Bring back the small cap IPOSeptember 5, 2012: 10:49 AM ET
The JOBS Act provides some relief, but there are still too many impediments to the public markets for smaller companies. Here's how we can fix that.
By Alan J. Patricof
FORTUNE -- As a venture capitalist financing start-up companies, I welcome the recent passage of the Jumpstart our Business Startup Act (JOBS Act), which will provide a degree of relief to the challenge of small companies accessing previously untapped broad sources of private capital.
However, now that the initial task of opening up avenues for very early stage financings has been accomplished through the JOBS Act, we need to address the next and perhaps greater challenge of how to deal with the series of structural impediments that have been put in place over the past 20 years which, while intended to decrease the cost of capital and prevent abuses in the market place, have had a persistent negative impact with the effect of reducing the ability of young small companies to access the public market. Fortunately, as part of passing the JOBS Act, Congress has directed the SEC to study and report back on the consequences of many of these past regulations.
In February 1971, Intel (INTC) went public with an IPO of 350,000 shares at $25 per share; an $8 million dollar offering supported by an underwriting group of 63 firms of which fewer than 10 are still in business in a similar form. As late as March 1986, Microsoft (MSFT) went public with an offering of $58 million with 116 underwriters of which no more than one quarter are still in operation in their original form. But those days are long gone as illustrated by the LinkedIn (LNKD) IPO in May 2011 which raised $358 million with only six underwriters.
The decline in underwriters who dealt with what would now be described as "small underwritings" is just the tip of the iceberg of the underlying problems impeding the public financing of small companies. The reasons for the decline can be directly attributed to four or five very specific rulings by the SEC among which changed decimalizing (the spread referred to commonly as tick sizes) from 25 cents per share to 1 cent per share, which took out much of the incentive for traders and market makers. (It did not help that while in past times fixed commission had been mandated, but in the 1980s these rules were cancelled and as a result commission rates went into free fall.) Is it any wonder that traders making markets in these small IPOs, brokers selling the stocks, research analysts providing coverage and, in general, attention paid to creating and stimulating markets has resulted in IPOs raising less than $50 million, declining from 70% of the IPO market in 1991, to barely over 10% last year? And superimposed on this is the cost and burden of being a small public company under the Sarbanes Oxley Act of 2002, which compounded the problem. (Some relief has been provided for small companies under the JOBS Act.)
While many of these rulings were intended to protect investors and reduce costs, they had the opposite effect, in many instances raising the cost of capital for most small companies in their growth phase. The result was a more than 90% reduction, according to Grant Thornton, LLP Capital Advisory Partners, in the number of IPOs under $50 million in size from 2990 from 1991-1997 to 233 from 2001 – 2007 and during the same period, the U.S. lost 43% of all listed companies as the share of the global markets shifted to China, Hong Kong and other countries.
So what can be done about the current dismal outlook for small company access to public markets? Without question we need to increase the number of underwriters focused on underwritings of under $50 million and we need to increase aftermarket support for this category of companies and that can only be accomplished by increasing incentives which translates into restoring tick sizes and commission rates so that traders and salesmen can be attracted to focusing their attention on small companies. Additionally the rules governing the critical relationship between research analysts and investment bankers have to be revised to encourage underwriting and after market support. By reducing tick sizes, the effect has been to reduce interest in small companies and shifted the focus of investing from smaller less profitable issuers to high volume short term, in and out computerized trading of large cap stocks. Incidentally the Investment Company Institute (ICI) which represents the mutual fund industry and through them the interests of 90 million retail customers came out in favor of increasing "tick sizes" at the Congressional hearings on June 20th.
After passing Titles I-IV of the JOBS Act, Congress wisely asked for comments on the rules for implementation and specifically directed the SEC to study the impact of decimalization on: 1) the number of IPOs; and 2) the liquidity for small and mid-size companies. The initial results of the study were not conclusive and the SEC has been directed to go back and determine whether additional rule making is called for. I hope that by at least modifying some current restrictions, this will lead to a resurgence in small-cap IPOs and a concomitant increase in financial firms specializing in this area of investment. There will certainly be those who will express caution over the possibility of increased fraud and deceptive practices and while I can't say this is impossible, it seems to me to be a small price to pay for the unleashing of capital raising by worthy companies.
Finally, it has been proven in a study by IHS Global Insight in 2011 that 92% of employment generation for a venture backed company takes place after a company goes public. What better shot in the arm to an ailing economy in need of high paying jobs than a wave of exciting young companies entering the public markets.
Alan Patricof, a longtime innovator and advocate for venture capital, is the Founder and Managing Director of Greycroft, LLC a venture firm focused on emerging companies in the digital media area.