The Broken Small-Cap Market Undermines the RecoveryAdam J. Epstein
From Main Street to Wall Street, most conversations about publicly traded companies dwell upon iconic American enterprises such as Apple, Procter & Gamble, and Pfizer. In reading the headlines of most newspapers or listening for a few minutes to any financial TV show, you could easily be excused for thinking that all publicly traded entities are enormous, multinational corporations.
In reality, the overwhelming majority of public companies are small. Nearly eight out of every 10 public companies in the U.S. have market capitalizations (the total value of the issued shares of a public company) of less than $500 million. More specifically, the median equity value of a U.S. company listed on a senior exchange such as Nasdaq is only $418 million, and an eye-opening 40 percent of those companies have market capitalizations smaller than $250 million (PDF), according to recent research from Keating Capital. For comparison, the market capitalization of General Electric is about $250 billion.
While they don’t often capture the spotlight, small public companies are crucial job creators. For example, a 2010 Kauffman Foundation report (PDF) on job creation concluded that without fast-growing, early stage companies, domestic job growth over the last 35 years would actually have been negative. And according to National Venture Capital Association statistics, 92 percent of job creation in early stage companies occurs after their initial public offerings. As the Securities and Exchange Commission’s Advisory Committee on Small and Emerging Companies (ACSEC) set forth in its Feb. 1 meeting notes (PDF), small reporting companies “have historically played a significant role as drivers of economic activity, innovation and job creation in the United States.”
Here’s the rub: Multiple years into an economic recovery characterized by anemic job growth, the small public company market is fundamentally broken. Since 2000 the number of companies that have disappeared from U.S. stock markets is double the number of IPOs that took place during the same period. Almost 30 percent of senior exchange-listed companies today have no equity research coverage.
Last month, ACSEC met in Washington to discuss, among other things, recommendations to enhance the capital markets ecosystem for small public companies. ACSEC’s nonbinding recommendations (PDF) were courageous, timely, and spot-on. (I have no involvement in ACSEC). The committee is wise to recommend that small reporting companies be treated differently than large public companies—and be permitted, among other things, to select their own tick sizes (the smallest increment by which the price of a stock can move).
Fretting over tick sizes might appear misplaced to a casual observer, but starting around 1998, the revenue potential per share traded for market makers began to plummet, from 25¢ all the way to 1¢, where it resides today. Indeed, their uniform decrease has eroded the profit incentives of the small-cap capital markets, as David Weild, former vice chairman of Nasdaq, has written (PDF) and said extensively. The results have been diminished trading volume, market-making, and equity research, undermining small companies that need capital to sustain themselves and expand.
Fixing the marketplace for small public companies won’t be so simple as just adopting ACSEC’s recommendations. It also requires changes that can’t be legislated. The most important is to address a mindset that pervades the corporate governance community: the conviction that governing a large company is the same as governing a small company.
One-size-fits-all corporate governance doesn’t work because small public companies have a fraction of the resources of their larger counterparts. Limitations include smaller, less-diverse boards of directors, less-experienced management teams, and business-ending risks that crop up daily. Succinctly, one-size-fits-all corporate governance ensures that the tens of thousands of directors who shepherd small public companies for risk-embracing shareholders have nowhere to go for help with their unique challenges. The best way to start fixing this problem is through continuing education, with particular emphasis upon the most complex risk that small public companies face—raising growth capital.
Most small public companies don’t generate sufficient cash flow to finance their operations and growth, so vast amounts of governance resources are focused on corporate finance. The hurdles facing small companies that raise money bear virtually no resemblance to issues arising out of elective financings undertaken by large public companies. Navigating the challenges poorly has dire consequences for small public companies. But these companies rarely have cash to hire capital-markets and corporate-finance experts as directors, and there is nowhere to turn for objective guidance. That’s why continuing education in this regard is so badly needed.
Having co-managed a hedge fund that invested in more than 500 small-cap financings, I am confident that as long as the corporate governance community continues to act as if governing Chevron is the same thing as governing a cash-strapped, $150 million biotech company, directors of small public companies will continue to struggle mightily. This will ultimately short-circuit corporate growth and hiring—and thus harm the economic recovery.