Level the IPO Playing Field for Smaller Companies
By Josh Levine
Editor, Levine's MicroCap Investor
Wall Street and the various media are abuzz about the upcoming IPO for Facebook, the largest social network. At a valuation as high as $100 billion, Facebook follows lesser Internet sensations such as Zynga (ZNGA), Groupon (GRPN) and LinkedIn (LNKD) into the public markets. By way of comparison, when Google (GOOG) went public in 2004 it was valued at just $23 billion.
These and most IPOs of the current era cater to the institutional investors already with big stakes awaiting an exit, while the investing public pays obscene premiums over pre-IPO prices doled out not long before. This wasn’t always so.
When Intel (INTC) went public in October 1971 it sold 350,000 shares at $23.50 for a total of $8.2 million and for a post money valuation of $58 million. That’s right – it was a microcap. It's also notable that in the previous six months Intel had revenues of less than $4 million and profit before extraordinary items of $93,000.
Obviously the game has changed tremendously. The bar is ridiculously high for any company considering raising capital in the public markets today. A few items from a list compiled by venture capital veteran Alan Patricof illustrate the hurdles faced by smaller firms seeking to go public:
- Many of the firms who underwrote small companies are no longer in existence;
- The investment bankers who remain cannot afford, in today's institutional world, to provide research coverage for companies with small capitalizations as it is not economic. The Global Research Settlement and Rule FD exacerbates this issue as it greatly restricts how research departments can operate;
- The allowed spreads on trades is too small to cover trades in low activity stocks, and;
- As a result of Sarbanes Oxley and other associated costs, going public and being public has become prohibitively expensive for small companies.
Bill Hambrecht, an investment banker who's been involved in IPOs as long as anyone provides numbers showing the extent of the impact: “There is a backlog of 45,000 small companies which in, circumstances more favorable for young small companies, would access the public market if it were available to them. They would like to sell 20% stakes to the public raising $10-20 million capital for future growth.”
But these companies' needs and appropriate valuations would suggest market capitalizations which are far below the realistic minimum in today's IPO market where $50 million or greater offerings are needed and $250 million or greater market caps to be viable.
Change the Incentives
The model for funding small innovative firms has been broken for many years. As a result the economic and opportunity costs are staggering.
Until a better system emerges, many of the most challenging economic problems faced by the United States, including terminal unemployment, decline in leadership of innovation-driven markets, and shrinking capital markets for emerging growth companies, may never be fully reversed.
One of the most effective ways I’ve seen to improve the situation is by changing the incentive system for financing small technology companies.
As two senior advisors at Grant Thornton -- Edward Kim and David Weild -- correctly point out, markets have become inhospitable to smaller private companies looking to raise less than $50 million.
In testimony for a U.S. congressional subcommittee as reported by CFO, they got right to the point:
“The main cause, as they see it, is lower trading fees, stemming first from online brokerages and new order-handling rules in the late 1990s, and then from decimalization, Sarbanes-Oxley, and the global research analyst settlement separating research from banking. Given the lower fees, it no longer makes economic sense for investment banks to support small-company IPOs with capital and research. Kim says that 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...”
Without a major revision of the economic incentives for funding and support, small firms will continue to have little choice but to pursue angel investors and VCs, or consider a reverse merger. Still, one piece of legislation that could be passed soon is the raising of the offering limit under Regulation A from $5 million to $50 million. This, at least, would ease some of the barriers to completing smaller IPOs and expand the playing field for more companies.
There is no simple cure for what ails smaller outfits, particularly those devoted to research and development. While a new Reg A limit would at least be a first step towards improving market conditions for emerging tech-driven companies, there's much more that can, and must be done.