“Food for Goldman”
Kim and Weild contend that the main reason behind the decline is that markets have become inhospitable to smaller private companies looking to raise less than $50 million. They see a stream of causes related to lower trading fees, stemming first from online brokerages and new order-handling rules in the late 1990s, and then from decimalization, which reduces bid-ask spreads. All of those factors reduce banks’ potential profits from a company’s stock activity. The global research analyst settlement separating research from banking has also contributed to the erosion of profit margins for banks.
Given those conditions, it no longer makes sense for investment banks to support small-company IPOs with capital and research, say Kim and Weild. Small companies “are not a product anymore; they’re just food for Goldman Sachs’s real clients” — hedge funds looking for quick gains through IPOs, asserts Kim. With such a large universe of companies shut out, he expects the pool of publicly traded companies to continue to shrink.
The decline means it will be harder for companies to grow, Kim says; it also weakens the capital-raising reputation of the United States against its global peers. Stock exchanges in virtually every other country continue to grow, particularly in China. A recent report from the Committee on Capital Markets shows that U.S. exchanges won only 14.2% of all IPOs last year, down from 16.9% in 2009 and an average of 28.7% between 1996 and 2006.
Indeed, venture capitalists now look at $100 million as the minimum revenue threshold for an IPO, says Mark Heesen, chairman of the National Venture Capital Association. With that as the target, he says, “VCs have to invest longer and spend more time on companies that are later stage, so they have less time and money to put in companies that are earlier stage.”
On the flip side, some venture capitalists are coming around to the idea that an IPO “isn’t the brass ring it once was,” Heesen says, and prefer the certainty and speed of a sale rather than a public offering. “I would much rather sell a company for the certainty of cash these days than go public, because [with the latter]…you may be locked up into something that looks like a falling knife,” says Michael Greeley, founder and general partner of venture-capital firm Flybridge Capital Partners.
Either way, the issue has attracted no shortage of attention in Washington, D.C. Treasury Secretary Timothy Geithner held a conference in March to examine the difficulty of funding for smaller businesses. Among other ways to improve liquidity, the Treasury Department is looking to put $1.5 billion in the hands of state officials to stimulate lending through partnerships with private lenders in the State Small Business Credit Initiative. (That may strike some companies as curious, given states’ effort to claw back economic-development funds (see “States Show Their Claws“).)
SEC chair Mary Schapiro also recently revealed that the regulator is taking “a fresh look” at ways to make small-business capital-raising easier. In an April 6 letter responding to questions from Rep. Darrell Issa (R–Calif.), head of the House Committee on Oversight and Government Reform, Schapiro noted that she had directed staff to study the possibility of expanding exemptions and sanctioning new capital-raising methods like crowd-funding for emerging businesses.
Capital By Other Means
Another effort to aid small companies that want to approach the public markets is the Small Company Capital Formation Act of 2011, sponsored by Rep. David Schweikert (R–Ariz.). That bill would increase the amount of money companies can raise in the public markets through Regulation A transactions from $5 million to $50 million. (Reg A allows companies to trade securities on the OTC market without having to register with the SEC, file regular reports, or be audited.)
The idea is that the additional capital could help companies grow without the costs of being public, allowing them to get big enough for major exchanges faster. Last year Nasdaq saw 54 companies upgrade from the OTC market to its exchanges, according to the market’s 10-K, an uptick from 47 in 2009 and 45 in 2008.
Raising the limit “would be a positive step that would reduce some red tape, and one that I think Congress will pass, but it’s just one step of many that would be needed,” says Kim. “I truly believe that without a completely different market model, we won’t fix these problems.”
Alix Stuart is CFO’s senior editor for small and medium business.