Equal Opportunity Initial Public Offering (EO-IPO)
Leveling the Playing Field for Early Stage Investors
One of the chronic imperfections in the capital markets, is the natural disadvantage of early stage companies competing with later stage firms for scarce capital. Seed money necessary to fund startups is hard enough to come by when times are good and almost impossible when times are bad. Startups are naturally riskier than later stage firms, and their failure rate is dramatically higher.
As a consequence, family and friends and so-called angel investors (individuals or Group Angels) have been the lifeblood of early stage firms. The lure is the opportunity to get in on the ground floor and to cash in on the success of the company at “exit” time.
Everyone who takes investment risks dreams of hitting the jackpot with a thunderous success, small and large investors alike. “We’re looking for the next $10 million business, says David Hseih (Cisco Systems)… who have absolutely no access to capital to take a great idea and turn it into a business.” (1)
When the time comes to plan for the pursuit of an Initial Public Offering (IPO) the entrepreneur in the fledging company stands at a second disadvantage. Entrepreneurs can offer their initial small investors a guarantee that they can share in the capital gain that might result from a favorable stock price for the IPO. These early-stage investors have not, however, been guaranteed appreciation on anything beyond the limited amount of stock that they have purchased in the first place. Early-stage public investors have had little or no chance of being allocated the opportunity to purchase shares at the opening price on the effective date of a future IPO. (2)
Typically, dealers and underwriters of securities will allocate those IPO shares to their preferred accounts. Small investors who have born much of the risk, even if they were an initial investor who years before helped to establish the company now “going public,” are excluded because brokers with large accounts at the IPO’s investment banker co-opt the IPO for themselves and their most favored clients.
The disadvantage to early-stage investors is certainly not trivial. In their 2007 treatise, Dow, Martens and Toffanin said:
“Ritter and Welch (2002) report that, in a sample of 6,249 IPOs from 1970 through 2001, the average first-day return was 18.8%. They note that the comparable daily market return averaged only 0.05% … A recent investigation of the Internet frenzy of 1999-2000 conducted by Cao and Shi (2005) further corroborates the striking first-day return of the IPOs in that period, reaching an average 65% at the peak of the bubble.” (3)
The larger the IPO, and the more fully developed the company is, and the more attractive the IPO stock is expected to be, the greater is the likelihood that the small investor will be squeezed out. This happened to one of the co-authors of this article in the 2008 VISA IPO, when VISA was the U.S. largest IPO on record ($17.9 billion) in only a handful of firms going public nationally for the first time. There was intense competition for allocation of VISA’s $44 IPO shares. The morning of their first trading day, those IPO shares peaked at $68.
Years ago, the SEC recognized the dilemma of a small startup company trying to go public with limited resources, by simplifying the paperwork and burdensome stock registration restrictions on small U.S. or Canadian firms under an exemption – SEC Regulation A. Under this simplified rule, a small company can have stock and warrants registered with the SEC under minimum red tape and expense. Reg. A allows a venture to advertise publicly in order to “Test the Waters”. Gauging the response, the US or Canadian venture may elect to raise up to $5 million publicly in each 12 month period. The SEC was willing to ease the cumbersome S-1 IPO registration rules for small firms because they are acknowledged to be a nerve center of innovation, job generation and competitiveness in the economy.
Communities can attract new jobs because there is no means test – everyday Americans who happen to hear or read a venture’s general advertisements to “Test the Waters” can participate. Budget permitting, ad copy can be as lengthy as the entrepreneur likes. The public can be directed on-line to view long ads with graphics. While online, any adult U.S. resident of a “full disclosure” state can check a box indicating roughly how much they might invest provided that they like what is later disclosed, if and when the entrepreneur chooses to offer that resident shares in the new venture under Reg.A.
A New Lifeline for Entrepreneurs and Investors – A New Warrant
In 2009, against the backdrop of heavy public criticism for failing to regulate the financial service industry adequately, the SEC took another important step to level the playing field in IPO investing. The SEC has ruled in the petition brought by George W. Beard of Harrisburg, Pennsylvania, that Reg A offerings to the general public can include stock with warrants attached which guarantee the early-stage investors an opportunity to share in the IPO gain and then some, by a sweetener.
This SEC interpretation of Reg. A now allows entrepreneurs the privilege of marketing their shares under dramatically better conditions. After conducting a self-valuation of their venture, entrepreneurs in the USA and Canada can now utilize the new type of warrant to the Reg. A common equity share they will offer the general public. These new warrants will guarantee investors in the Reg. A offering the opportunity to purchase shares of any subsequent IPO equity offering at the opening price on the first day of trading. Wherever project vetting finds a startup to be potentially scalable enough to someday go for an Initial Public Offering, the new venture is now in a far better position to attract investors to the Reg. A offering.
The early-stage investor in turn, is in a better position to profit if the company eventually does go public. An investor in the Reg. A can reap the capital gain on his or her initial shares plus exercise the warrants for shares in the full-blown S-1 Initial Public Offering on its “effective date.”
