Insights for technology companies June 2011

Q: Current market structure — friend or foe of small businesses?

While the IPO market has shown some life in 2011 — with 71 IPOs as of May 31, 2011 — activity is far below the average of 520 IPOs in the years leading up to the dot-com bubble and not much ahead of the average of 130 IPOs post-bubble starting in 2001. And still in question is the capacity of the U.S. markets to support small public companies and sustain the volume of IPOs needed to drive the U.S. economy. Of this year's 71 IPOs, eight offerings total under $50 million in market capitalization, and shares at 29 companies are trading at or below their offer price.

Sub-$50 million IPOs once comprised more than 80% of all IPOs, but by 2000 — before decimalization and Sarbanes-Oxley — that number had fallen to a mere 20%.

Sources: Dealogic, Capital Markets Advisory Partners. Data includes corporate IPOs as of Dec. 31, 2010, except for funds, REITs, SPACs and LPs

Timeline of erosion in the Wall Street ecosystem that supports issuers 1994 Christie-Schultz study 1996 First online brokerage 1997 New Order Handling Rules 1999 Online brokerage surges and stock bubble inflates; Gramm-Leach-Bliley Act 2000 Regulation FD 2001 Decimalization 2002 Sarbanes-Oxley Act 2003 Global Research Analyst Settlements 2005 Regulation NMS

A: Foe — and the reasons for that have been long in coming.

Market structure is the primary cause of this IPO crisis, and the beginning of this crisis dates back to 1997. The collective effects of uncoordinated regulatory changes and inevitable technological advances have culminated in a perfect storm of unintended consequences. The economic model that once supported investors and small-cap companies with capital commitment, sales support and high-quality research has been stripped away, causing a devastating erosion of the U.S. IPO market.

Evolution from foe into friend

Challenging markets produce alternatives — Small companies may want to consider going public despite the fact that stock markets are less supportive than in the past. But to do so, small companies must develop self-directed, comprehensive, ongoing aftermarket support plans on their own. Wall Street no longer provides support.

"Small businesses interested in raising capital face challenges given the current market structure, but they can still go public. They just have to approach today's markets differently and adapt to them," says David Weild of Grant Thornton LLP's Capital Markets practice. (Weild was formerly vice chairman of the NASDAQ.)

Some companies have turned to the auction process as an alternative to the traditional book-building method of IPO execution. The auction process allows the market to determine pricing and allocations and distributes stock to individuals and institutions through a more effi cient and equitable process. Advocates believe there are a number of potential benefi ts to the auction process:

  • Companies are more likely to move stock into the hands of long-term investors (because shares are allocated on a fi rst-come, fi rst-served, bestprice basis).
  • Pricing is more equitable (because there is less incentive to underprice in order to generate alpha for the manager's best-paying customers), resulting in less dilution.
  • Investors receive equal access and equal treatment.

"The idea was to develop an auction process through which companies would go public and their price would be set by the marketplace. What that did, of course, was eliminate the negotiated deepdiscount pricing that was so prevalent in the IPO process. The new auction process also took away the allocation power of the book runner or managing underwriter.

"The statistics pretty well show that they do get priced at the market — they don't jump up on the fi rst day; they don't respond right away. But what's also interesting to me is we have the best aftermarket performance record of any underwriter" says Bill Hambrecht, chairman of WR Hambrecht + Co and founder of Hambrecht & Quis.

On the legislative front — From our meetings on Capitol Hill, we sense that today's legislators are disposed to create a more favorable environment for capital formation. Support for change is evident in HR 1070 (the Small Company Capital Formation Act of 2011), a bipartisan bill which has been introduced by Rep. David Schweikert. It has proceeded through the House Committee on Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises and is currently awaiting markup from the full committee.

Proposed to amend the Securities Act of 1933, HR 1070 would authorize the SEC to increase the offering threshold from $5 million to $50 million for companies exempted from SEC registration under Regulation A. This exemption would provide small companies with a less costly and more effective alternative for accessing the capital markets. HR 1070 proposes several changes to Regulation A that would be enormously benefi cial for small companies, capital formation and the U.S. economy:

  • An opportunity to test the waters — The legislation would continue to allow issuers to meet with investors before incurring the signifi cant costs of an offering.
  • A blue sky exemption — The bill would let small companies list themselves on national exchanges and thereby obtain an exemption from costly blue sky state fi lings.1
  • Streamlined offering and disclosure requirements — Under HR 1070, Regulation A would drive down costs for small issuers by continuing to permit the use of a simplifi ed Offering Circular for the SEC's review.

HR 1070 is a straightforward, if partial, fi x for the problem of risky and costly market access. The bill is one of the fi rst steps toward encouraging small businesses to access U.S. stock markets for the growth capital that will spur innovation, generate jobs and revitalize the U.S. economy. Yet measures are needed — such as provisions of stock research, sales liquidity and other visibility-sustaining measures — that will provide market participants with economic incentives to support companies once they have gone public.

Clearly, the dwindling number of IPOs is hurting our competitiveness and our economy. As evidenced by the growing support for modifi cations to Regulation A, such as those proposed in HR 1070, Capitol Hill has begun to understand the desire — and the need — to connect access to capital with small company growth and U.S. economic recovery. We are encouraged to see this building momentum for change

Footnotes

1 A blue sky fi ling is a notifi cation to an individual state that a company is soliciting people in that state to become investors. Each state has different fi ling requirements, making compliance extremely onerous for smaller companies.

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