) the more investors like you, in all markets, and (b) the less you’re harmed by bad markets.

I often tell startups after raising money that they should act as if it’s the last they’re ever going to get. In the past that has been a useful heuristic, because doing that is the best way to ensure it’s easy to raise more. But if the funding market tanks, it’s going to be more than a heuristic.

For some of us in the technical world, it may be a little hard to imagine one IPO having so much of an impact. Even though Facebook’s IPO losses have been crushing blows to some, it seems obvious to others that after assembling such a massive audience, the world’s largest social network will not fail to find ways to monetize. Even on mobile, because they really haven’t even started trying yet.

However, financiers and venture capitalists may look more at the pure financials of the situation, see major losses, and overreact. Financial markets are, after all, not exactly rational. That’s why there are tulip bulb crazes and dot-com blowups.

As Graham says,

The startups that really get hosed are going to be the ones that have easy money built into the structure of their company: the ones that raise a lot on easy terms, and are then led thereby to spend a lot, and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up. So don’t be that startup. If you’ve raised a lot, don’t spend it; not merely for the obvious reason that you’ll run out faster, but because it will turn you into the wrong sort of company to thrive in bad times.

What’s your opinion? Do you think the Facebook IPO could have a catastrophic effect on capital markets?

Image credit: ShutterStock

In May 1996, Open Market completed a successful IPO and more than doubled on the first day of trading, ending with a $1.2 billion market capitalization.  We had recorded $1.8 million in revenue the year before.

If investors observing this extraordinary phenomenon in 1996 were to have concluded that the technology market was in the midst of an unsustainable bubble, they would not have been wrong.  But if that observation led them to refrain from investing in the Internet sector, they would have missed one of the most stunning legal creations of wealth in history.

In 1997, a Charles River Ventures fund yielded a stunning 15x return, backing such superstars as Ciena, Vignette and Flycast.  Matrix had a fund in 1998 that yielded an eye-popping 514+ percent IRR.  The Internet bull market continued to run for four more years after the Open Market IPO, finally ending in the spring of 2000.  The average venture capital fund raised between 1995 and 1997 returned more than 50 percent per year.

Amidst all the recent talk of boom vs. bubble, there is a hue and cry that the current environment may smack of 1999.  But what if it’s actually more akin to 1996?  What if the fundamentals are good enough to support four more years of insane behavior before the music stops and the natural business cycle correction settles in?

The chart to the right from a recent Economist on unemployment made me pause and consider this question.  As evidenced from the unemployment curve in the last economic cycle, these business cycles can often last 4-5 years.

2009 was the trough year of the most recent business cycle – and a deep trough at that. 2010 was a year of firming and climbing out of a hole, but the tepid IPO market and general macroeconomic malaise seemed to linger until late in the year (similar to how 1995 felt).  2011 is the first year where it feels like a real boom – much like 1996.

Employment lags economic output and is an admittedly imperfect indicator, but if you continue the analogy, it may be that the next 4-5 year boom cycle lasts until 2015!

Consider the following:

• When bellwether players go public (such as Netscape in 1995), there is a massive rush of capital and companies that follow.  Facebook will likely go public in 2012 and be valued in the $50-75 billion range.  This IPO and others like it (e.g., Groupon, Zynga) will create tremendous liquid wealth for a number of people and institutions who will likely pour that wealth back into the start-up ecosystem.  That liquidity flowing back into the start-up ecosystem will arguably fuel the boom.
• Macroeconomic choppiness is holding back more dramatic market euphoria. Tsunamis, Middle East crises, government shutdown threats and a looming budget deficit are all dampers on the market.  But if some of these dampers clear out – if there is a period of reasonable international stability; if a divided US government can strike another fiscally responsible deal for the upcoming budget year and begin to deal with some of the long-term, fundamental drags on growth, then the markets will become even more euphoric.Remember, it wasn’t a straight line between 1995 and 2000 – there were a series of macroeconomic crises on the domestic front, such as a near government shutdown (sound familiar?) as well as international crises, including the Mexican debt default, Russian currency defaults and the Asian market crisis.  Let’s not forget that Time Magazine featured Alan Greenspan, Rob Rubin and Larry Summers on the cover in February 1999 with the headline:  “The Committee to Save the World.” At times, this period saw pretty grim macroeconomic trends, while the Internet continued to boom in the trenches.
• Thanks to recent decades of strong growth, the combination of China, India and Brazil have GDPs that are 4x the size and impact on the global economy as compared to the 1990s (see chart below).  Demand from these, now larger, economies are having a very positive effect on the US tech market. They are gobbling up mobile devices, PCs, routers and other technology gear at a rapid rate.  This powerful source of economic demand didn’t exist 15 years ago.
• All the existing technology players are awash in liquidity and all the numbers are bigger this time.  There are eight US-based global technology companies with market capitalizations of greater than $100 billion (Apple, Google, Oracle, IBM, Microsoft, Intel, HP, Cisco).There are a handful of companies that are very well-positioned, growing fast and could be the next $100 billion players (Amazon, Dell, Netflix, EMC, VMWare, Salesforce.com and Baidu come to mind).These companies either didn’t exist in the mid-90s or are in infinitely stronger positions than they were 15 years ago.  Internet usage, mobile phone usage, advertising dollar spend – all have grown enormously over the last 15 years to provide a stronger foundation underneath the latest boom.

The point here isn’t to be Pollyannaish.  I recognize that we have major structural issues in the global economy and they are perhaps more daunting than they have ever been.  And the recent run up in the stock market has many arguing that the bull market won’t last much longer.  If oil soars to $150 per barrel, a few more sovereign nations default on their debt obligations and gridlock persists in Washington, we could be looking at another recession as soon as 2012.

Yet, with entrepreneurship on the rise, with this generation of young people (“the Entrepreneur generation”) surging in their use and interest in technology and digital content, with some of the positive fundamental forces in innovation, it may just be that the music may not stop for another 4-5 years.  Wouldn’t that be something?