By Jeff Solomon
During the last Century, economic growth in the United States was unparalleled. A large portion of that growth came from the explosion of capital formation for small companies. It is high time that America gets Back to that Future.
In the U.S., we’ve been on a search to find the right financial regulation necessary to ensure markets operate properly, protect investors and provide for growth. There’s no question that regulation is essential – we’ve seen the consequences of allowing for markets to operate without proper controls. However, in recent years we’ve also seen unintended consequences from the burden current regulations have put on America’s biggest job creators – new public companies. Today’s regulatory environment has made it difficult, and often financially disadvantageous, for small companies to go public, reducing the number of public companies in the U.S. significantly over the past decade. So, it’s time to modify and evolve financial regulation to encourage capital formation, foster job creation in the U.S. and lessen our dependence on fiscal spending to reposition the country as an emerging growth economy.
Now, more than ever, the U.S. needs to allow for capital formation to thrive again. The President’s Council on Jobs and Competitiveness recently released a report recommending that the government reduce regulatory barriers and provide financial incentives for small and mid-sized companies to go public so that they may have better access to stable and secure financing to support growth. Importantly, the report noted that 90% of job creation for public firms occurs after they’ve gone public.* It doesn’t matter where you are on the political spectrum – capital formation through IPOs is just plain good for the economy.
Over the past decade, the price of becoming or remaining a public company has become unnecessarily burdensome – especially for small and mid-sized companies. The IPO Task Force’s October report to the Treasury Department estimated that “…the average cost of achieving initial regulatory compliance for an IPO at $2.5 million, followed by ongoing compliance costs once public of $1.5 million per year.”** While that may not seem like much money for large organizations, the report also noted that the cost of being public can significantly reduce cash and market cap size of smaller companies. This, in turn, has negatively impacted job creation in the U.S. by stifling private companies on the verge of expansion into the public markets.
I speak with private companies and their investors on a regular basis about their frustration of not being able to access public capital markets for growth. Despite opportunities for sustainable growth, given the right financial resources, these companies are incentivized to be acquired by larger public organizations. As the Jobs Council report notes “…fewer high-growth entrepreneurial companies are going public, and more are opting to provide liquidity and an exit for investors by selling out to larger companies. This hurts job creation, as the data clearly shows that job growth accelerates when companies go public, but often decelerates when companies are acquired.”*
Not only do regulators need to re-examine the environment to allow companies to go public, we need markets that support small companies so that they can sustain themselves as public entities. Market liquidity is a major concern for investors in small-cap stocks. Conversion to a decimal system from a fraction system made sense for some in 2001, but it’s an area where we once again find a set of unintended consequences.
Reduced profit potential from trading in smaller increments and a lack of transparency has made it less profitable and more risky to be a market maker in the small cap companies. What was meant to reduce execution costs for investors, by forcing brokers to make markets in pennies rather than fractions, has actually had the effect of reducing liquidity in the small cap universe. In turn, this lack of liquidity, which has increased single stock volatility and made it less attractive to invest in small cap stocks, has pushed institutional investors away from small cap growth markets. These investors are the foundation of capital formation as buyers of small cap IPOs.
Without adequate profit incentive for buyers and sellers of small cap stocks, it will be difficult to return to the days when IPOs were aplenty and capital formation was prevalent. As David Weild, former Vice Chairman of Nasdaq and overseer of capital markets research at Grant Thornton said in a recent interview, “One-size-fits-all stock trading has become a disaster for all but our nation’s largest companies…” as trading volumes in small capitalization stocks has declined precipitously in recent years.
The good news is that there are solutions to these problems – modify Sarbanes-Oxley to scale back the requirements and costs associated with being a small-cap public company. Small cap companies should not be expected to incur the same compliance and expense burden as mid or large cap companies. Coupled with a small cap exchange that trades in wider increments than pennies, which will bring necessary liquidity back to the small-cap marketplace, there is a real possibility to enhance capital formation efforts in this country by re-igniting the IPO engine. Making these changes will also stimulate job growth by allowing small companies the opportunity to become large, public organizations that can advance their businesses in the U.S. It is time for the regulators to make public markets more attractive for small companies that are most in need of support for growth. In doing so, America can finally get Back to the Future.
Jeffrey Solomon is Chief Executive Officer of Cowen and Company. Currently, he is also a member of the Committee on Capital Markets Regulation.
*Source: The President’s Council on Jobs and Competitiveness, Interim Report Taking Action, Building Confidence
**IPO Task Force Presentation to Treasury Department, October 20, 2011, Rebuilding the IPO On-Ramp – Putting Emerging Companies and the Job Market Back on the Road to Growth