Every once in a while, someone leaves a snarky comment on this blog along the lines of “Well, have you ever started your own company?” I usually leave them alone, although occasionally I can’t resist responding. In general, I just think that my experience co-founding one company in one industry does not really qualify me to say anything that knowledge and logic wouldn’t qualify me to say anyway. In particular, having been through the experience, I can say that the amount of luck you need dwarfs any other attributes you bring to the table, so starting a company is not a particularly useful filter.
But now Michael Malone has managed to aggravate me with an op-ed in the Wall Street Journal called “Washington Is Killing Silicon Valley.” And Silicon Valley being one of the parts of our economy I know particularly well, I feel compelled to respond.
Malone’s thesis is that government regulation is threatening the ability of “Silicon Valley,” meaning the venture capital-backed entrepreneurs, to start successful new companies. He says that Sarbanes-Oxley, options expensing, and full disclosure requirements “have managed to kill the creation of new public companies in the U.S., cripple the venture capital business, and damage entrepreneurship.”
Malone’s evidence is that there have only been 6 venture-backed IPOs in 2008, as compared to over 200 in 1999 and 1996. First of all, when anyone quotes you two random figures from a series, you should be suspicious. There were 73 IPOs in 1998. (My numbers for the 1990s are from a National Venture Capital Association presentation from 2006, and are slightly but not significantly different from Malone’s.) Second, the big fall-off in IPOs was from 2000 to 2001, when the number of IPOs fell from 264 to 41. Why was that? Evil government regulators? No, as I recall vividly, the technology bubble burst; the company I was at, Ariba, saw its shares lose 99% of their value. After the crash, the number of IPOs built back up again, reaching 86 in 2007 as the stock market climbed to its all-time highs in October. And why are there so few IPOs this year? Do I really need to spell it out? Given that you’re reading this blog, I don’t think so.
By the way, Sarbanes-Oxley was enacted in July 2002, after venture-backed IPOs had already fallen off a cliff. Stock option expensing was enacted in December 2004 and went into effect in the second half of 2005 or 2006, depending on the company.
Malone’s other evidence (other than bald assertion)? He says that every business plan these days ends by saying “And then we sell to Google,” instead of going public, and that VC firms are underwater. (Yes, these are really just bald assertions, but I’m stretching to find evidence in his article.) It’s hard to see the desire of small software companies to sell out to Google – a company that has a habit of buying small software companies, and that is by all accounts a great place to work – as evidence that Silicon Valley is broken. It’s also a claim that only makes sense if you restrict your field of vision to online software companies – ignoring, for example, the little bubble in “cleantech” that appeared over the past couple years.
If venture capital firms are underwater, there’s a very simple explanation for that. Venture capital firms invest in private companies. Those companies have valuations, even if they aren’t traded daily on markets. Those valuations are closely linked to the valuations of public companies, because private companies are usually valued using multiples: for example, you might say that a software companies is worth 3x or 5x its revenues. Those multiples are “calculated” by looking at comparable public companies. So now that the NASDAQ has fallen by 50%, all of the multiples have fallen by 50%, and the values of all of the VCs’ portfolio companies have fallen by 50% (or they will the next time they think about how much those companies are actually worth).
And he has one quote from an executive at Cypress Semiconductor complaining about accounting regulations. Note that Cypress Semiconductor has been public since 1986. I’m not sure what Malone is trying to prove here, but he does also blame mark-to-market accounting for the failures of Bear Stearns and AIG.
But despite the lack of worthwhile evidence, is there something to Malone’s argument anyway? Yes, Sarbanes-Oxley has made it harder to go public, and it is definitely something that companies like mine think about. But it’s just a cost of doing business. Every venture-backed startup, once it reaches a certain size, plans on going public, for the simple reason that you can’t plan on being acquired, because it isn’t under your control. You have to go public. In our case, it just meant we had to be a little bit more serious about our financial infrastructure than we might have in 1999 – which, as I see it, is entirely a good thing, both for us and for anyone who might invest in us in the future.
As for option expensing, though, that’s a complete red herring. The new accounting regulation had absolutely no effect on our option granting policies – we didn’t discuss it for one second – and I can’t imagine it affecting any other Silicon Valley company I would want to work at. First, the option culture is too deeply ingrained. Second, startup companies are run on cash, not accounting statements, and we know that the accounting treatment doesn’t affect cash. If you investors think it matters, fine.
Malone lets out what he really cares about toward the end of his op-ed, however: capital gains taxes! He’s afraid that Obama will raise capital gains taxes, thereby really dealing a deathblow to Silicon Valley. On his reading, reductions in capital gains taxes under Carter and Reagan “unleashed the PC and consumer electronics booms of the 1980s, just as the Taxpayer Relief Act of 1997 restored the 20% rate and did the same for the Internet economy in the late 1990s.” If I were Bill Gates, Steve Jobs, Scott McNealy, Larry Ellison, Jeff Bezos, Jerry Yang, David Filo, Larry Page, or Sergey Brin, I think I might be just a bit insulted. No, wait, I’d be too rich to be insulted.
That argument fails to draw a convincing link between capital gains tax rates and entrepreneurialism. Reagan boosted the capital gains tax rate back up to 28% in 1987, where it stayed until 1997. Some of the companies founded during that dismal, high-tax decade: Netscape, eBay, Yahoo!, Siebel, Amazon, Palm, and most of the companies that went public during the technology boom before the IPO window slammed shut in early 2000. “An increase in the capital gains tax could end most new (nongovernment) job and wealth creation in the U.S. for a generation,” Malone warns ominously, while failing to explain why the economy did just fine between 1987 and 1997 (yes, there was a recession in there, but there was also the first half of the longest boom of the postwar period).
Finally, I can say with certainty that capital gains tax rates had absolutely nothing to do with my decision to start a company. I didn’t even know what the capital gains tax rate ways at the time. Starting a company was an absolutely terrible financial decision – I would have been much better off become a middle manager in some big, sleepy, high-paying company – and the fact that I might someday pay 15% on the gains from stock I assumed was worthless at the time, as opposed to 35% on a salary I didn’t have, didn’t enter the outer fringes of the calculation.
(No, no, I hear you saying, it’s the incentives for the investors that matter, not the entrepreneur’s incentives. But I still don’t buy the argument, because a lower capital gains tax rate, if it does anything, increases my propensity to invest rather than consuming – or working, for that matter, and how is that good? It doesn’t affect my choice of what to invest in; I am just as likely to invest in gold, paintings, or super-senior CDOs as I am to invest in VC funds.)
So Michael Malone: Don’t you worry about Silicon Valley. It will be just fine.