Obama seems determined to roll back the few remaining elements of the New Deal. As we’ve recounted, he’s keen to cut Medicare and Social Security; he said as much in a dinner with leading conservative luminaries shortly after his inauguration. And his JOBS Act, which guts securities law protections on smaller stock offerings, is touted as a way to increase employment by helping to fund smaller businesses. In reality, the only jobs it is likely to create will be due to the resulting explosion in stock scamsters and bucket shop operators.
Amar Bhide, who has written the classic, The Origin and Evolution of New Businesses, has decisively debunked the idea underlying the Obama Bucket Shop act, which is that public stock offering are an important source of funding for new businesses. The problem is, as Bhide explained, is that academics focus on the easy to study but relatively inconsequential venture capital funded companies which look to IPOs as an exit. Bhide found that only 1% of new and young businesses were funded by venture capital. Similarly, his multi-year study of Inc 500 companies found that a comparatively small portion had VC backing, and even then, many got VCs in at a late stage, not because they needed the money but having the “right” VCs would lead to a much bigger premium when they went public.
Bhide found that most new businesses are based on an insight about an business opportunity that the founders discovered as employees (ie, they saw a market niche that incumbents were ignoring). These ventures were funded by savings, friends and family, and credit cards.
Similarly, the idea of venture capital or stock promoter funding as some sort of boon for entrepreneurs is wildly overstated. I’ve gotten involved in some early stage tech deals. One of the people I worked with often, an attorney buddy who was tech and deal savvy, viewed VC as the absolute least preferred source of funding. She was very creative about getting vendor finance or getting advances on licenses. Selling equity in early stage companies is not only costly, but you are one step away from losing your control over your destiny. I’ve seen cases where the founder was ousted (and the business tanked afterwards) not because he wasn’t performing, but other members of the team conspired against him (and persuaded the dunbnick VCs that they were better operators). Even in healthier relationships, it’s altogether too common for the VCs to confuse aggressive babysitting with effective and productive oversight.
And this isn’t just my view. The value added of venture capital is questionable. It produces stock-market type returns with more volatility. A colleague who founded a successful venture capital firm left when it went to do a second round of funding (the junior partners stayed on). He gave a long form, compelling analysis as to why: when you actually went through the numbers, the returns to the entire asset class depended on the returns of a very few firms, and even at them, of a very very few deals (And the indirect proof was his firm was raising money having realized profits on only about 1/3 of its portfolio; you’d have to accept their view of how the rest would turn out to think it was worth joining their new fund).
And funding via cheap stock operators is even worse. I had a client wind up getting funded by a Florida pink sheets player (he had an existing business that was being spun out of a bank; they actively undermined the effort which is why he wound up where he wound up). They backed his business into a public shell they had sitting around. It was simply fodder for them to run the price up and down. They eventually merged that company into another one at not-worth-all-the-trouble price for the management team, which has restricted stock and weren’t able to exit during the phase when the touts were having fun playing the stock.
Moreover, the idea that small businesses aren’t being formed or hiring has much to do with access to equity funding is bunk. Surveys of small businesses continue to show that they are cautious on the staffing front (there has been a small uptick in hiring plans from a low base). The big reason is uncertainty, meaning uncertainty over demand for their products and services. New businesses have even tougher sledding than existing ones. Better access to costly equity (even if that resulted) is not what is constraining new business formation or hiring by small businesses. It’s the crappy state of the economy.
Simon Johnson and Bill Black have attacked the other obvious flaw of this bill: it’s terrible for the US capital markets. In the 1990s, the US equity market was the deepest and most liquid not just because the US was a big economy, but also because investors had confidence that tough rules on disclosure and prohibitions against insider trading and abuses like front-runnning protected them.
Johnson stresses that the bill will increase rather than lower the cost of capital for young firms:
The premise is that the economy and startups are being held back by regulation, a favorite theme of House Republicans for the past 3 ½ years – ignoring completely the banking crisis that caused the recession. Which regulations are supposedly to blame?
The bill’s proponents point out that Initial Public Offerings (IPOs) of stock are way down. That is true – but that is also exactly what you should expect when the economy teeters on the brink of an economic depression and then struggles to recover because households’ still have a great deal of debt. And the longer term trends over the past decade are global – and much more about the declining profitability of small business, rather than the specifics of regulation in the US (see this testimony by Jay Ritter).
Professor Ritter, a leading expert on IPOs, put it this way:
I do not think that the bills being considered will result in a flood of companies going public. I do not think that these bills will result in noticeably higher economic growth and job creation.
In fact, he also argued that the measures under consideration “might be to reduce capital formation.”
Professor John Coates hit the nail on the head:
While the various proposals being considered have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing, in similar ways, the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand. (See p.3 of this December 2011 testimony.)
In other words, you will be ripped off more. Knowing this, any smart investor will want to be better compensated for investing in a particular firm – this raises, not lowers, the cost of capital. The effect on job creation is likely to be negative, not positive.
Sensible securities laws protect everyone – including entrepreneurs who can raise capital more cheaply. The only people who lose out are those who prefer to run scams of various kinds.
Bill Black, in a letter opposing the bill, is more curt:
The “Jumpstart Our Business Startups” Act, the comically forced effort to create a catchy acronym, is the most cynical bill to emerge from a cynical Congress and Administration. It is an exemplar of why Congressional approval ratings are well below those of used car dealers. The JOBS Act is something only a financial scavenger could love. It will create a fraud-friendly and fraud-enhancing environment. It will add to the unprecedented level of financial fraud by our most elite CEOS that has devastated the U.S. and European economies and cost over 20 million people their jobs. Financial fraud is a prime jobs killer.
Deregulation was the root of the financial crisis just past, but no on in the administration seems to have gotten the memo. This bill is astonishingly wrong-headed., which means it is par for the course for Team Obama.