Should I Stay or Should I Grow? Small Business Owners Struggle to Expand

Hundreds of small business owners have acknowledged the discouraging reality that they cannot afford to go public. The Initial Public Offering market (IPO) for small and micro-capital companies is drying up for several reasons.

Beginning with the post-9/11 economic downturn and continuing with the passage of The Sarbanes–Oxley Act of 2002, the traditional IPO model (the small startup) has continued its slow and steady deterioration with help of recent events including the credit crisis and financial meltdown of 2008.

Several recent articles illustrate this unfortunate trend. For instance, in a story published in The Star Tribune, columnist Wendy Lee writes that "Venture capital investment in Minnesota companies plummeted 48 percent to $139.5 million in 2010."

The story continues, "To make matters worse, Minnesota has gotten a smaller slice of the venture capital pie. Minnesota ranked 19th on average in quarterly tallies of venture capital investment last year, Hare said. That compared with ninth in 2007."

The IPO market is not faring any better in the South. Take for example the state of Georgia, where it "produced $69.95 million in venture capital, drawn from 13 deals for the first quarter of 2011, a big drop from first-quarter of 2010, when [Georgia] posted $118.55 million garnered from 16 deals. Georgia also sagged from the fourth quarter of 2010, when 13 deals brought in $102.51 million."

Perhaps the outlook is better in the West.

Colorado "plunged from 27 deals and $256.20 million in the fourth quarter to 15 deals and 63.13 million in first quarter 2011."

Nope.

Despite this bleak outlook, there is one small scrap of positive news: "[venture capital] put $6.4 billion to work in U.S. companies in Q1, a 35% increase over Q1 2010," VentureSource reported. However, even this good news is short-lived when one takes into account venture capital deals have remained stubbornly stagnant, growing by only 5 percent.

Although there is clearly a problem, there may still be hope; not all is lost.

First, it is important to understand that new business startups are an essential element in determining and sustaining the long-term economic growth of our economy. Businesses and the people who own them generate jobs and wealth, not the government. Although the government can help to foster new business development, it generally can do very little to provide the initial capital and support necessary for the start-up phase.

This is the responsibility of the business owner and it is usually accomplished through "seed" capital generated by a full-time job, personal savings, the sale of assets such as cars and boats, borrowing against the family home, or loans from family members.

After making the initial investment, the business owner may decide that he wants to go public with his company in order to finance its continued growth and expansion. In a perfect world, he would make an Initial Public Offering.

There are several advantages to an IPO. One of them is that the amount of equity capital that can be raised in the public equity market is usually larger than the amount that can be raised through private sources. There are literally millions of investors in public stock markets and it is easier for companies to reach these investors for financial aid rather than rely on the amounts that they might raise from private firms.

Another example: after a firm has completed an IPO, supplementary equity capital can be raised through Secondary Market Offerings (SEO) at a low cost. This is because the public markets are liquid and investors are more likely to pay higher prices for the liquid shares of a public organization than for the relatively illiquid shares of a private firm. This enables the entrepreneur to diversify his portfolio or to sell shares in order to kick back a little and enjoy his success.

IPOs also enable business owners to attract top management—while incentivizing current managers—because senior executives generally own equity in the firm with a part of their compensation tied to the firm's stock. It is a well known fact that publicly traded companies more easily attract top-notch employees because the financial information pertaining to its success and profitability is readily available.

Finally, investing in an IPO does not mean that the owner loses control by going public: he only gives up whatever portion will allow him to raise the necessary funds.

Despite the advantages of IPOs, making a move in this direction has become a nightmare for small business owners. There are several reasons for this.

First, there are the obvious risks and costs involved. The costs are due to the fact that the stock is not "seasoned," that is, it does not have an established record. The likely liquidity of a stock that is sold in an IPO is not entirely known and therefore its value is uncertain. For this reason, investors are less comfortable buying a stock sold in an IPO and will not pay as high a price for it as they would for a similarly seasoned stock in a mature company.

In addition, the out-of-pocket costs, such as legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes can substantially add to the cost of making an IPO.

Next, small businesses owners have to worry about the Securities and Exchange Commission (SEC) and its mountain of regulations.

Since the imposition of several SEC directives (among them the law that demands that companies have "a measurement metric that is self-calibrating; a standardized measurement and methodology for computing market capitalization," and "a date for determining total market capitalization"), the process of going public has become a labyrinth of expensive red tape. Complying with ongoing SEC disclosure requirements has become a financial burden that most startups are either unwilling or unable to bear.

According to Chartered Financial Analyst Dr. Robert Parrino, "Once a firm goes public, it must meet a myriad of filing and other requirements imposed by the SEC. For larger firms, these regulatory costs are not terribly important because they represent a relatively small fraction of the total equity value. However, regulatory costs can be significant for small firms."

Furthermore, "the requirement that firms provide the public with detailed financial statements, detailed information on executive compensation, information about the firm's strategic initiatives, and so forth can put the firm at a competitive disadvantage relative to private firms that are not required to disclose such information."

Why go public with so much at risk?

Many investors also believe that the requirement for IPOs to forecast their quarterly earnings and financial statements encourages managers and investors to focus only on the short-term profit of the company rather than its long-term value. In the event that a company fails to meet its quarterly forecasts, a company will usually see its stock value drop and its investors scatter (regardless of whether or not the forecasts were realistic).

Some have attempted to address these issues. According to an article in The Wall Street Journal, the SEC could be "moving toward sweeping new rulemaking in a number of areas that impact capital raising by small businesses."

The Wall Street Journal article based its focus on an Apr. 6, 2011 letter from SEC Chairman Mary Shapiro to Congressman Darrell E. Issa in which Shapiro discusses the aforementioned disadvantages that SEC regulations have imposed on startups. However, it is very doubtful that these concerns will be addressed in a timely manner.

As if existing SEC regulations, Sarbox and the recession were not harmful enough, there is one more disincentive against making an IPO. The House of Representatives recently decided to pass HR 4213 which contains "a provision to change the taxation of carried interest from capital gains to 75 percent ordinary income and 25 percent capital gains."

Surely, someone in Washington understands that there needs to be a meaningful tax incentive for investors to consider a long-term investment with a startup company. How can business owners be expected to afford all of this?

The obvious result of this perfect storm has been for entrepreneurs to shy away from expansion.

Suzanne McGee writes in Portfolio.com , "only a dozen IPOs of U.S. companies have made their way to market so far this year, according to data from Dealogic, while another eight have been postponed or withdrawn."

"I think that what is going on in the wider universe, the global economic issues, weigh on psychology and sentiment, and that is affecting demand for IPOs far more than fundamentals are at the moment," said Dan Cummings, head of Americas Equity Capital Markets for Bank of America Merrill Lynch.

The best solution to this mountain of discouragement is not immediately clear.

Ultimately, it comes down to risk (which is considered a dirty word among investors). Entrepreneurs and venture capitalists will simply have to decide whether or not they would rather coast on safe but low-yielding investments or whether they are willing to gamble on a prospect that might flop.

As long as the bootstrap mentality is alive and as long as investors are willing to take risks, IPOs will remain active. However, what would really assist the IPO market, what would really breathe some life into it, would be the easing of Federal regulations and the introduction of tax-break incentives. Give the investors a reason to risk their capital. Give them room to grow and they will produce and provide.