Last month, I was invited by Congress to testify at a hearing about capital formation. It was a terrific opportunity for me to discuss topics critical to the future of our country, and offer my thoughts on the regulatory hurdles facing private companies in this country. SEC Chairman Mary Schapiro also testified, and I was pleased to hear that the Commission is earnestly assessing the state of the public stock markets and the usefulness of decades-old rules governing capital formation.
The hearing, convened by the Committee on Government Oversight and Reform, was a tangible step towards correcting outdated rules and regulations to assist American growth-stage companies. In fact, the House Financial Services Committee introduced a bill this week to revise one of the outdated rules. That's the good news. The bad news is that many Americans are unaware that the U.S. public stock markets no longer support growth-stage companies. Systemic changes have caused companies to remain private far longer than in previous decades, potentially impacting job creation and American global competitiveness.
This post is the first in a series where I will summarize my testimony and address three interconnected but distinct topics: (1) The Past: The Systemic Problems in the U.S. Public Stock Markets; (2) The Present: The Role of SecondMarket and the Private Company Stock Market; and (3) The Future: Proposed Regulatory Changes to Support Growth-Stage Companies.
Part One - The Past
For several decades, startup companies in the U.S. followed a familiar path -- they raised angel capital, a few rounds of venture capital, and went public within five years. The vast majority of IPOs were for companies raising $50 million or less, even adjusted for inflation. Smaller public companies could thrive in the public markets, with equity research coverage and market makers driving investor interest in growth-stage companies. However, in recent years, the market structure changed and the public markets became inhospitable to smaller public companies.
Quite frankly, prior to SecondMarket's involvement with private company stock, I did not understand the breadth and depth of the problems facing public companies in America. After analyzing the topic over the past few years, including reviewing research findings from leading industry observers, I came to appreciate the broad impact of the systemic changes in the market. Several factors have been recognized as contributing to the problems in the American public stock markets:
•Online Brokers - Although the introduction of online brokerages helped to make trading less expensive, these online brokers disintermediated retail brokers who helped buy, sell and market small-cap, under-the-radar public companies to investors. Stockbrokers collectively made hundreds of thousands of calls per day to their clients to discuss small-cap equity opportunities; they were not calling to recommend buying shares of IBM or Procter & Gamble. The proliferation of online brokerages decimated the profession and removed a critical marketing tool for the country's small-cap companies.
•Decimalization - Stock prices used to be quoted in fractions (e.g., the price of Company A was 10¼ or 10½). The difference between fractions created profit for firms providing market making, research and sales support. When the markets began quoting prices in decimals (e.g., now Company A is $10.25 or $10.26), trading spreads were reduced and profits were significantly cut. It became unprofitable to market small-cap equity because there was inadequate trading volume in the small-cap companies. In other words, the penny spreads were not adding up to support the traders and research analysts covering smaller companies.
•Sarbanes-Oxley - The legislation is a popular punching bag in Washington and is often blamed for the lack of IPOs; however, many observers believe it is not the most significant factor in companies electing to remain private. Nonetheless, corporate compliance with the Sarbanes-Oxley Act has certainly increased costs for public companies.
•Global Research Settlement - After decimalization began, in an effort to continue writing research reports, Wall Street began funding research with investment banking profits. Not surprisingly, once the practice began, conflicts of interest emerged and positive equity reports began to be written for undesirable companies. It's difficult for research analysts to write objective reports about companies that are also investment banking clients! State attorneys general got involved, eventually leading to the global research settlement. The result was that research reports stopped being written for small-cap public companies and, consequently, a significant marketing mechanism for those companies was eliminated.
•High-Frequency Trading - Although high-frequency traders bring significant liquidity to the public markets, they require the volume and velocity that can only be found in trading stock of larger public companies. A recent report stated that high-frequency traders conduct more than half of the trades in the U.S. equity market. High-frequency traders essentially ignore small-cap companies because there is insufficient liquidity in small companies to support high-frequency trading objectives.
•Average Hold Period - Over the past forty years, the average time that a public market investor holds stock has dropped from approximately five years in 1970 to less than three months today. Investors now focus their attention on short-term earnings performance, rather than long-term, business-building initiatives.
Virtually all of these developments emerged from either well-intentioned policy decisions or the natural evolution of the markets in an electronic age. Nonetheless, taken in the aggregate, these (and other) factors have made the public markets undesirable for many companies. Throughout the 1980s and 1990s, the regulatory environment and overall market structure actively supported high-growth private companies joining the public markets. From 1991 to 2000, there was an average of 520 IPOs per year, with a peak of 756 IPOs in 1996.
Today, the lack of a properly functioning public market structure is strikingly obvious. Since 2001, the United States has averaged only 126 IPOs per year, with 38 in 2008, 61 in 2009 and 71 in 2010. Companies are electing to remain private longer than in previous decades, and the average time a company remains private has essentially doubled in recent years.
Simply put, the lackluster IPO market is not providing the solution for investors and early employees who need liquidity. M&A is an alternative option for companies to obtain liquidity; however, acquisitions often result in job losses and stifled innovation. The growth market is a significant and vital part of the capital formation process, and the systemic failure of the US capital markets to support healthy IPOs inhibits our economy's ability to create jobs, innovate and grow.
Over the past few years, I have developed relationships with executives at numerous private companies. These executives are concerned that they are not ready or able to successfully navigate the public markets, which increasingly cater to traders, rather than investors. They are concerned about regulatory hurdles that restrict their ability to remain private. They are concerned about the proliferation of high-frequency trading and the casino-like atmosphere in the public markets. They are concerned that when traders own stock for weeks (or seconds), they don't care about company fundamentals or long-term objectives. They are concerned about activist shareholders. They are concerned about managing to quarterly earnings when they're trying to build something long-term.
Clearly, a new growth market must emerge. In my next post, I'll discuss how SecondMarket can be part of the solution.