July 17, 2012
The past year has seen a number of developments in the U.S. markets that will affect small-cap companies and their ability to access the capital markets. Depending upon your perspective, these developments can be viewed as either positive or negative. The most substantive of these changes are the JOBS Act (Jumpstart Our Business Startups Act ) and the seasoning rules that relate to the ability of companies that have become public through reverse mergers with public shells to up-list their securities to a listed exchange such as NYSE-Amex or a national market such as NASDAQ. Other issues that are worth watching include the recent backlog of issuers seeking DTC eligibility and the potential affect of the SEC’s decision in favor of International Power Group Ltd , as well as the apparent move by many clearing firms to phase out clearing trades of “penny stocks” or accepting paper certificates.
As I have recently written two articles specifically addressing the JOBS Act and its potential impact on the markets, I will not devote substantial time in this article to that legislation. However, I remain cautiously optimistic that at least some of the elements of the JOBS Act will ultimately lead to increased capital formation for small-cap companies. Specifically, the ability to confidentially file registration statements by so called “Emerging Growth Companies” and the cessation of the ban on general solicitation and advertising in connection with certain private offerings targeted to accredited investors. I also believe that the changes to Regulation A could be a potential game changer for smaller companies. These changes include raising the limit on money raised pursuant to Regulation A from $5 million to $50 million and exempting these offerings from state Blue Sky merit based review. Unfortunately, at this point the SEC has not yet issued the specific rules that will govern Regulation A offerings under the new legislation and, as a result, it is too early to determine if these changes will provide a much needed catalyst to capital formation, as we all hope.
This past year also saw the implementation of seasoning rules for former shell companies that wish to up-list to a higher exchange. Under the new rules implemented by both NASDAQ and NYSE, companies that became public through a reverse merger with a public shell company will have wait at least one full year before they can apply to up-list to a higher exchange. Further, since the new rules require that any such company file at least a full year of Exchange reports, including a 10-K, depending upon when the reverse merger occurred, some companies may have to wait as long as two years post-reverse merger to be eligible to up-list. Although I understand the rationale of the exchanges and the SEC behind these new seasoning rules, the affect can only be to further limit the capital raising options of smaller companies. What this means for smaller companies seeking a public listing is that they (and their investors) will now have to choose between an extended stay on the over-the-counter markets or an alternative path to such listing, which may or may not be available.
Other issues that should be of deep concern to smaller companies is the difficulty to obtain DTC eligibility and the hostility of many clearing firms to lower priced securities. Fortunately, with regard to the first issue, the SEC in the International Power Group matter stated that DTC cannot simply deny eligibility to a company’s securities without giving such company a fair hearing. Hopefully, this will mark the beginning of the end of the slow down in receiving DTC eligibility for smaller issuers. If so, this would be a very positive development, as non-DTC eligible securities are much less attractive to investors since timing for clearing trades in such securities is questionable. Unfortunately, the related issues of the clearing firms phasing out clearing trades for penny stocks, as well acceptance of physical stock certificates, do not seem to be trending in a positive direction. Whether it is due to the perceived compliance risk with regard to handling smaller stocks or the higher cost of processing physical certificates, this is not a positive trend for small-cap public companies, as it creates yet another risk for investors that until recently was not present.
All that said, if you are the CEO of a small-cap company, is it still worthwhile to consider a public listing, and, if so, what is the best path to going public? I think the answer to the first question really depends on your company and whether you have other options available, such as venture capital, private equity, etc… Many companies do not have access to these latter two types of financing or, if they do, such investors will demand a controlling stake in the company before they invest. In this regard, the public markets still provide an attractive option to entrepreneurs, as the valuation they will receive as a public stock will usually be higher than they would receive from the venture capital or private equity investors. However, managers and shareholders of smaller companies that are considering a public listing should be aware that they will be entering a market with seemingly ever increasing regulation, which means increasing costs for compliance and increased personal risk for officers and directors.
With regard to the best method to go public, that also depends upon the company. What I can say with certainty is that reverse mergers have become substantially less attractive as a result of the new seasoning rules and the regulators’ undisguised animosity to this method of becoming public. For companies that may not be able attract an investment bank willing to commit to sponsor them for an IPO, I believe that self-underwritten public offerings will be a popular alternative. A self-underwritten offering is when a company files a registration statement without the support of an investment bank. These are complicated and will require patience in establishing a public market but they also lack the stigma and limitations of a reverse merger. Other options include, voluntarily registering your company’s stock under the Exchange Act on Form 10 and thus, becoming a public reporting company prior to having a public market for your stock. This option would provide greater visibility and surety with investors who may be reticent to invest in a purely private company. Finally, if the new rules for Regulation A are favorable, this may prove to be an attractive method for companies that are not yet public to raise capital, as the cost could be potentially much lower since a company that raises capital under Regulation is not required to immediately begin reporting under the Exchange Act.
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