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Did Small IPOs Dip Because Companies Had Better Options?

One proposed explantion for the decline in small-cap IPOs is the abundance of alternatives for small companies. But what are these alternatives and do they explain the decline?

While government officials and experts fret about the slow death of small company public offerings, Neil Dhar, co-head of public offerings and capital-raising at PricewaterhouseCoopers, argues that much of the decline reflects an abundance of attractive alternatives for young firms.

“Over recent years the range of options for firms needing capital or wanting trade shares have been expanding,” Dhar says. “Aside from the fact that borrowing has been much cheaper, we have also seen the rise of private stock markets. Selling out to larger rivals is also an attractive option.”

Private stock markets seem to have made it easier for firms to delay stock market offerings until they reach maturity. The most prominent of these is SecondMarket, a forum for trading illiquid assets. This forum completed $557 million in private company transactions last year — a 55 percent rise compared to 2010. It has also hosted a wide range of prominent firms, most notably Facebook, Twitter, LinkedIn and Tesla Motors.

Such private markets act as a pressure value, allowing staff at startups to sell stock in a firm before a public offering. SecondMarket calculates that almost 80 percent of sellers are ex-employees of the listed firms, with another 10 percent current members of staff.

Still the rise of SecondMarket and rivals like SharesPost, has serious limitations. For a start, SecondMarket only launched trading in private companies in 2009 — more than a decade too late to explain the decline of small firm public offerings.

In addition, Securities and Exchange Commission rules allow only “sophisticated investors.” This bars individuals whose net worth falls short of $1 million or institutions that manage less than $100 million in securities. Companies are also limited to 500 shareholders before they have to file with the SEC.

Meanwhile, unlike the public markets, the secondary market is more geared towards trading shares than raising capital for future investment. In addition, SecondMarket was recently forced to lay off about 10 percent of its workforce after Facebook suspended trading in its shares in the run-up to a full public offering.

Another more sanguine explanation for the decline in small firm offerings is that the modern economy has made it harder for tiny corporate to flourish. As a result, small fries can achieve greater value by allowing them to be taken over by larger rivals — an option that many have taken.

Jay Ritter, a finance professor at the University of Florida, put the case forward. In a paper in March, Ritter argued that the problem was rather the “increased inability of small companies to remain profitable.” Among microcapitalization firms offering shares to the public, Ritter calculated that the proportion that were profitable three years later had fallen from 42 percent to only 27 percent over the past decade. Small firm stocks have also underperformed the benchmark by an average of 17 percent three years after their offering. “There has been a structural change in many industries resulting in lower profitability for small independent firms,” Ritter argues. “Encouraging small firms to remain independent rather than realize greater value as part of a larger organization might harm the economy.”

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