Monday, December 22, 2008

Shutting down the engine of growth 

Contrary to the received wisdom on the left, the Bush years have been more hostile to entrepreneurialism and business in general than any administration since Jimmy Carter's. This crisp op-ed explains part of the problem more clearly than I ever could:

From the beginning of this decade, the process of new company creation has been under assault by legislators and regulators. They treat it as if it is a natural phenomenon that can be manipulated and exploited, rather than the fragile creation of several generations of hard work, risk-taking and inventiveness. In the name of "fairness," preventing future Enrons, and increased oversight, Congress, the SEC and the Financial Accounting Standards Board (FASB) have piled burdens onto the economy that put entrepreneurship at risk.

The new laws and regulations have neither prevented frauds nor instituted fairness. But they have managed to kill the creation of new public companies in the U.S., cripple the venture capital business, and damage entrepreneurship. 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.

Faced with crushing reporting costs if they go public, new companies are instead selling themselves to big, existing corporations. For the last four years it has seemed that every new business plan in Silicon Valley has ended with the statement "And then we sell to Google." The venture capital industry is now underwater, paying out less than it is taking in. Small potential shareholders are denied access to future gains. Power is being ever more centralized in big, established companies.

For all of this, we can first thank Sarbanes-Oxley. Cooked up in the wake of accounting scandals earlier this decade, it has essentially killed the creation of new public companies in America, hamstrung the NYSE and Nasdaq (while making the London Stock Exchange rich), and cost U.S. industry more than $200 billion by some estimates.

Meanwhile, FASB has fiddled with the accounting rules so much that, as one of America's most dynamic business executives, T.J. Rodgers of Cypress Semiconductor, recently blogged: "My financial statements are a mystery, even to me."

This is a huge topic, but indulge me in a few additional points, each worthy of a long essay.
  • Process has come to dominate the management of public companies at the expense of advancing the underlying business. As any executive or director of a public company knows, the intersection of Bush-era regulation, populist and ignorant press coverage, and the conservative advice of lawyers who have seen the criminalization of business judgment have driven boards and management to the last defense available to them when tort lawyers or prosecutors come calling, that they ran a good process. The result is that directors spend their time on essentially bureaucratic matters instead of understanding the strategy of the business and guiding management in its execution. Worse, the most entrepeneurial directors are quitting out of boredom or crowded out to make room for CPAs and lawyers to staff the audit and compensation committees.

  • One of the reasons why so few companies are going public is that it sucks to be an executive of a public company. It used to be good, now it is not. Not by any measure. I do not know a single executive of a public company who would not prefer the same job, even at some cut to compensation, in a private company. Why? See the first bullet above.

  • Whether or not the expensing of options is the disaster that Michael Malone says that it is, it is far from the boon for transparency that its advocates claim. Right now, for example, there are hundreds of public companies that are booking essentially phantom "equity compensation" expense related to options that are so far out of the money that they will never be exercised. Just when the economy needs companies to show earnings, the accounting rules are artificially depressing them.

  • Of the many new burdens on public companies, the new world of accounting is particularly nettlesome for at least two reasons. First, the various accounting authorities compulsively write new rules that create new work and expense for public companies or private companies that aspire to go public. These rules are promulgated in an ultimately pointless quest for theoretically improved transparency in financial statements. Unfortunately, the constant changes in the rules are themselves a source of confusion and distraction for the investors who are supposed to benefit from them. Since even top financial analysts are rarely expert accountants, they have to spend an inordinate amount of time learning the new treatment for convertible securities, for instance, or acquisition expenses, instead of learning about the actual business of the company. Is this a good use of their time? These rules changes, which have come relentlessly in the last few years, certainly justify the existence of the FASB, the academic accountants who dominate it, and the huge fees charged by the (now only four) top firms, but do they really make companies more understandable even to professional investors? Doubtful. And yet they continue unabated, even though the SEC has now declared that within five years American "generally accepted accounting principles" (GAAP) will be a dead letter and we will all convert, en masse, to international "principles-based" accounting standards. Why, then, are we fine-tuning GAAP when it is, in theory, down to its last few years of usefulness? No investor wants it. Only academic accountants care, and only public accountants benefit.

