JOBS Act Interview: David Weild on Capital Formation and Small Tick Sizes

Henry Truc |

While small businesses and new technologies are important to the U.S. economy, the majority of the public may not understand just how critical this area of the market is for the future. More importantly, most people don't understand how much this segment needs to be nurtured and consequently, how much it has been neglected over the years. While the JOBS Act as a very significant step in the right direction toward fixing this issue, it really is just the start. In our previous interviews with Congressman David Schweikert and David Feldman of Richardson & Patel, we discussed some of the concerns and improvements that is addressed in the JOBS Act.

To get a better understanding of where these problems may have started and what still needs to be addressed, Equities.com spoke with David Weild, Head of Capital Markets for Grant Thornton LLP, a noted expert on capital formation and market structure, and driving force behind the creation of JOBS Act. Weild has testified in Congress and at the Securities and Exchange Commission on structure issues affecting the stock market and economy. His research, along with co-author Ed Kim, on the collapse of the IPO market has been cited by academics, major financial publications and lawmakers, and has been a fundamental influence on pushing these topics to the forefront of important conversations that led to the JOBS Act.

EQ: One of the major goals of the JOBS Act is to help emerging growth companies and startups to access capital, which would translate into helping the overall economy grow. Why is this area of the market so vital to the economy's recovery and future growth?

Weild: The vast majority of job growth occurs in the private economy and private markets, and there has been work done by organizations like the Kauffman Foundation that essentially demonstrates that. There’s also been work that has been done that shows most of the job growth at a company will occur after they go public. When you put those two things together, then you start to understand that if you want to accelerate job growth where it traditionally occurs in the private markets, you have to accelerate the rate of investment in private companies, and there’s nothing like a successful IPO market to give people the confidence that they will be able to ultimately succeed and reach the brass ring. It instills confidence in private companies, and encourages investors to start looking at investing in private companies. There’s a virtuous circle effect, if you will, that’s created where companies go public, then people take cash off the table to invest into new private companies and ideas, which accelerates innovations, thus creating jobs, and then it repeats when people take money back out after going public again. If the IPO market is compromised, then the entire economy bumps along at a lower level.

EQ: You've been a major advocate of the JOBS Act. Can you discuss the role that you've played and why it is important to you?

Weild: I had been disturbed for years at what I felt was a steady erosion in our capital markets in the United States. The problem was that there really was no longitudinal historical information that simplified and allowed the laymen to understand what was happening in the market. The decline wasn't a market cycle issue; it was secular structural issue. So a lot of people on Wall Street would go out and say that the IPO window had closed, implying that it was just a rough patch but that there was nothing wrong with the stock market itself. We knew that wasn’t the case, and we also knew that there were other people that shared our view. The problem was that nobody had pulled the information together in a way the laymen would understand.

So we wrote the first paper Why Are IPOs In the ICU in 2008, and the press started to pick it up gradually. It then started to get circulated among Wall Street and ultimately onto Capitol Hill. It allowed people to see that we had a real serious problem with how market structure was impacting capital formation. I’m talking about the whole package ranging from regulation to the way stocks are traded, and it served as the foundation for the discussion. A lot of people have said, and I think it’s true, that if it wasn't for the studies we wrote and published, then there might be no JOBS Act. It’s what put everyone on the set and got them to start the discussion.

In fact, I got Kate Mitchell, who was at the time chairman of the National Venture Capital Association, interested in the IPO problem. She became the chairman of the IPO Task Force whose report to the U.S. Treasury ultimately became Title I of the JOBS Act. She took a real active interest in the IPO market in general and she stayed involved as an active voice in this market.

There have been a number of Congressmen and Senators that have cited our work. Democrat Senator Ted Kaufman from Delaware, who was the chief of staff to Joe Biden and his appointee when the vice president left the senate, started to sound the alarm before the Flash Crash on some of these market structure issues. He picked up our capital formation argument and spoke on the floor of the U.S. Senate and, specifically citing us said, “Show me, Mr. President, how we can bring back the $25 million IPO and then we’ll get America back to business.” Senator Kaufman’s Chief of Staff, Jeff Connaughton, introduced me to the Executive Branch to a Senior Policy Advisor and on September 7, 2011 he reached out asking questions about the IPO market.  The next day, President Obama spoke about helping the IPO market in his “Jobs speech.”  Senator Johnson, who chairs the Senate Banking Committee has been very thoughtful.

In the House of Representatives, Congressman David Schweikert of Arizona, who is the Vice Chairman of the House Subcommittee on Capital Markets, has read everything that we've published. He authored several provisions in the JOBS Act including the Title that will  increase the permitted size of Regulation A offerings from $5 million to $50 million. We’ve also had people like Congressman Ed Royce of California and Congressman Patrick McHenry of North Carolina, who sponsored the Crowdfunding Title, and many others, Republicans and Democrats, who are aware of our published work in this area. There’s also New Jersey Representative Scott Garrett, who is Chairman of the House Subcommittee on Capital Markets, and even all the way up to Representative Spencer Bachus of Alabama, who is Chairman of the Financial Service Committee for the House of Representatives. So our work has helped to frame  the problem and getting people motivated to address these issues.

