Tuesday, May 08, 2012

Capital Formation in the Digital Age

Some of us remember calling the Securities and Exchange Commission on the phone for copies of filings, which came by express mail.  Eventually investment banking firms figured out fax machines and then e-mail.  Although it is hard to imagine now, there was a time that NO company had a corporate website that would allow a research analyst to size up a company by its Internet presence.  These days Internet searches are as much a part of investment due diligence as the roadshow.

Even as the investment world has adopted new communications and media platforms, the way securities are created and offered to investors has remained largely unchanged for decades.  The Jumpstart Our Business Startups Act of 2012 or the JOBS Act, is about to change that  -  perhaps in a way that the bill’s sponsors did not envision.

IPOs and Job Creation

Over the past two or three years has been a ground swell of support for better access to capital for smaller companies.  The sentiment is nothing new, but gained urgency after the financial crisis in 2008-2009 when large lending institutions went out of business and the loan spigot was all but turned completely off by those banks left standing.  A stubborn unemployment rate coupled with the realization that large business could not be counted on to bring cash back home from foreign production sites to create jobs.  Popular business mythology is that smaller businesses create the bulk of new jobs anyway.  A study completed in 2009 by accounting firm Grant Thornton “A Wake-up Call for America suggested over 20 million jobs had been lost to the declining initial public offering market in the past two decades.

The data from the Grant Thornton study was bandied about during Congressional hearings considering precursors to the JOBS Act.  Data was also offered by Professor Jay Ritter, Cordell Professor of Finance at the University of Florida that contradicted the Grant Thornton math and concluding that young public companies do create jobs, just not so many as the Grant Thornton Study suggested.  Ritter also demonstrated how slipping profitability among smaller companies is at the heart of the declining IPO market, suggesting that economies of scale are ever more important to earnings and consequently to valuation.  The rising portion of venture backed companies that go through trade sales instead of IPOs seems to back up that view.  

Capital Formation and Social Networking

If Ritter is correct, the JOBS Act may not have the originally anticipated effect on capital formation or job creation.  I expect a transformation of the capital markets nonetheless.  Mark Zuckerman probably did not anticipate the widespread use of Facebook by the arts, business and industry when he conjured up an algorithm to deliver an individual’s “dating status.”  Likewise, I expect the JOBS Act to open capital formation to the social networking practices and methods that have proven effective for just about everyone with a product, service or viewpoint to promote and sell.

First, the JOBS Act provides for so-called crowd funding  -  the capital markets adaptation of crowd sourcing, a marketing strategy using social media.  Bill sponsors claim it will democratize capital formation  -  a least at the small-company end of the spectrum.  The idea of crowd funding is simple.  Online fundraising platforms are set up via social networks or at least using social networking concepts to raise awareness of business ventures and projects and enable the electronic collection of investments or donations from individuals.  Capital raises are limited to $1 million per year.

A number of platforms, cooperatives of sorts have already cropped up around the world.  Kickstarter appears to be the most visible, but do not discount CircleUp or HyperFunding.  A longer list is shown at the bottom of this post.  Of course, most of these had been launched well before Congress passed the JOBS Act.  The open, fluid nature of the Internet seems like fertile ground for abuse.  Most of the current crowd funding platforms appear to be a bit short on capital markets experience.   

The 1993 Securities Act is far reaching  -  making it easy to run afoul of capital raising restrictions.  It will be clearer by the end of this year how much latitude businesses will have in using crowd sourcing to raise capital.  The SEC has nine months to come up with guidelines for JOBS Act provisions and then most likely there will be a shake-out and a few platforms will rise to the top.

The JOBS Act did not stop with social networking.  It also expands Regulation A, one of the exemptions to the limitations imposed on companies trying to capital.  Regulation A can now be relied upon for capital raises up to $50 million dollars, a significant increase from the previous limitation of $5 million.  There are also some changes that streamline the process of using Regulation A.

A new class of companies was also created by the JOBS Act  -  emerging growth companies or EGCs.  Generally, companies that earn less than $1 billion in annual revenue or have less than $700 million in public float would qualify.  An EGC cannot have more than $1 billion in non-convertible debt.  EGS will be given a five-year grace period to comply with Sarbanes-Oxley regulations related to internal controls and other disclosures.  To put in perspective how this might affect the IPO market, well over 90% of the initial public offerings since 1980 were by companies that earned less than $1 billion in sales. 

During Congressional hearings several individuals offered testimony suggesting that the JOBS Act might usher in a new wave of fraud.  More inexperienced participants, lower standards for disclosure, and less oversight of internal controls  -  it is a mix asking for trouble.  In my view, with the latter two provisions, we may have taken on a bit too much fraud risk for what we have gained in lower transaction cost or friction, but that is just me.  Just how far the door has swung open for abuse will become more measurable when the SEC issues its JOBS Act guidelines.

All the fraud talk aside, what has me interested in the JOBS Act is the potential to shift the capital markets from the cronyism of the present private offering and IPO processes to a more open and accessible market.  It might be very interesting for example, to see small biotechnology companies raise funds to support clinical trials through a more open process that would allow patients, physicians and the like to participate as individuals.  If crowd sourcing methods work for small companies and small capital raises, I expect the same tactics to filter into larger deals.  The JOBS Act was not necessarily intended to bring this about, but I think the genie has been let out of the bag.  

Fondomat (Russia)
PleaseFundUs  (UK)
Sponsume (UK)

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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