  • The second problem with accounting is Sarbanes-Oxley. The chief complaints against this law revolve around the cost of compliance, and that it is driving business to overseas capital markets, or deterring companies from going public. While these are all meritorious indictments, my own objection is to the impact of the law on the culture of business. In the production of financial statements, SarBox quite literally elevated process -- that word again -- to the same stature as outcome. Whereas before it was only necessary to produce financial statements that neither misstated nor omitted a material fact and were true in all material respects, now one must do that according to a process that is under "control." Your auditors audit both the statements and the process. It is therefore possible to produce legally accurate financial statements and still be liable for not actually running your company in a way that ensures that you pass the process audit. Whether intended by Congress or not, the de facto requirements of SarBox demand that "business processes," which are pretty much everything that involve financial transactions (buying, selling, manufacturing, invoicing, collecting, paying, order-taking, the administration of computer systems, and so forth), must be structured in a way to avoid the possibility of "conflicts." That can significantly increase the people necessary to do a particular task, the time it takes to do it, and the level in the organization at which decisions about "responsibilities" may be made. The net effect of this elevation of process is to confine decision-making, bureaucratize authority, and destroy risk-taking and creativity at all but the highest levels. It is devestating to the culture of American business, heretofore the greatest engine of wealth the world has ever seen.

  • Oh. And it is important to have the right "tone at the top." The lack thereof can impeach an otherwise buttoned-down process. Officially, therefore, I do not believe any of what I just wrote, and would deny these opinions if called to account for them.

    CWCID: Glenn Reynolds.


    By Anonymous Anonymous, at Mon Dec 22, 05:38:00 PM:

    When you look at the economic problems of places like Buffalo or Rochester or Detroit, which used to be prosperous ... it's not just the jobs they've lost ... but the new jobs that never got created -- but were created elsewhere -- that kill their economies in the long-run. These "missing new jobs" don't show up in official statistics. Smaller businesses are critical to creating these new jobs.

    Without private sector employers, you can't support state and local government. When a city like Rochester finds that one day its only big employer -- e.g., Kodak -- has hit hard times, they're screwed. They can't tax their way out of the problem. Creating enterprise zones and the like only help the politically connected.

    We may see this phenomenon writ large for the US. It has been a tough environment to start a new business, and its only going to get worse. Our venture capital industry is dead. I could go on ....


    By Blogger Mrs. Davis, at Mon Dec 22, 08:54:00 PM:

    One of the important but subtle changes in the accounting profession was the transition from statements that adhered to principles to ones that followed rules.

    The rules were intended to help implement the principles, but clever practitioners could bend the rules to subvert the principles. And no one cared, least of all the partners. Because their touches were covered.

    When one (Anderson) was held to account for violation of principle, the profession retreated to security in more government sanctioned rules and less judgment and principle. CPAs are now simply high paid agents of the SEC and IRS.

    It is interesting to see the profusion of rules not only in accounting, but in every facet of business. Rules are what lawyers are good at. But Moses needed only 10 and Jesus 2. Which trend is better?  

    By Anonymous Anonymous, at Mon Dec 22, 09:04:00 PM:


    Good points on this topic, as always. The power to tax and legislate is the power to destroy. The processes are paralyzing and draining.

    This reminds me of a story about JFK's cabinet, the "best and the brightest" that Halberstam wrote about. After one meeting in the White house, Lyndon Johnson remarked to Speaker of the House Sam Rayburn about how bright the group supposedly was. To which Rayburn replied, "I would feel a whole lot better about them if one of them had run for sheriff just once."

    I would feel a whole lot better about Congress and the regulators if some of them had worked for a for-profit business for a meaningful part of his or her career. Then they'd see how hard it is to "create new jobs" and compete. With all the regulation Congress places on companies and the derision they deploy to win elections, it's amazing that are companies aren't faring worse.

    The Centrist  

    By Blogger smitty1e, at Mon Dec 22, 09:27:00 PM:

    >Bush years have been more hostile to entrepreneurialism and business in general

    See, now, if you'd just get with the narrative, you'd realize that government is _the_ business, in general; the only hostility to be found has been towards old, dead ideas like the free market and stuff.
    Viva the Bolivarian Revolution!
    Narrative uber goober!

    By Blogger Purple Avenger, at Mon Dec 22, 11:47:00 PM:

    driving business to overseas capital markets

    Indeed. The Fraunhofer Society is courting my posse right now and want us to move all of our operations to Germany. They're telling us we're crazy to stay here in the USA.

    Other than the nice Florida weather, which we all like, they're probably right.  

    By Blogger Andrewdb, at Tue Dec 23, 12:06:00 AM:

    I am a lawyer. Part of my job is to do SEC reporting for a public company.

    Amen, Brother Hawk!  

    By Anonymous Anonymous, at Tue Dec 23, 10:30:00 AM:

    I am a non-practicing lawyer - who until 36 months ago was the General Counsel of a Nasdaq company. Truer words never were spoken TH.  

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