Kathleen M. Kahle and René M. Stulz write (link now fixed),
US public firms are very different now compared to 1975 or 1995: fewer, larger, older, less-profitable, with more intangible capital, less investment, and other changes. The US firms that remain public are mostly survivors. Few firms want to join their club. A small number of firms account for most of the market capitalization, most of the earnings, most of the cash, and most of the payouts of public firms. At the industry level, revenues are more concentrated, so fewer public firms are competing for customers. A large fraction of firms do not earn profits every year and that fraction is especially large in recent years, which helps to explain the high level of delists. Accounting standards do not reflect the importance of intangible assets for listed firms, which may make it harder for executives to invest for the long run.
The authors discuss various explanations for this, but my inclination is to tell the story as follows:
Think of any investment project as going through two phases. First, there is the start-up phase, which may or may not produce profitable results. Then, for successful projects, there is the cashing-in phase, where the profitable enterprise gets sold to a wider set of investors.
Forty years ago, a lot of investment projects were started within large public firms. With the firm already public, there was no need for an additional cash-in phase. The stock already was widely held. Meanwhile, if a not-yet-public firm launched a successful enterprise, the best deal it could get in the cash-in phase was often to go public.
Today, large public firms are doing less of the first-phase risky investment. Instead, they are letting private firms take the risks and then handling the successful start-ups’ cash-in phase for them by buying them.
So that’s a story. A leading example of that model would be pharma. A lot of the speculative research gets done at small start-ups. Once a start-up is successful, its best option is to be acquired by big pharma. The legacy firms have a comparative advantage in handling the second phase. The start-ups have a comparative advantage in the first phase.
Hey Arnold, the link to the article seems to be broken at the moment.
So, is this because of market inefficiencies that allow the large companies to have bargaining power so that they can off-load their costs and risks of R&D?
Or is it possibly a rational move on the part of entrepreneurs who may otherwise work for the big companies but find independence to be desirable? I can tell you, I love not having to fill out sketchy time cards.
I would assume that, in part, it is because to go into production requires platoons of lawyers and others to interface with the regulators and the eventual official trials.
I would agree that the end result is pharmas are basically evolving in division of labor to basically an expertise regulatory arbitrage and medical sales and marketing.
Your thoughts are understandable since whenever a business is successful, it would eventually expand and seek more partnerships with other companies.
I guess one question is — is this unhealthy? Is it a bad thing that startups aspire to be acquired rather than go public and that public companies focus on acquisitions rather than internal development? Did large public companies used to be better at internal development? Or have they just correctly recognized that they were never very efficient at it and that it makes more sense to let smaller, nimbler organizations do the early stage work?
Another factor may be the relatively recent increase in accessibility to “venture” funding, whether offered by private equity investor groups or by institutional investors like mutual funds and pension funds.
Put together a decent business plan, pitch it to an investor conference audience, and boom! you’re funded. The venture funding sources figure that, if one out of what? ten? opportunities results in a commercially viable product, they more than cover the other 9 losses, and still put beaucoup bucks in their investors’ pockets.
Public corporations outsourcing their R&D to venture capital and buying only the “winners” is [loosely, to be sure] like the NFL using college football teams as their “farm clubs.” Why financially support very expensive endeavors with uncertain results when someone else will do it for you?
“Another factor may be the relatively recent increase in accessibility to “venture” funding…”
Yep. In the old days, big corporate labs were necessary for R&D and the little guys were at a distinct disadvantage. The availability of VC seems likely to have been a critical factor in changing that dynamic.
Do not discount the impact of the tax code. The US tax laws tax US public companies at a higher rate than private companies. Public companies normally must be C corporations, with 2 levels of tax. A private company can be an LLC which is taxed as a partnership. Not only are profits only subject to one level of tax, losses can used by investors to offset other income (think Uber, which has lots of losses). Also, because of this high tax rate on US public companies, a no growth or slow growth business is generally much better off in a high leverage LLC structure (think private equity). You often hear of private equity companies selling a business to another private equity company as an exit rather than going public.