EQ: Looking particularly at the IPO market and the drop off in the last decade. How has that impacted the public markets and the economy?

Weild: The headline is that we think the collapse of the small IPO has cost the U.S. economy about 10 million jobs. When you look at where we started to have jobs problems in the U.S., it occurred shortly after the drop off in the small IPO, which occurred in 1998 during the dot com bubble. It’s one of the reasons why that discovery of ours is rather notable. Most people thought the IPO market was fine during the dot com bubble of 1998 to 2000, and that it wasn’t until the end of 2000 when it imploded.   So people don’t think to look at 1998 and what happened there. What happened was we switched market structure from a quote-based market where people still had to get on the phone to execute most large trades to one that ushered in the  age of electronic order execution in progressively smaller tick sizes (A “tick size” is the smallest increment that a security can be quoted in – 1 penny today). This shift collapsed the economic incentive to support small caps stocks, which tend to trade at lower volumes. That was probably not a big issue for large cap stocks, which trade with natural liquidity, but it was absolutely catastrophic to the small cap market. Over the next 14 years, we ended up averaging about 126 IPOs a year, versus the prior decade where we averaged over 500 IPOs. When you go back to the 1980s, we were doing 350 to 400 IPOs a year. So our capacity to manufacture and support IPOs and those stocks in the aftermarket was destroyed by the loss of the economic incentive required to support small companies once they’re public and the firms that provided support to small cap companies. Most people think it started with decimalization in 2001, and a lot of the academics will look at decimalization and say they don’t see any profound effect. That’s because the damage was already done but it was obscured by this great bull market going on in 1998 during the height of the dot com bubble.

As a result, from peak to trough—peak being 1997 to the end of 2011—the number of listed companies in the U.S. stock market has declined every single year. We've now lost over 43.5 percent of all publicly listed companies from the NASDAQ, New York Stock Exchange, and AMEX, and it’s actually epic in terms of impact on the economy. That is why it’s so absolutely critical that we fix it. When you do the math—and we’ve done it—where you pace the growth of the IPO market with GDP growth of 3 percent, we end up with a range that predicts that we should be doing anywhere from 600 to 1,200 IPOs a year. Yet, right now we’re averaging 126 IPOs. So when you take the difference between what we should be doing and what we’re actually doing, and combine it with the Kauffman Foundation numbers, assume just  one incremental job in the private market per one incremental job in the public market, you very quickly get up to numbers like 10 millions jobs. It’s really profound and I think a reasonable person looking at that would realize that pulling the rug out from under the IPO and small cap markets  must be having a depressive effect on the economy.

We have to reverse that trend. It’s just that simple, and that’s what all of our work is geared to doing down in Congress. We need to grow the economic pie for the American people.   Let’s stop arguing about who gets a bigger slice of the pie. Let’s figure out how everybody can profit by getting back to basics and doing those things that will contribute to growth the U.S. economy.  This is one of them.

EQ: The impact of smaller tick sizes has received some attention, but is still largely an area that most don’t fully understand. Can you talk about your new study that digs deeper into the issue?

Weild: It’s very clear that our work isn’t done. Our new study, The Trouble with Small Tick Sizes, will hopefully contribute to that process as well. We think that larger tick sizes will bring back capital formation, jobs, and investor confidence. We maintain that we need the JOBS Act Part Two because we still haven’t addressed the economic incentives that are required to put the rug of support back under small and microcap stocks in the U.S. stock market. There was a window opened by the JOBS Act: Title I Section 106(b) of the JOBS Act is  entitled “Tick Sizes”. It required the SEC to report on the impact of decimalization on capital formation and authorized them to increase tick sizes. The SEC was rushed in its report and concluded that the subject would require further study. I know from my conversations with the SEC and on Capitol Hill, that everyone is very interested in how tick sizes might help bring back support for public companies and help to drive capital formation and job growth.

The argument we make is that penny tick sizes and an electronic order driven market may work for large cap stocks because they trade with natural liquidity and don’t need  external support. However, the natural state of the small and microcap stocks is that they trade with little natural liquidity and visibility – so they need help in staying visible and liquid. An increase in economic incentives through tick sizes is likely essential to pay for visibility creation (research and sales) and liquidity creation (capital commitment by traders). Right now, the United States has a one-size-fits all model which is ridiculous when you understand how different the small cap markets are from the larger cap markets? Small cap stocks (sub $2 billion in market value) make up only 6.6 percent in market value, yet they include 81 percent of all listed companies.

So the problem with small microcap and nanocap stocks is that they trade asymmetrically: There will be a big buyer and no seller, or a big seller and no buyer. So what happens is institutional and professional investors, because they can’t get liquidity in these names, start to back away. Then you have stock prices declining and lagging the market, and issuers rightly begin to shy away from what has become a dysfunctional market. Company managements spend more and more of their time  trying to do investor relations that previously was shouldered by Wall Street and the stock market becomes less and less responsive to news. It the stock trades at a discount to where it should be, at some point, management takes the company out of the stock market – whether through a trade-sale or a going private transaction. That’s a sign that this market structure just doesn’t work for companies of all sizes – when the number of delistings is consistently higher than the number of listings. Today, every stock  trades at a penny tick size whether you’re Intel, Exxon, or some $50 million tiny nano cap company. It’s just not smart.

