How Shutting Small Companies Out of the IPO Market Hurts the Economy

For small businesses that can't get a bank loan, this year's uptick in IPOs reinforces another hard truth: They also stand little chance of raising money by going public. While that's not exactly news, it does highlight the difficulty such enterprises face raising the capital they need to grow.

From 1991 to 1997, nearly 80 percent of U.S. companies that went public raised $50 million or less. Offerings in the $10 million range were common. But changes in the capital markets -- including the rising dominance of big banks -- has put an end to that.

In 2009, the median IPO was $140 million. The companies that are making it out of the gate these days, such as Tesla Motors (TSLA), Oasis Petroleum (OAS) and Accretive Health (AH), are, by historical standards, raising big bucks. This year is shaping up to be no different, as investors await blockbuster offerings from GM, private equity firm KKR and (gulp!) Facebook, among others giants in the IPO queue.

Why we should we care? One word -- jobs. Small companies account for the lion's share of new employment in the U.S. Shutting these businesses out of the public market deprives them of a key source of capital. That hurts entrepreneurs, diminishing the economy's ability to renew itself.

As the chart above indicates, the trend toward bigger IPOs began in the mid-1990s, before the Internet boom. In a recent report, accounting and consulting firm Grant Thorton identifies a number of factors that have driven this shift over the last 25 years:

• Wall Street's growing focus on trading, especially of the high-speed variety, means big banks have less interest in meeting the needs of long-term equity investors.
• Financial industry consolidation has put the investment banking boutiques that once catered to smaller companies out of business.
• Issuance in 1996 of the "Manning Rule," along with other stock order-handling regulations, made it less profitable for financial firms to take small-cap companies to market.
• Regulation Fair Disclosure, a 2000 rule that requires all public companies to disclose material information to all investors at the same time, inadvertently decreased the volume of stock research. That makes it hard for investors to get information about small companies.
• Adoption of decimal pricing for stocks in 2001 reduced trading spreads, further eroding the economic incentives for investment firms to deal in small-cap stocks.
• Venture capitalists in recent years have increasingly relied on selling companies, not IPOs, to generate the "liquidity events" their investors demand. That means many small companies are acquired before they seek capital in the public markets.

But let's not forget about the small company IPOs that have worked out rather well. Intel (INTC) raised a meager $8 million in going public in 1971, while Microsoft (MSFT) netted roughly $60 million in going out in the mid-'80s, just to name two.

Of course, more small firms going public is no panacea for unemployment and faltering economic growth. That's a much larger issue, as my colleague Carter Dougherty noted yesterday in assessing Intel CEO Andy Grove's economic prescriptions.

But the virtual extinction of small IPOs, coupled with the broader decline in new offerings, compounds our problems. Fewer IPOs means that less capital is made available for companies to create jobs. The vicious cycle is completed as investor interest in smaller companies withers away. Sen. Ted Kaufman, D.-Del., summed up the risks well in a speech last year about how to get the U.S. economy back on track:

Now I am deeply concerned there is a choke point in our efforts to return to economic vibrancy, a choke point that can be found on Wall Street. Our capital markets, which have long been the envy of the world, are no longer performing one of their most essential functions; that is, the constant and reliable channeling of capital through the public sale of company stock, known as initial public offerings -- or IPOs -- which small companies use to innovate and, most importantly, to create jobs.

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