Opinion by Timothy J. Keating
In his opening remarks to the 2007 Government-Business Forum on Small Business Capital Formation, former SEC Chairman Christopher Cox acknowledged the critical importance of small business to the U.S. economy:
- “Small firms represent…99.7% of all the employer firms in the United States.They employ half of the entire labor force in the private sector.”
- “Of all the net new jobs created in our country, small business generated between 60 percent and 80 percent in every year during the last decade.”
So, one might reasonably ask, if small business capital formation is so important to the U.S. economy, why is it now nearly impossible for small businesses to go public? The answer: one ill-conceived government regulation piled on top of another in the past decade, which collectively have brought public company capital formation to a grinding halt.
The lack of new public companies matters greatly to a capitalist society because the vast majority of value creation, and hence new jobs, occurs after these entrepreneurial companies have gone public. To deny access to the public markets for the most promising of private enterprises seeking growth capital is the moral equivalent of eating one’s offspring before they have a chance to thrive. Regrettably, we believe the most effective way to revive small business capital formation, i.e. reverse the damage already inflicted by regulatory and legislative malfeasance, is to work through the SEC and Congress.
The blame surely begins with the infamous Sarbanes-Oxley Act of 2002. Originally designed to cover the 1,000 largest public companies, in a wave of Congressional exuberance Sarbox was eagerly extended to cover all public companies. While we disagree with some of our peers in the small business community about the actual real cost of complying with Sarbox, in the end it doesn’t matter. The perception of $1 million compliance costs for smaller companies trumps the reality of closer to $100,000 and is enough to set less-informed companies running from public markets.
Next on the hit parade came former New York Attorney General Eliot Spitzer’s $1.5 billion “Global Settlement” with Wall Street in 2003 aimed at combating tainted equity research. As part of the settlement, Spitzer forced Wall Street investment banks to spend $460 million on independent stock research. According to a recent article in The Wall Street Journal, it “turns out that many investors couldn’t have cared less.” The Journal goes on to report that in one recent year at Credit Suisse Group, “just 16 retail clients had retrieved reports from the bank’s Web site.” Spitzer’s massive initiative only directly affected a few investors, and perversely, actually decreased the amount of available equity research. Talk about the cure being worse than the disease.
The list goes on and on. For each capital markets “reform” (ahem, regulation) enacted in the past decade, there is a group decrying it as the root of all evil. Regulation Fair Disclosure, Decimalization, Regulation SHO…pick your poison.
Ayn Rand presciently warned about the consequences of government regulation in extremis in her 1957 novel Atlas Shrugged. The protagonist, Dagny Taggart, sees society collapse around her as the government asserts control over all industry, while society’s most productive citizens, led by the mysterious John Galt, progressively disappear. Galt describes the strike as “stopping the motor of the world” by withdrawing the “minds” that drive society’s growth and productivity.
The “minds” behind small business capital formation have increasingly gone on strike and are innovating new solutions.
Consider the following:
- Nasdaq OMX recently announced that it has entered into an agreement with Morningstar to provide a research profile targeted at retail investors for all of the more than 3,600 companies that trade on the exchange-including nearly 900 (25%) that have no analyst coverage at all. [See related article on page 2.]
- Fidelity Investments and Kohlberg Kravis Roberts & Co. recently announced that they have entered into an agreement to provide Fidelity’s brokerage customers to buy into KKR-sponsored IPOs.
- At least four new private exchanges (Second Market, Inside Ventures, SharesPost, and XChange) have sprung up in the past few years to fill the IPO void and satisfy investors seeking to participate in investment opportunities of emerging growth companies.
So while we generally applaud innovation in all of its forms, these developments all share one thing in common: they are Band-aids to a badly broken capital formation process. More insidiously, certain of these initiatives run counter to the most important function of an exchange, namely creating a centralized pool of liquidity. Fracturing liquidity serves neither investor nor issuer under any circumstance. In that regard, these liquidity-diffusing solutions are not the long-term fix that is required.
Instead, we think the better solution is to fix the root of the problem: bad and excessive regulation. The recommendations of the 2008 SEC Government-Business Forum on Small Business Capital Formation (http://sec.gov/info/smallbus/sbforum.shtml) include 22 securities law changes and a further 15 recommendations on tax issues. We support nearly all of these recommendations. Unfortunately, the very well-intentioned SEC’s Office of Small Business Policy headed by Gerry LaPorte seems to be impotent and lost in an otherwise disgraced and dysfunctional agency.
Nevertheless, given the pervasive and highly visible hand of government in the capital markets, we believe that working through the auspices of the Office of Small Business Policy is regrettably a Hobson’s choice for those who are serious about reviving small business capital formation. Thus, we encourage all who are involved in the micro-cap public market ecosystem to join the cause of working to agitate for the restoration of rational regulation to our capital markets sooner rather than later.
