Markets In Action

How capital formation fuels business expansion, job growth and investment

A recent Project Invested article examined the worrisome decline in the number of emerging growth companies (EGC) taking advantage of the initial public offering (IPO) process in the capital markets to acquire financing.

As that article explained, the decline is troubling because fewer public companies can mean reduced economic growth, less job creation and fewer investment opportunities for average investors. The question is, what can be done to turn this trend around?

Increasingly, financial industry experts, policymakers and regulators point toward “capital formation” as a vital element needed to encourage business development and to help start-ups make the leap from private to public company. Let’s take a closer look at the concept of capital formation to better understand why it matters, particularly for the smaller and mid-sized businesses that constitute such an important part of the U.S. economy.

Why capital formation matters

“Capital formation,” in its financial sense, refers to the process through which a business acquires the capital it needs to launch, expand and continue growing. For different businesses, that process of building a pool of working capital will take different forms.

At the simplest level, imagine a small business launched by an owner with a bootstrap mentality, who taps her savings and credit cards, along with some additional investment from friends and family, to secure the capital she needs to transform her business plan into a business reality.

Or think of the founders of a promising new technology start-up pitching to angel investors and venture capitalists to convince them to provide the funding that will take the company from concept to a viable product. Or it could be an established public company seeking to expand into new markets, securing the financing they need from investors by issuing bonds (i.e., debt) or new stock (i.e., equity).

All of these examples describe the essential process of forming a pool of working capital to finance the business by drawing from multiple streams—and the more numerous and deeper the streams a business can draw from, the more capital it will be able to accumulate. With more capital, a growing company can grow faster, creating new jobs (and additional tax revenues) while driving the innovation we need.

The U.S. public capital markets are among the world’s most efficient allocators of the credit and capital that businesses need to grow. Yet in today’s marketplace, businesses are increasingly less likely to seek access to those markets, for a variety of reasons. Financial industry leaders point to the numbers that illustrate the decline.

“In 1996, we had 812 IPOs and small cap companies made up almost 50% of the offerings,” Warren Stephens, president and CEO of Stephens Inc., pointed out in 2017. “In 2016, we had 99 IPOs and small caps made up 13%. We’re doing something wrong.”

Brett Paschke, head of equity capital markets at William Blair, noted in a recent blog post for SIFMA that the number of publicly listed domestic U.S. companies peaked in 1996 at more than 8,000. Today, the total number of public companies is around 4,300, he wrote.

There are a number of reasons for the decline in the number of public companies, but one of the contributing factors is surely a burdensome regulatory regime that makes many companies wary of going public.

“I don’t think there is any doubt, as well-meaning as we have tried to be in our regulations, they have stifled growth, they have stifled capital formation,” Stephens added.

As a result, more start-ups that a few decades ago might have been candidates for an IPO instead opt to remain privately held. Instead, they may turn to private equity sources, or seek to become the target of a merger and acquisition with a larger entity. Such avenues can allow them to limit or sidestep the compliance burdens, regulatory scrutiny and shareholder demands associated with going public.

“This evolution matters,” Paschke wrote. “One important implication is that many startup companies are being built to be sold, as opposed to being built to be independent public companies. This often does not lead to the same level of expansion and job growth that a long life as an independent public company does.”

Ways to expand the IPO on-ramp

A consortium of groups interested in capital formation published a white paper, “Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public,” that lays out a number of policy changes that would promote greater capital formation and encourage more companies to go public. Among the report’s broad recommendations: 

  • Enhancing the 2012 Jump Start Our Business Start-Ups (JOBS) Act, which began the process of reducing regulatory and reporting burden on companies exploring IPOs.
  • Encouraging more research of Emerging Growth Companies (ECGs)s and other small public companies.
  • Improving corporate governance, disclosure, and other regulatory requirements to ease the IPO process.
  • Streamlining the financial reporting process for EGCs.
  • Tailoring equity market structure to better serve the capital needs of small public companies.

Meanwhile, regulators and policymakers have taken notice and are advocating for policy changes to encourage capital formation through markets.

One prominent example: In August, Jay Clayton, chairman of the Securities and Exchange Commission (SEC), spoke to a conference for entrepreneurs in Nashville, Tenn., to discuss how his regulatory agency is seeking to encourage greater dynamism in the small business and start-up sectors. Key to that goal is encouraging more capital formation through public markets. Part of the solution, Clayton said, is streamlining the regulatory process, while ensuring investor protections, to reduce the burdens of going public.

Importantly, Clayton emphasized that improving the rate of capital formation for emerging growth companies won’t just help the founders and early investors in those companies. Ultimately, it will also create new investment opportunities for all retail investors, a point he underscored in his Nashville presentation.

“For example, investors in these types of companies will have access to investment opportunities in more companies and will benefit from stronger and more complete disclosure than they would likely receive if companies continued to eschew the public markets as a matter of course,” Clayton said. “This is particularly the case for Main Street investors who generally do not have the opportunity to invest directly in high-quality private companies.”

Reversing the decline in the number of public companies won’t happen overnight—it will take sustained commitment over time. But with a renewed focus on reducing regulatory burdens and creating a policy environment that encourages capital formation through the public markets, policymakers can work with leaders from the corporate and financial world to set a new course.

Additional resources:

Expanding the On-Ramp report