Academic journal article Journal of Applied Finance

Reenergizing the IPO Market

Academic journal article Journal of Applied Finance

Reenergizing the IPO Market

Article excerpt

*From 1980-2000, an annual average of 310 operating companies went public in the United States. During 20012012, on average, only 99 operating companies went public.' This decline occurred in spite of the doubling of real gross domestic product (GDP) during this 33-year period. The decline was even more severe for small-company initial public offerings (IPOs), for which the average volume dropped 83 percent, from 165 IPOs a year during 1980-2000 to only 28 a year during 2001-2012. Figure 4-1 illustrates the pattem on a year-by-year basis for both small and big companies. Small and big companies are defined on the basis of inflation-adjusted (2009 dollars) annual sales in the twelve months prior to going public, using a cutoff of $50 million to define small and big.

Many commentators have been alarmed at this prolonged drop in small-company IPOs, since it is the conventional wisdom that companies going public create many jobs. The Wall Street Journal editorial page has bought into this argument, as has Congress, culminating in the April 2012 passage of the Jumpstart Our Business Startups (JOBS) Act.

The JOBS Act is intended to encourage the funding of small businesses, primarily by easing various securities regulations. The JOBS Act, among other things, encourages crowdfunding; eliminates restrictions on general solicitation (that is, permits advertising securities offerings to the general public); creates a category of firms, emerging growth companies, defined as firms with less than $1 billion in annual sales, and for their first five years as public companies exempts them from certain regulations, including some of the Sarbanes-Oxley regulations; increases the number of shareholders of record from 500 to 2,000 before public disclosure requirements are triggered; eliminates "quiet period" restrictions that had prohibited the analysts working for underwriters from publicly making buy and sell recommendations at the time of an IPO; raises the Regulation A limit on securities offerings for which there are fewer regulatory requirements from $5 million to $50 million; and requires the SEC to conduct a study on "the impact that decimalization has had on the number of initial public offerings."

In this paper, I address why IPO volume, and especially small-company IPO volume, has been so depressed for more than a decade. The conventional wisdom is that the main culprits are a combination of heavy-handed regulation, especially the Sarbanes-Oxley (SOX) Act of 2002, a decline in analyst coverage of small firms, and lower stock prices since the 2000 technology bubble burst. I present an alternative explanation-the economies of scope hypothesis-that has very different policy implications. I also discuss the effect of tick sizes on the IPO market, as this is the current focus of policy recommendations from the SEC's Advisory Committee on Small and Emerging Companies. I then discuss the number of jobs created by companies going public and the effect of alternative venues for cashing out and raising capital, SecondMarket and SharesPost. Lastly, I offer some thoughts on what can and should be done to reenergize the IPO market.

Heavy-Handed Regulation

The most common explanation for the decline in IPO activity is a series of regulatory changes, with the SarbanesOxley Act of2002 shouldering the greatest blame. Motivated by the securities frauds perpetrated by WorldCom and Enron, Section 404 of SOX requires external audits of the internal control systems of publicly traded companies to ensure that their financial reports are accurate.2 Following complaints that the Section 404 compliance costs were excessively high for small firms, at the end of 2007 small firms were exempted from many of the requirements.

If SOX costs were a major impediment to being public for small companies, small-company IPOs should have rebounded after 2007. Of course, the Panic of 2008 would have delayed this rebound, but 2010, 2011, and 2012 saw fewer, not more, small-company IPOs than in each year from 2004 to 2007. …

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