Dual Equities Pricing System Would Be A Boon to Job Creation

The U.S. initial public offering market is back. After plunging 94 percent—from nearly 500 IPOs in 2000 to just 27 in 2008—178 companies went public on U.S. exchanges last year, followed by 165 in just the first half of this year. While still significantly short of the mid-1990s pace of 500 or more annually, the sharp recovery has been enough to stoke talk in the markets recently of an IPO bubble.

What has not recovered, however, is the number of new and smaller companies going public. Of the 165 IPOs so far this year, less than 7 percent were valued below $50 million, and only 22 percent were valued below $1 billion. By stark contrast, 80 percent of the 3,000 companies that went public between 1991 and 1997 were valued at less than $50 million.

In testimony before Congress last year, David Weild, former vice chairman of NASDAQ and co-author of a recent study on the world’s 26 largest IPOs markets, stated, “In the 1990s, the U.S. was the top-ranked IPO market for both small and large IPOs. Today, despite having the world’s largest GDP, the U.S. ranking for small IPOs has fallen to a dismal 12th place.”

The collapse in small capitalization IPOs has come at tremendous cost to the U.S. economy, particularly with regard to job creation. According to research by tax and consulting firm Grant Thornton, the decline in IPOs since the late 1990s has cost the U.S. economy as many as 19 million new jobs.

Fortunately, a recent initiative by the Securities and Exchange Commission could reverse this devastating trend. On June 24th, the SEC directed U.S. stock exchanges to submit a plan to implement a 12-month pilot program that will widen minimum share price increments (tick sizes) for certain small capitalization stocks. The program could be a first step toward a dual pricing regime that would help correct one of the most vivid examples of unintended consequences in U.S. regulatory history, and would be a tremendous boon to capital formation and job creation.

In early 2000, the SEC, concerned that the fractional pricing of equities was leading to artificially wide spreads, hindering quote competition, and undermining the competitiveness of U.S. equity markets, ordered exchanges to submit a plan to implement decimal pricing. The decimalization of stock prices was completed in April of 2001, dropping the minimum tick size from one-sixteenth of a dollar, or 6.3 cents, to one penny. In a 2004 release, the SEC stated that decimalization had “reduced spreads, thus resulting in reduced trading costs for investors.”

But, according to many market participants and outside experts, decimalization also destroyed the economics that had supported the marketing, research, trading, and liquidity of small capitalization stocks, causing underwriters to all but abandon smaller IPOs. In October of 2011, a group of noted industry experts and practitioners, called the “IPO Task Force,” released a report stating:

Fewer small companies going public is highly problematic for a number of reasons. For example, because investors in new companies recover their capital and realize any returns only when financed companies go public or are bought by other companies, fewer IPOs means capital is tied up in existing investments for longer periods, rather than recycled into the next generation of new companies. According to the National Venture Capital Association, the average time between initial venture investment in new companies and venture-backed IPOs more than doubled between 1999 and 2009, from less than 5 years to more than 10.

Fewer IPOs, or companies waiting longer to go public, also reduces the opportunity for millions of investors to share in the wealth created by high-growth companies. Intel’s IPO in October of 1971, for example, just two years after the company’s founding, issued 350,000 shares, raising just $45 million in today’s dollars. Intel’s market capitalization has since risen to more than $150 billion, creating wealth for millions of employees and investors. By contrast, Facebook’s IPO in May of 2012—8 years after the company’s founding—issued 421 million shares, raising $16 billion and creating vast fortunes for comparatively few insiders.

Most importantly, fewer IPOs means fewer jobs. From the standpoint of job creation, IPOs are far more important than the sale of new companies to larger companies. Following the issuance of shares to the public, young companies are flush with cash to buy equipment, research potential markets, and develop and launch new products—all of which requires additional staff. According to the NVCA, over the past four decades more than 90 percent of the jobs created by rapidly growing new companies were created post-IPO. 

The Jump-Start Our Business Start-Ups, or JOBS, Act of 2012 directed the SEC to study how decimalization has affected the number of IPOs. In its report, submitted to Congress in July of 2012, SEC staff found that “the decline in smaller public company IPOs, and IPOs in general, coincides with the implementation of decimalization,” and that “in contrast to the United States, with its essentially flat, ‘one-size-fits-all’ tick size regime…many countries have percentage tick sizes that are four or more times wider than the United States.”

Under the SEC’s pilot program, certain stocks with a market capitalization of $5 billion or less, average daily trading volume of 1 million shares or less, and a share price of at least $2 will be traded at a minimum pricing increment of 5 cents. Whether 5 cent tick sizes and a year-long pilot program are analytically sufficient remains to be seen, but the initiative is an important step in the right direction.

Two parallel equity pricing regimes, operating side-by-side, would preserve the pricing and liquidity benefits of one-penny spreads in the market for larger company stocks, while also re-establishing the economic infrastructure necessary to support the research, underwriting, and liquidity upon which a thriving market for smaller IPOs depends. In doing so, a dual pricing system would help restore the link between emerging growth companies and investors who want to invest in them, helping more young companies access the public markets, with all the associated implications for economic growth and job creation.

John R. Dearie, Executive Vice President at the Financial Services Forum, is co-author of “Where the Jobs Are: Entrepreneurship and the Soul of the American Economy,” published by John Wiley & Sons.  You can follow him on Twitter here.  Mr. Dearie thanks Brent Bainwol for his contribution to this piece.

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