EQ: How has this lack of incentive to serve the small cap market affected the financial industry and the institutions that operate in this space?

Weild: Many small investment banks have cut support for small public companies. Others have simply thrown in the towel: Thomas Weisel Partners sold out to Stifel Nicolaus. Think Equity shut its doors recently on October 17, 2012. We hear that other firms are in trouble. The cash equities business must be profitable to the firms that serve the small-cap market or the “IPO On Ramp” (as Title I of the JOBS Act is called) becomes “The On Ramp to Nowhere.” There are lots of firms that have wanted to get back into that business of taking small caps public and a lot of people have tried and a lot of people have busted their picks on that rock. The reason why we have not seen a reemergence of firms like the “Four Horsemen” (Alex Brown, Hambrecht & Quist, Robertson Stephens and Montgomery Securities) is because the economic incentives and opportunities needed to support those businesses have been stripped out of the market. The real loser is the American consumer who has lost jobs, tax revenues, and municipal services when municipalities are unable  to hire as many teachers, firemen, police officers, etc. Penny tick size and electronic market structure has created an incredibly “vicious cycle.” Until you restore the appropriate economic incentives, you’re not going to get America back in business, at least not through the equities markets. The corporate market is your long-term source for innovation and high quality jobs, and you really need the stock market to work for the entrepreneur. If it doesn’t, then one of the most important tools in the toolkit of the U.S. economy is compromised.

EQ: Do you feel that small companies understand the benefits of the JOBS Act enough yet? How can they be helped to increase their awareness of the advantages?

Weild: The SEC’s web site serves as a focal point for the dissemination of information – especially answers to FAQs (Frequently Asked Questions). From there,  securities law firms write about the Act and its implementation and disseminate analysis to clients via seminars, blogs, webinars and other outlets. Morrison & Foerster LLP has a good blog, as does Wilson Sonsini Goodrich & Rosati out in Silicon Valley ..  Richardson Patel, who was a sponsor of this webinar with Congressman Scwheikert, is extremely focused on smaller companies and has had an active dialog with the SEC. Grant Thornton has been very active. I have been a keynote speaker for at least two events or webinars a week since the summer ended. The media plays a big role too. So information gets distributed broadly into the market, but it takes time to develop into standard practice. It is further complicated by the fact that  the SEC hasn’t fully promulgated rules on everything yet either. In fact, the frustration for some in the market and some in Congress is that many of the rules just literally have not been written yet by the SEC for implementation.   Obviously, there can be no benefit to the economy until those rules (especially Reg. D, Reg. A and Crowdfunding) are written and approved by the SEC.

The major exception to that is Title I of the JOBS Act, which is the emerging growth company classification. It allows companies to file confidentially with the SEC and just about everybody is filing confidentially now. It allows companies to test the waters and so I think there’s a big sigh of relief. A lot of companies were actually speaking to institutional investors prior to doing IPOs, but this creates a bright line safe harbor to de-risk transactions by engaging in conversations with institutional investors to test the waters. This allows companies to see what investors are thinking and whether the market will be there if they go public. It’s important because the failure rates on IPOs have gone up consistently over the last 15 years as the sales incentives collapsed with  Regulation ATS and decimalization in 1998 and 2001, respectively.

EQ: What is the purpose of the upcoming webcast? What do you hope to accomplish?

Weild: There are a lot of mistaken beliefs in the market about the things that harm it. We've done a great job of getting everybody to understand that the IPO market is depressed for self-inflicted (mostly SEC) structural reasons. However, people need to understand which structural changes caused which problems if we are going to be able to fix them. It’s not what everybody thinks. It’s not Sarbanes Oxley, and it’s not decimalization. You have to go back to 1998 where the small IPO fell off a cliff and see that  the SEC converted the stock market from one that was quote-based to one that was electronic-order based. This shift dropped  economic incentives from what was a 25 cents per share spread to a much smaller “tick size” of as little as 3.125 cents. .We literally lost 75 to 87.5 percent of the economics in the market with one fell swoop in 1998. That’s the fact that’s lost on the vast majority of people. What people don’t realize is there was this great flesh-eating bacteria that was unleashed on the bottom of the market through the compression of the economic incentive. Once you understand that, then you understand why it really is important to get more carrot in the right place to support small and microcap stocks. There has to be economic incentives put back into the model.

I believe that education on the real issues is absolutely critical. Knowledge is power and the more we can frame the problems in a way that people will understand, the higher the likelihood that people will seek solutions. In a way, we need to reach a tipping point where the forces of enlightenment outweigh the forces of naivety. So it’s an opportunity to educate and broaden the message. We’re a nation where our political system reacts because large numbers of people start to say that these things are important, so what I can do is to serve as a catalyst to help frame the arguments. Then it’s up to you to internalize this knowledge and to do something with it effect the kinds of changes that we need to get America back in business.

For more on the JOBS Act, be sure to visit Equities.com’s JOBS Act Section:
Equities.com JOBS Act Section

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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