This is a guest post by Scott Kupor, managing partner, Andreessen Horowitz.
We are holding back the middle class in America. But it’s not for the reasons you think, and the culprits are not those most people think of. Rather, the US government has systematically cut the middle class out of the most important wealth creation opportunity for the next 50 years. Through a series of byzantine regulations, the government has made it virtually impossible for working Americans to enjoy the fruits of America’s greatest strength: innovation.
Over the past decade or so, regulatory changes have reduced the frequency with which the stocks of high-growth companies get offered to the public during their most dramatic phases of growth. That prevents ordinary investors from getting in on the wealth creation, and hampers the creation of middle class jobs. Fortunately, there’s a simple solution.
We’ll get to that shortly. But first let’s look at the cases of two companies founded by Harvard drop-outs.
Microsoft went public in 1986 at roughly a $500 million market cap. Today, Microsoft has a market cap of $234 billion. Thus, the public investors in Microsoft have had the opportunity to realize $233.5 billion in market cap appreciation; the private investors had only a $500 million head-start. From IPO, a single share of Microsoft stock has appreciated close to 500x.
Facebook, by contrast, went public in 2012 at roughly a $100 billion market cap. That means that, whatever public stock price appreciation Facebook has over the coming years, private investors have had a $100 billion head-start against the public investors. Even if you were prescient enough to buy Facebook at its public low of approximately a $50 billion market cap, the private investors remain way ahead. If you bought Facebook stock at its IPO, to realize a similar multiple that Microsoft’s public shareholders have earned, Facebook’s market cap would need to reach nearly $50 trillion, roughly the size of the total market capitalization of all publicly-traded companies in the world.
What accounts for the differences between these two cases?
Up until the last decade, about 300 start-up companies went public each year, with more than half of those companies raising less than $50 million in proceeds (small IPOs.) The average age of the companies at the time of IPO was just under five years old.
Fast forward to the most recent decade and fewer than 100 companies each year have gone public, with less than one-third of those being small IPOs. The average age of the companies going public has also roughly doubled to 9.4 years.
Why should we care if the world has fewer billionaire public company founders and CEOs?
Because IPOs democratize wealth creation and create jobs for the 99.9% of Americans who are unlikely to be the next Zuckerberg, fueling long-term economic growth for the country and guaranteeing access for all to the American Dream.
Indeed, we are quickly creating a two-tiered investment market—one for wealthy, accredited individuals and financial institutions and a second for the remaining 96% of Americans.
If you are an accredited investor (which the rules define as someone with annual income of at least $200,000 or a net worth of $1,000,000), you can buy or sell privately-held stock of high growth, startup companies via exchanges such as Second Market and SharesPost. If you are an accredited investor, you can become a limited partner in one of over 400 venture capital firms that invest in such companies. If you are an accredited investor, you can buy privately held stock of such companies directly from the issuing companies themselves.
However, If you are among the 96% of Americans that are not accredited investors, you can wait the 9.4 years that it takes for the average startup to go public and miss out on all of the price appreciation in the private markets that inures to the benefit of accredited investors.
Despite the many very positive changes introduced by Congress via the 2012 Jumpstart our Business Start-up Act (or the JOBS Act), the middle class remains sidelined. On the one hand, the JOBS Act potentially exacerbates the already “long time to IPO problem” by increasing to 2,000 the number of shareholders a private company may have before it is required to report as a public company.
Yet, in the same JOBS Act, we welcome “the 96%” least-wealthy Americans to invest (via crowdfunding) in the absolute riskiest stage of new company formation—early, seed-stage financings. Somehow, we have concluded that unaccredited investors should be able to likely lose their hard-earned money by investing in the most risky of asset classes. Yet precisely as the risk diminishes dramatically in the subsequent stages of a company’s development, the spoils go only to the wealthy. As veteran investor Steve Rattner pointed out recently, most Americans would have better odds of winning the lottery than of successfully investing in seed-stage companies.
There’s another important implication of the changes that have lengthened startups’ path to IPOs. On average, the Kaufman Foundation estimates that companies that go public increase their post-IPO employment levels by approximately 45%. More significantly, for small IPOs, that number more than triples to 156%. This makes sense—an IPO is a capital raising event for a company. That new capital, in turn, is invested by the company to increase growth, which requires more employees to achieve.
Had we not seen IPO volumes fall off of a cliff in the last decade, the Kaufman Foundation estimates that we would have created an estimated 1.9 million new jobs. Even more significantly, Professor Enrico Moretti of UC Berkeley has identified a multiplier effect with technology-related jobs. For every one new technology job, Professor Enrico estimates that five new service sector jobs are created.
To put the job numbers in context, the number of total US employees in 2001 was just shy of 138 million people; 10 years later, that number was only 139 million. Thus, the potential to add a minimum of two million jobs—and potentially more with the multiplier effect—to an otherwise stagnant employment environment is immense.
What’s the solution?
A number of policy and market changes—all with well-intentioned goals—have created a hostile environment for new IPOs and, in particular, for small IPOs. Arguably the most significant among the changes was the 2001 move to decimalization. Much has been written about the “death star” of decimalization, a phrase first coined by David Weild, former vice chairman of Nasdaq. But simply stated, decimalization eliminated all of the profits from trading small-capitalization stocks. How did this happen? Because decimalization reduced the “tick size,” the minimum increment in which stock prices can trade, to a penny (from its previous level of 25 cents). Thus, a trader who previously might have purchased a block of small-cap shares knowing that a $0.25 tick size likely represented his minimum profit potential on a trade now found his minimum profit potential reduced to a penny. Facing this uneconomic situation, small-cap traders simply abandoned the market, killing liquidity for these stocks.
The 2003 Global Research Settlement (which prohibited investment banking revenue from subsidizing investment research) proved the final death knell. Pre-decimalization and pre-Global Research Settlement, traders of small IPOs could actually make money, and profits from this trading activity subsidized the publication of investment research for small IPOs. Thus, the double whammy of these two policy changes not only sucked all of the profits out of trading the stocks of small IPOs—making it very difficult for these companies to build liquidity by attracting retail investors—but also choked off the use of trading profits to fund research on these companies. Lacking the ample liquidity that active trading desks and investment research create, newly public small IPOs simply can’t attract new, long-term shareholders, raise new capital and ultimately grow their businesses.
All hope is not lost, however.
The simple act of jettisoning decimalization would resuscitate the small-cap IPO market. And the US Securities and Exchange Commission already has the authority under the JOBS Act to make this happen. The SEC could test this change in the form of a broad, intermediate-term pilot and could even provide boards of directors of small IPO issuers the discretion to determine whether doing so would be in the best interests of the company and its shareholders.
Here’s what higher “tick sizes” will mean:
—Trading desks will commit capital to trading small-cap stocks.
—Research analysts will cover small-cap stocks.
—Institutional sales desks will market small-cap stocks to their clients.
—Retail investors will return to this market.
As a result, we will increase liquidity and reduce volatility for small-cap stocks, shocking the small-cap IPO market back to life and breaking the shackles that are holding back the middle class.