In 2008 and 2009, there were fewer than 20 VC backed IPOs. There were many reasons for this precipitous decline from the 25 year median of 125. I’d like to focus on the Sarbanes Oxley costs today.
In 2001, investors and employees of WorldCom, Tyco and Enron lost billions due to false and misleading financial statements by those companies. In 2002, the government enacted Sarbanes Oxley, called SOX or SarBox, requiring additional disclosures from public companies. These additional documents were intended to prevent future “financial irregularities.” Additional reporting means higher accounting costs for public companies – $1.8M in additional annual costs, according to recent studies.
I was curious to know the impact of these costs for companies of various sizes, so I asked a friend to run some numbers for me. Below, you’ll find this analysis. We start with the market cap of companies on the Nasdaq by decile. For example, the smallest 10% of companies have market caps between $22-25M. Next, we know the average PE ratio on the Nasdaq is about 13. We can use that to determine the average earnings by decile in column D. We know that SOX costs $1.8M per year and we can calculate the ratio of SOX costs to earnings by decile.
Two things stand out from this analysis:
- 70% of companies on the Nasdaq have market caps smaller than $860M
- For these companies, SOX costs are between 5 and 106% of profits.
For a company with a market cap below $500M, the costs of remaining a public company are significant relative to average earnings. SOX has a massive impact on profitability. Only the companies with market caps of $860M or more can view these costs as incidental. In other words, this implies venture backed companies need to achieve market caps near $1B to file for an IPO to make sense. Additionally, this means that nearly 70% of the Nasdaq’s customer base isn’t well served by the exchange.