Unfortunately, this new approach to exempt Reg. A public offerings is available to John Q. Public only in so-called “full disclosure” states such as New York, Illinois and Colorado where stock registration requirements are based only on full disclosure of what the company intends to do. By contrast, in “merit review” states, entrepreneurs generally must have invested ten percent of the offering. That requirement inevitably becomes an “American ingenuity” show stopper. For example, after spending $150,000 or more for their international patent protection and independent market research, very few entrepreneurs or inventors have the capital – an additional half-a-million – to satisfy these merit review requirements for registration of a $5 million Reg. A offering. Wealthy Americans qualify to invest wherever they reside. Furthermore, there are reported to be in excess of 6000 “accredited” investors in the New York, Illinois and Colorado combined, each having liquid assets in excess of $1 million. Moreover, under Reg. A exempt offering rules, there is no “means test” in these full disclosure states.
The Reg. A interpretation permits the long standing trading feature: both the initial shares and the warrants sold to the public via the Reg. A offering, directly by the company and/or by broker-dealers, can be quoted (4) on the Pink Sheets OTC (over-the-counter) electronic trading facility by registered brokers and dealers who are members of FINRA, the Financial Industry Regulatory Authority – a self-regulating nationwide association of securities dealers. Once a broker-dealer has filed Form 211 with FINRA, no merit review state in the nation denies its residents the right to buy these, or any securities, quoted in the “pinks” and traded in this secondary (OTC) market. (5)
Under the new Regulation A interpretation, the early stage investor is not shielded from downside risk any more than before. Due diligence on the technology, market potential, the valuation and competence of management still needs to take place before investors can be attracted. The Reg. A opportunity for a cold startup company to directly access up to $5 million of pure equity (no debt) from the general public, and up to $5 million more each year thereafter, will take on increasing importance in years to come (6) as the new warrants profoundly enhance the upside investment opportunity if the firm floats IPO shares. This changes the landscape for early stage entrepreneurship and investing across all industries.
Investors in the public shares of a Beacon Group BDC will be alerted to the opportunity to acquire a “ground floor” share in the BDC’s client’s private placement prior to any Reg. A offering. In 2009, the U.S. tax law was changed to eliminate 75% of capital gains tax on such investments if held for five years. While institutional investors in Beacon BDC (Business Development Company) shares may just wait for their tax-free stipend down the road when the BDC liquidates its position in a start-up client, John Q. Public may enjoy having two bites at the apple.
Lighting the Way to Make Ingenuity Pay
If the new Reg. A interpretation succeeds as expected in the disclosure states, who knows how far its leveling of the playing field in New York, Illinois and Colorado will spread to the other states seeking new employers. It has the potential to spur recovery for IPOs nation-wide. In any case, the innovation sector of the economy has just been given a potent shot in the arm – to the delight of the Obama administration, the entrepreneurial community, and early stage investors specifically.
President Obama summed up the new American Dream of reduced dependence on consumption spending and increased investment spending in a speech on April 14, 2009 titled The New Foundation at Georgetown University: “We can see a vision of America’s future, that is … a place where anyone from anywhere with a good idea … can live the Dream.”
1. Source: “ The Power of the Prize,” by Anya Kamenetz. http://smallbusiness.aol.com/article/_a/the-power-of-the-prize/20080515183209990001
2. Source: “Equal Opportunity IPO Brings Innovation Back to Main Street,” October 8, 2008, by Amy Bauman, http://www.microatm.com/blog/?p=623
3. Source: “IPOs in the Upside Down World of Overvalued Equity,” March 15, 2007, page 4, by Dow, Martens and Toffanin, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972666http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972666
See also “The Stock Spinners” by James Surowiecki, Jan. 16, 1998 www.slate.com/id/2636, and “The Bribe Effect” J. Surowiecki, Oct. 7, 2002 , The New Yorker, Financial Page
4. Common shares bought in the Reg. A can be quoted without delay – warrants after one year.
5. The author expresses appreciation to Attorney Robert L. Slater of NYC for his wise counsel and advice on the legal technicalities of SEC Regulation A. Robert L. Slater & Associates, LLC is a unique practice located just off Wall Street and practicing both corporate securities and intellectual property law. E-mail Slater@aol.com
6. “Venture to Nowhere,” Forbes.com, January 12, 2009, by Rebecca Buckman
Lighting the Way to Make Ingenuity Pay© is the mission statement of Beacon Investment Partners, LLC dedicated to the vetting and public finance of scalable early-stage ventures in the US and Canada.
About the Authors
Vincent A. Fulmer is a co-founder of the M.I.T. Enterprise Forum and a member of its Executive Board. He is a nationally recognized advocate of entrepreneurship.
George W. Beard is Managing Member of Beacon Investment Partners, LLC (Delaware, USA) and founder and CEO of KeepTrack USA. KeepTrack is a development-stage physical cargo security and supply chain IT firm. KeepTrack features a portable Katie Bar® internal locking platform for containers which securely incorporates patented sensing and imaging while offering every innovator an “open” standard, “plug-and-play” bus and an open application programming interface (API).
FORWARD LOOKING STATEMENTS
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