The Federal Government’s Role in Limiting Business Funding
When the stock market crashed in October 1929, public confidence in the markets collapsed. Investors large and small, as well as the banks that had loaned to them, lost great sums of money in the ensuing Great Depression. For the economy to recover, the public’s faith in the capital markets needed to be restored, so Congress held hearings to identify the problems and search for solutions.
The SEC and the first securities laws
During the peak year of the Depression, Congress passed the Securities Act of 1933. This law and the Securities Exchange Act of 1934 (which created the Securities and Exchange Commission [SEC]) were designed to increase public trust in the capital markets by requiring uniform disclosure of information about public securities and establishing rules for honest dealings.
The main purposes of these laws can be reduced to two common-sense notions:
Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they’re selling, and the risks involved in investing.
People who sell and trade securities — brokers, dealers, and exchanges — must treat investors fairly and honestly, putting investors’ interests first.
Monitoring the securities industry requires a highly coordinated effort, so Congress established the SEC to enforce the newly passed securities laws to promote stability in the markets and, most important, to protect investors.
The Securities Exchange Act of 1934 requires that issuing companies register distributions of securities (stocks) with the SEC prior to interstate sales of these securities. This way, investors have access to basic financial information about issuing companies and risks involved in investing in the securities in question.
The SEC was founded in an era that was ripe for reform. The 1933 and 1934 laws set the way the capital markets would function for about the next 50 years.
Regulation D: Defining accredited investors
From 1933 to 1982, the way business was conducted in the U.S. capital markets stayed relatively unchanged. In 1982, the SEC adopted Regulation D, which established three exemptions from the registration requirements under the Securities Act of 1933. The term exemptions is used because the updates enabled some companies, in certain situations, to issue securities without the requirement to register them with the SEC.
Included within Regulation D’s definitions was the term accredited investor. The SEC adopted two definitions of the term, one based on net worth and the other based on income:
Net worth criteria: Under the net worth test, an accredited investor is someone who, at the time when she purchases a security, has a net worth of $1 million or more, not including the value of her primary residence. (Note that net worth could be the individual’s net worth alone or that of herself and her spouse.)
Income criteria: Under the income-based definition, an accredited investor is someone with individual income above $200,000 during the two most recent years or with joint income (with a spouse) above $300,000 in each of the two most recent years. (This person also should expect to achieve a similar income in the current year.)
Why do these criteria matter to you? Because prior to the 2012 JOBS Act, a company issuing stock to investors had to restrict the number of unaccredited investors it sold to. If you were starting a small business raising less than $5 million in securities in 2010 and wanted equity investors, you could have only 35 unaccredited investors. (You could have an unlimited number of accredited investors.)
This structure allowed for your closest supporters (your mom and a handful of other cheerleaders) to become equity owners in your business while preventing you from roping hundreds or thousands of other people into investing in a company that might carry loads of risk.
In the pre-Internet world, sounds reasonable, right? Unfortunately, the side effect of this regulation was that small investors found themselves largely shut out of some of the most lucrative investments (such as technology startups), and small businesses and startups found themselves relatively restricted when trying to raise funds.
Plus, the underlying implication of the definition is that small investors are, by virtue of their smallness, less educated, sophisticated, or knowledgeable about risk than larger investors.
The effects of Sarbanes-Oxley on small businesses
The 1990s and early 2000s saw the rise of a whole new level of financial engineering: the creation of financial structures and instruments that allowed corporations greater flexibility (and much greater risk) in their investments. Most of the time, the “flexibility” really was code for leverage (the practice of betting on the direction of a stock’s, or other financial instrument’s, movement).
The larger the bet on the direction, the larger the risk (and losses) if the stock moved in the opposite direction. When corporate bets worked as planned, companies showed significant gains. What happened when these bets soured?
Enron was an energy, commodities, and services company based in Houston, Texas. Between 1995 and 2000, it was called one of America’s most innovative companies. Enron filed for bankruptcy in December 2001, and several of its top corporate officers were later convicted of financial crimes. These executives were hiding huge losses in offshore accounts that were not reported in Enron’s financial statements, and their “engineering” finally collapsed.
In July 2002, just seven months after Enron’s demise, WorldCom also declared bankruptcy after using fraudulent accounting and finance practices to hide losses and inflate revenues. Again, the company’s collapse led to thousands of job losses and billions of dollars of stockholder losses.
With back-to-back, multi-billion-dollar business failures that were based on accounting and finance fraud, the federal government was pressed to enact significantly enhanced financial regulations. As a result, the Sarbanes-Oxley Act of 2002 (commonly referred to as SOX) was the largest overhaul of federal securities laws since the 1930s. It covered a wide range of corporate governance, accounting, industry analyst relations, and financial reporting issues.
Although well intentioned, SOX had enormous unintended consequences for all businesses and the public capital markets. These negative consequences were most profound for small businesses that were interested in going public to raise capital. Because SOX treated all companies (regardless of size, industry, geography, or market) exactly the same, all companies faced a similar burden related to regulatory costs.
This setup may seem reasonable at first blush, but imagine a mom-and-pop store trying to achieve the same reporting and accounting standards followed by a Fortune 500 company; it can’t be done.
Effectively, SOX ensured that if your business is worth less than $100 million, it makes zero financial sense to go public. That’s because, in order to execute an initial public offering (IPO), you’d spend millions of dollars, and then your annual compliance fees would be well over $1 million. That fact effectively closed the IPO market for all but the largest corporations and dramatically reduced small businesses’ access to capital.
Tighten capital access with Dodd-Frank
The financial crisis of 2008 was rooted largely in real estate and sub-prime mortgages (and financial engineering and leverage). The financial regulation that responded to it was called the Dodd-Frank Act. Among its consequences, Dodd-Frank significantly limited homeowners’ ability to use credit cards or lines of credit on their homes to finance new businesses.
Granted, many people had been getting into trouble because they used such lines of credit like free ATMs, so regulation seemed necessary. But prior to Dodd-Frank, equity lines of credit and credit cards were very common (and in some cases viable) ways to access capital to start or grow a business.