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The Cost of Regulation on Small-cap Companies

The scandals of major corporations like Enron and others in the banking industry caused a significant tightening up of regulations in the securities industry. As a result, large corporations scrambled to keep pace with new expectations for compliance. Fortunately, they had the financial resources to do so. That hasn’t been the case with many smaller corporations, which found that the cost of compliance affected their bottom-line profitability, causing many of them to lose their standing as publicly traded companies. Start-up companies are questioning whether it’s worth their while to become public companies. There are rumblings on Wall Street about how the regulations need to be modified to make it feasible for a larger number of smaller corporations to compete in the public market.

The Cost of Regulation Is Prohibitive for Small-cap Companies

The number of initial public offerings (IPOs) in the United States dropped drastically after the financial crisis of 2008. The SEC heard the cries of smaller corporations about the financial impact of the Sarbanes-Oxley Act (SOX) regulations against their bottom lines. Their research shows that the average cost of achieving regulatory compliance to enter the marketplace as an IPO is about $2.5 million. Once they are established, small-cap companies can expect to pay about $1.5 million in ongoing compliance costs every year.

Increased Cost of Liability

Small- and mid-cap companies are finding that the pressures to comply with the requirements of SOX and the increases in penalties have substantially increased the potential for civil and criminal liabilities that directors and officers face on a daily basis. Smaller corporations need to take risks in order to grow, but fear of liability concerns is holding them back and creating a culture of caution. Insurance companies are also concerned about potential payouts over liability concerns, and are making it more difficult for small- and mid-cap companies to get Directors’ and Officers’ liability coverage.

Increased Costs Related to Director Search and Compensation

The new regulations require companies of all sizes to include independent directors and qualified financial experts on their boards of directors. Small and mid-sized companies are finding it hard to keep up with the level of compensation that qualified directors expect. Companies can also reasonably expect to incur fees for executive search firms to help them find the right people.

Increased Audit and Legal Expenses

SOX increased the standards for financial accounting, controls and disclosure, causing publicly traded companies to rely more heavily on accounting, auditing and legal services. The increased demand for such services has driven up costs in those industries. Studies have shown the impact of increased audit and legal fees for small- and mid-cap companies have risen to $89,000–$170,000.

Increased Costs for Software and IT

Many corporations are now relying on software programs to help them comply with the financial disclosure regulations. Ongoing costs of keeping software updated, employee training and consulting services can cost corporations fees in the hundreds of thousands of dollars.

Costs of Outsourcing Services

Some of the new compliance regulations are easier for larger corporations to implement. For example, corporations of all sizes are required to have whistleblower policies. Small and mid-sized corporations are finding that the only way that they can adequately meet the requirements of their whistleblower policies is to outsource the responsibility for them to an independent third party.

Productivity Losses Yield Lost Revenue

All of the attention on satisfying compliance measures takes away from the focus on daily sales and other operations, which is also affecting bottom-line profitability, although the amount of lost revenue is difficult to quantify. A study by Foley & Lardner showed a 247% increase in lost productivity costs.

Benefits of Scaling Regulations for Small- and Mid-cap Companies

Small- and mid-cap companies are the leaders in innovation. Their efforts lead to newer, better products. Smaller companies also create most of the jobs across the country, so enhancing their viability will create demand for jobs, which creates careers for our college graduates and others. Increased innovation and job creation will have a trickle-down effect and improve the overall economy.

Financial experts are discussing the possibility of scaling down regulations for small and mid-sized companies to make mandatory disclosures reasonable for the size of the corporation. Changes in regulations would also promote efficiency and capital growth.

JOBS Act Is a Good Start

The Jumpstart Our Business Startups Act (JOBS) passed in April 2012, and it was a good effort toward aiding smaller corporations with the effects of stricter regulations. The goal of JOBS was to relax some of the regulations that the SOX Act created on small-cap companies.

JOBS allows companies to engage in certain forms of solicitation that were previously prohibited, like crowdfunding platforms such as GoFundMe, Indiegogo, Kickstarter and Fundable.

The JOBS Act gives the smaller corporations a fighting chance to stay in the market and gives the larger corporations some healthy competition.

The JOBS Act only applies to companies that sold common equity after December 8, 2011, so it didn’t help all smaller companies. JOBS also makes an exception for small-cap companies to enter the marketplace. They can now go public with only $1 billion in revenue and a public offering of less than $700 million as an “emerging growth company” (EGC).

What Reforms Would Help Small- and Mid-cap Corporations?

Some financial experts believe that it wouldn’t be that difficult to make it easier for small- and mid-cap companies to continue competing in the open market. What would it take? A good start would be to create some surveys that would clarify the types of increased costs that are driving small caps out of the market. Impactful regulatory reforms would require input from smaller firms and the U.S. Government Accountability Office (GAO). Perhaps taking a closer look at eliminating the requirements that do little or nothing to protect investors and scaling disclosure requirements would be good places to start.

Small-cap Companies Are Weighing the Decision to Go Public

The increased costs of being publicly traded are causing many small-cap companies to revisit their reasons for being a public company. Being public gives them the benefit of achieving the liquidity that certain investors expect and gives them non-cash currency for growth and acquisitions. It’s also a way to obtain cheap capital for the company.

In addition, publicly traded companies attract quality jobseekers because they want the opportunity for profit sharing and the prestige of working for a known brand name.

SOX has made things so difficult for companies that many of them are wondering if they have enough to gain by going public, or if they are better off as a large, private company.

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