July 20, 2006
IPOs on the Internet
The United States has long had an advantage over other countries in how it nurtures small businesses. IBM and Microsoft, among many others, both started in garages and grew to major companies.
That advantage is dissipating due to regulatory ossification.
A small business that needs to raise money to grow by selling ownership units, shares of stock, is regulated by the Securities Act of 1933. The Securities and Exchange Commission, responsible for implementing the act, crafted rules in the '30s when we were a paper and telephone based society.
We have been in the Internet Age for over ten years and we still have the paper and telephone based rules. The SEC has not adapted its rules to allow for the use of the Internet, and its cost savings, in raising money. Other countries have.
Here is how we still do it in the United States. A small company can sell shares in either a private or a public offering. In a private offering, the company cannot use the Internet to solicit buyers of its shares unless the money sought is small in amount and the company jumps through several regulatory hoops that are not worth the trouble given the small amount needed.
In a public offering, known as an IPO (Initial Public Offering), a small company must go through a full registration of its offering with the SEC. The registration offering process is based on the creation of a paper document, the prospectus, that must be delivered to offerees. The delivery of the shares revolves around the use on investment banks, underwriters, as intermediaries. The banks buy the shares and resell them to the public, taking a cut.
The underwriting process is very expensive and underwriters will only take companies that want to raise $50 million or more. A $50 million public placement will net a company only $45 million or so, a haircut of $5 million.
If small companies could use the Internet to solicit buyers and place their own shares, they would save a substantial amount of the haircut and could raise lesser amounts of cash – down to $20 million – in public offerings. But they cannot; it is illegal to do so.
The SEC has not approved the Internet offering process for small companies because they fear an increase the fraudulent fund raising activity and they worry about investors that do not have access to the Internet. I believe an increase in enforcement activity aimed at fraud is a better solution to the former concern than cumbersome procedural rules. The latter concern is silly; people who want to invest will find a way to access the Internet and many of such folks should not be investing in these stocks anyway. The small stocks are for the pros.
The truth of the matter is that the SEC suffers from regulatory ossification. It is reluctant to change its ways, that have worked in the past, in response to the new environment. The agency may make mistakes and will upset established market players, the investment banks who have political clout.
The result is that many of our companies are running to foreign markets to raise cash. The London Stock Exchange has started an Alternative Investment Market (AIM) that is luring United States companies to sell shares in London. Listing on the AIM costs less than half what the same listing would cost in the United States.
Not surprisingly, the number of IPOs in the United States is down but up in London. Allowing our small companies to use Internet solicitations would reverse the trend. If we do not wise up we are going to squander one of the country’s more precious economic advantages – the successful nurturing of small vibrant companies, companies that turn into international giants.
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