Red tape is the usual suspect for most problems faced by American business. So it is no surprise that overregulation is the preferred explanation for the decadelong paucity of small-cap public offerings. But a closer look suggests the finger is pointed in at least partly the wrong direction.
Early this month the House of Representatives passed the Reopening American Capital Markets to Emerging Growth Companies Act — an effort to trim bureaucracy for emerging businesses wishing to float shares on the stock market. There is certainly strong circumstantial evidence for the “red-tape” explanation. The burden of regulation has mounted over the past decade, especially due to the passage of the Sarbanes-Oxley Act in 2002. This law, passed in response to the accounting fraud that caused the collapse of Enron and WorldCom, forces companies and their accountants to conduct rigorous tests of internal controls. This may be a healthy activity that gives companies more information about their business. It is also extremely costly, especially for small businesses.
In October 2011 a Treasury Task Force on public offerings estimated that the average cost of complying with pre-IPO regulations was around $2.5 million, followed by ongoing expenses of around $1.5 million a year once public. For a start-up this can be a significant share of a company’s earnings and can lower the company’s market capitalization by “tens of millions of dollars,” the Task Force concluded.
“Regulation is part of the cumulative toxic effect that has made it ever harder for smaller companies to list on the stock exchange,” says Chuck Robel, a former chairman of computer security company McAfee and a member of the Treasury Task Force. Robel estimates that most companies need to start investing time and money in regulatory compliance about a year and a half ahead of a public listing. “This is time and money that could have been devoted to building the firm,” he says.
There is other evidence that the Sarbanes-Oxley Act and other rules make listing on U.S. exchanges rather pricey, at least relative to some less-regulated exchanges. While the cost of listing on the Nasdaq is around 13 percent to 15 percent of the total capital raised, the cost on London’s Alternative Investment Market (AIM) is only about 10 percent to 12 percent, according to AIM Advisors, which helps U.S. companies list on the British exchange.
The Reopening Capital Markets Act tries to remedy this situation by giving emerging growth companies relief from compliance. Companies with revenues below $1 billion a year will have five years to fully comply with all of the government rules, instead of having to do so as soon as they go public.
This may help at the margin, says David Weild, a former Nasdaq executive. But he believes there is compelling evidence that the regulatory burden is only part of the problem.
For a start, the decline in small IPOs began before the 2002 Sarbanes-Oxley Act was passed. Secondly, other developed markets — even less-regulated ones like AIM — seem to be having a similar problem. In 2011, just 90 companies launched on the exchange, less than a fifth of the level seen around the mid-2000s. Indeed by the end of 2011 the number of companies listed on AIM was at its lowest level in seven years.
So lawmakers may be disappointed if they expect a surge of smaller IPOs following their latest effort to cut red tape. Instead deeper problems with the functioning of the capital markets also appear to be causing the IPO drought.
