Is the great American financial engine that gave the world Intel and Google grinding to a halt? Last quarter marked the first time in 30 years that not a single company backed by venture capital went public in the U.S.

A fluke? Two weeks into the current quarter, the drought continues. Dealogic reports that just one venture-backed company has gone public, California-based Energy Ventures, Inc.

Of course this is a horrible market across many asset classes. But even before the credit crunch began last year, initial public offerings of young companies had become rare. Venture-backed IPOs in 2005 and 2006 were far below the levels of the early 1990s, never mind the boom years that followed. A recovery in the early months of 2007 still didn't push IPO numbers anywhere close to the number of young companies being acquired by bigger, more established firms.

David Gothard
This is bad news for the U.S. economy. Does anyone think that we would be better off if Bill Gates and Michael Dell had sold out to corporate behemoths early in their careers, instead of leading their firms for years as public companies? Would consumers enjoy the same vibrant market in Web services if Yahoo had gobbled up a nascent Google? How powerful would our computers be if Intel had become an IBM subsidiary, instead of going public in 1971?

Of course we can't run these experiments. What we do know is that entrepreneurial drive, combined with venture investors' money and experience, plus access to the public markets, equaled a tech revolution and an industry that is the envy of the world. That model may be collapsing.

True, investment in U.S. venture funds is holding up well despite the market downturn, with investors pouring $9 billion into this asset class in the second quarter. But over the long term, venture investments have to result in a healthy number of home-run IPOs to justify the risks and offset the inevitable failures. The industry cannot continue raising the money to fund American innovation if its returns trail the stock market indexes, as they did for the five-year period through 2007.

Some have ascribed the broken venture model to the "cheap revolution," meaning that, thanks to earlier innovations, the tools to create new tech products are so cheap that entrepreneurs don't even need funding from venture capitalists. That's great, but we're not seeing a flood of IPOs of young companies built without venture money, nor the creation of lots of privately held global powerhouses. By and large, founders of Internet startups are not creating companies with the dream of conquering the world, but rather with the intention of selling to Google, eBay, Yahoo or Microsoft.

Our society should be encouraging these entrepreneurs to dream big. Instead, they're looking for the exit before they have to deal with the burdens of our public markets. "All things being equal, 85-90% of our portfolio company CEOs would say they would rather be acquired than go public," says Steve Harrick of Institutional Venture Partners.

Think about "all things being equal." An IPO generally means that the founders can continue to run the companies they have painstakingly built, except with greater resources. An acquisition generally means that the founders move on, see projects they championed get axed, and watch old colleagues get fired. How many company founders would aspire to conduct a sale of the business instead of a public offering, absent some bizarre and unnatural conditions in the market?

"A lot of our CEOs are reticent to go through the public process. The [Sarbanes-Oxley] and governance issues are cumbersome, and it means they spend all of their time as administrators versus growing their companies," reports Kate Mitchell of Scale Venture Partners. She adds that chief executives don't want the liability risks of running a public firm and the same goes for candidates to serve as outside board members.

As for Sarbanes-Oxley, or SOX, the hope was that by now firms would have gotten over the hump of learning to comply, and auditors would have stopped obsessing over minute risks. Last year the Securities and Exchange Commission explicitly advised firms to focus only on material threats to the integrity of a firm's financials. "The SEC's heart was in the right place, but the accounting firms' hearts are not," says Mark Heesen of the National Venture Capital Association. He adds that the Big Four accounting firms "continue to feast on SOX audits."

Ms. Mitchell says the "SOX tax" runs up to $3 million per year per company, which can reduce a firm's market value by much more. Mr. Harrick says the costs of being a public company can approach $5 million.

Most venture capitalists tell a similar story, but Novak Biddle co-founder Jack Biddle says that another reform of the early 2000s has caused even more damage than SOX. He fingers the 2003 analyst settlement forced upon Wall Street by then New York Attorney General Eliot Spitzer. The theory was that separation between investment banking and stock analysis would eliminate biased research. The result is very little research of smaller companies by investment banks.

Nobody wants research peddled merely to help Wall Street firms win lucrative fees from the companies that are the subject of the research. But is no information better than information with an agenda? "The issue is that if banking cannot subsidize research, there will be no research, and therefore no institutional buyers or liquidity for small cap companies," says Mr. Biddle. "The trading alone isn't profitable enough to provide coverage. Spitzer did more harm to the small cap IPO than did Sarbanes."

Mr. Biddle may be an outlier in handing most of the blame to Mr. Spitzer. But he's not alone in diagnosing the problem of limited research coverage by Wall Street firms. "Lack of analyst coverage and the rules surrounding that make these stocks less visible to the potential audience," says Ms. Mitchell.

How likely is reform to make U.S. capital markets more hospitable to entrepreneurs? When it comes to SOX, the SEC has told auditors it is looking for 50% reductions in compliance costs for smaller companies. To check their progress, the Commission is conducting a SOX cost/benefit analysis. If the results match those reported by Silicon Valley VCs, the Commission should continue to exempt the smallest category of public firms from the most onerous portions of the law and enact broader exemptions until the costs are under control. Neither presidential candidate is calling for a repeal of the infamous Section 404, which requires costly audits of internal controls, though John McCain did say he would consider amending the law during a December visit to The Wall Street Journal's editorial board.

As for the analyst settlement, the 12 participating firms cannot take back the more than $1.4 billion they coughed up to cut the deal in 2003. However, starting in July of next year they will be free to stop paying tens of millions each year to outside firms for independent research. The idea behind this provision was to offer Wall Street's brokerage clients objective research without any connection to the firms' banking business. But it turns out that most people choose to be clients of Goldman Sachs, for example, because they want Goldman's opinion, not analysis from some other firm.

Rather than paying to offer various views on a particular stock, perhaps Wall Street firms should consider investing in new coverage of stocks that they don't cover at all. The various parties to the settlement should also review the agreement's other provisions. This October they can suggest revisions to the federal court overseeing the settlement. All participants should be ruthless in knocking out provisions that prevent investors from participating in the growth of America's most innovative young companies.