Regulators must facilitate new age of easier-access capital formation

The U.S. capital market is diverse and multi-dimensional. Its simple objective is to raise and distribute capital from a society of investors to a deserving group of builders and inventors seeking a return on their ideas and hard work.

For too long, though, the barriers to entry for such wealth distribution have been substantial, primarily restrained by financial intermediaries holding on to their “good old boy” ways. Slowly, technology is making disruption at the nexus of capital raising and making capital ownership easier, spurred on by both public policy and financial intermediaries elbowing each other out to get a bigger piece of a declining pie.

Raising capital is a private activity engaged in by the moneyed-class even in publically-traded markets. The ability to participate at the point of capital raising, those first rounds of financing, has been closed to the vast majority of investors.

{mosads}Capital is initially raised through direct negotiation with a go-to set of investors — venture capitalists, angel investors, private equity firms, institutional investors and friends and family. Thereafter, further rounds of financing are offered to previously excluded/former declining investors as interest is invigorated by the investment’s performance.

Again it is distributed privately at a price determined by negotiation. Eventually, the expectation is that the privately-negotiated prices are less than the prices determined by a larger population’s demand when the offer is made in public markets, thus providing an early profit and exit opportunity for those who were offered the opportunity to invest before others.

The early financing rounds are usually the riskiest part of capital raising, where significant returns are to be made before the public is offered a chance to invest. Therefore, it is argued, those who took risk at pennies on the dollar are allowed to offer these investments to others at multiples of a dollar, when ideas turn into companies making money for their investors. These ownership shares are then offered in the public markets through exchanges, dealers in securities and other trading venues.

Shares are offered only in digital form (stock certificates were eliminated long ago) where computers determine supply and demand and set prices. Anyone with a connected computer and a brokerage account can buy and sell these shares. This digitization has opened up a vast new opportunity for alternate mechanisms for automating capital raising and share distribution. 

In 2012, the Jumpstart Our Business Startups Act (JOBS Act) was passed to help fund small businesses as a step to increasing employment. This act is permitting small businesses to go public and raise up to $50 million from all investors directly, not relying on the moneyed-class to raise seed capital in the private markets.

Exchanges are opening up to these innovations. In one instance, the NYSE is allowing one small company to list its securities directly, having no support or earlier introduction by an investment bank — the usual procedure for such offerings. More broadly, the NYSE is looking to permit any-sized direct offerings and has requested their regulator — the SEC — to sanction this approach. In so doing, they will be cutting out the middlemen — primarily the investment bankers. 

Such direct offerings were tried before, in a different form. The most memorable of these attempts was the Initial Public Offering (IPO) of Google in 2004. Using the internet’s improved access afforded to all interested parties, an electronic auction was conducted.

After a few weeks of accepting online bids, the offering price was set at the lowest price at which all shares could be sold. Still, the offering fell short of accommodating all the demand in the market, as witnessed by the subsequent day’s secondary market trading, which saw a further run up in Google’s stock price.

Google’s IPO was considered a failure as it underpriced its shares. Bankers drummed home the message that money saved in underwriting fees was dwarfed by the amount Google left on the table through the underpricing.

It was a hollow argument given the behavior of investment banks during the dot-com boom of 1998-2000. Back then, critics accused them of underpricing IPOs — discounting the share price on the day of the offering — to curry favor with the institutional buyers, effectively failing to maximize funding for the sponsoring company. One estimate had underpricing of IPOs between 1999-2000 at $62 billion.

Fast forward to 2010 and General Motors’ (GM) conventional IPO run by a syndicate of established investment bankers. Here the U.S. government missed the opportunity to use GM to resurrect the online internet IPO auction by offering stock to all U.S. taxpayers who by then, owing to the bailout by our government, owned GM.

In a more recent IPO, that of Facebook, its founder chose not to offer its shares directly to its clients, the billion or so who used Facebook, in favor of a conventional IPO. How appropriate it would have been to have Facebook set the direct placement trend anew. In so doing, it would have set itself apart as an innovator in financial services as it had done in social networking. Also, by so doing, Facebook’s founders would have reinforced their professed culture of transparency and democracy.

Already, a next generation of financial technology disruptors are exerting pressure on the entrenched intermediaries in the capital market supply chain. Dwindling IPO revenues are also taking a toll.

Government policymakers would be wise to focus on a comprehensive review rather than responding to one-off requests for changes in policy. The SEC, in particular, needs to clarify policy on such innovations as direct listings and trading of digital assets, but within a comprehensive framework, lest we incrementally move our already fragmented capital markets toward further unintended consequences.

Allan Grody is the president of Financial InterGroup Advisors — strategists, consultants and researchers in financial services with particular focus on bank regulation. Grody is also an editorial board member of the Journal of Risk Management in Financial Institutions. His work, writings and research focus on the intersection of risk, regulation, data and technology.

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