All Dried Up?

Market Fissures

Shifts Affecting Small Businesses

Sweeping changes in stock market bode ill for small-business financing-both public and private.

Magazine Contributor

November 1, 2000 9 min read

This story appears in the November 2000 issue of Entrepreneurs Start-Ups magazine. Subscribe »

Spunky Productions is about as much on the leading edge as a business can get. As a digital media company, the San Francisco firm is producing and syndicating what co-founder Karl Kronenberger, 32, calls one of the largest collections of original Web-based interactive cartoons and live-action programs for children in the world.

Plus, Spunky Productions is at the crossroads of one of the hottest trends in Hollywood: the distribution of entertainment content over the Internet. According to Kronenberger, "Many international media companies who can't own cable or television assets in the United States see the Internet as a viable distribution channel for entering the U.S. market." Moreover, he says, the entertainment industry will be in for another radical redefinition when the next generation of wireless Internet products come to market during the latter half of 2001.

The incredible opportunities that companies like Spunky Productions are pursuing require more than just creative genius and an audience, however. They require capital, and lots of it. And growth capital is getting harder to find, because investors are getting much more cautious. A sell-off of Internet stocks notwithstanding, the reasons for this change are more systemic and, in fact, threaten the longest-running economic expansion in U.S. history.

David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business (Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public, and is a member of the National Advisory Committee for the SBA.

Investment banker Kenneth Kamen, co-founder of Princeton, New Jersey-based Princeton Securities Corp. and chair of the trade group Regional Investment Bankers Association (RIBA), suggests the culprit for this ominous prediction is, surprisingly, the stock market itself. Specifically, he says, the markets are evolving and changing in ways that are tremendous for large companies and institutional investors but disastrous for small companies looking for capital, like Spunky Productions.

Based on this evolution, Kamen posits the following scenario as potentially very dangerous to the economic prosperity of the country. More precisely, as the markets get regulated into a posture that emphasizes large companies over small ones, the appetite for IPOs dries up. Venture capital investors and angel investors, seeing their exit strategies disappearing, pull in their horns and dramatically reduce the number and dollar amounts of investments they make in promising entrepreneurial businesses. Suddenly, the volume of venture capital tumbles from 1999's volume of some $50 billion to the $5 billion that the National Venture Capital Association says was more typical in the early '90s.

In many ways, the fissure has already begun. Consider these statistics: RIBA, which consists of investment banking firms that focus on IPOs of $20 million or less, has seen the number of deals completed by its members fall off dramatically as the markets have focused on larger companies. For instance, during 1994, association members completed 190 offerings and raised $2.3 billion. In 1999, the number was 38 offerings for $228 million. But the numbers provided by RIBA aren't the final word. After all, not every investment banker who provides services to small businesses is a member of the association. Yet, as a proxy for overall market activity, the trend they indicate is clear: The stock markets are less receptive to small businesses. Says Kamen, "It's not the investment bankers who are suffering from this decline, it's the companies looking for capital." history.

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According to Kamen, some of the more fundamental shifts that have worked against small businesses include:

The emergence of ECNs. Electronic Communications Networks (ECNs) represent a new, more efficient way for institutional investors to access and trade in the market. And groups like Institnet, Island and Archipelago have captured a substantial portion of the trading that used to be conducted through brokerage firms. The problem with this trend, suggests Kamen, is that ECNs haven't fully reached into the lower tiers of the market, namely the OTC Bulletin Board. "The great technological advancements haven't been implemented in the lower-tier markets," says Kamen. "Therefore, when the only way traders and investors can access these companies is through technology that's totally archaic, they'll cease to support and invest in these small companies."

Tightening of listing standards. Kamen says the tightening of initial and continued listing standards, which was implemented in 1998 for the Nasdaq SmallCap market, has undermined the cause of small issuers. "Increased listing standards for the Small-Cap market had two unfortunate side effects," he says. "First, it meant that many companies could no longer go public, because they wouldn't be large enough to meet the new listing requirements. Second, many companies that were once trading on the SmallCap market got delisted for failing to meet the new standards." There are informed investors who are willing to accept the risks involved with these stocks, but the latter occurence, says Kamen, "was a tragic event for many companies because they were thrown onto the OTC Bulletin Board, a marketplace that reduced their access to a broad base of brokers and institutional investors."

The emergence of for-profit stock markets. This past April, members of the National Association of Securities Dealers (NASD), which owns Nasdaq, voted to spin off the stock market as a for-profit entity. "The idea of a for-profit stock market is a good one," says Kamen, but "how will [it be regulated]? Will the cost of regulation be so high that it drives the brokerage firms which support and fund small companies out of business?" In addition, Kamen says the prospectus detailing the spinoff of the stock market makes the future of the Bulletin Board unclear. "There was only one paragraph that even referred to the Bulletin Board," he says, "which does not bode well for the businesses that are trading there."

The trend toward late trading. Brokerage firms that trade and make markets in Microsoft or Intel can profitably do so 24 hours per day, because the average daily volume is in excess of 30 million shares. But for firms that concentrate on smaller issues, trading perhaps just 50,000 to 100,000 shares per day, or less, a longer trading day means just one thing: longer business hours waiting for business that is unlikely to come. Says Kamen, "The effect of across-the-board longer trading hours will cause the firms which have traditionally supported small business to focus on larger companies, further exacerbating the large company focus in the marketplace."

Efforts to narrow trading spreads. A trading spread is the difference between the bid price of a stock-what buyers are willing to pay-and the ask price-what sellers want for their stock. Large spreads are detrimental to investors because they result in higher prices. Kamen says the securities regulators, such as NASD and the Securities and Exchange Commission, have worked to narrow these spreads through the adoption of new order-handling rules in 1996, and, more recently, with the approval of trading in decimals rather than fractions to allow smaller increments of the spread.

"Narrowing spreads is a completely noble motive by securities regulators to protect investors and to make the markets more attractive to capital," says Kamen. "But the trend toward a one-size-fits-all market is a critical error. A company like Oracle with a market capitalization of $240 billion has significantly different trading characteristics than a stock with a market cap of just $35 million." Specifically, Kamen says, if spreads are tightened too much, there's little profit motive for brokerage firms to support and invest in smaller companies. "If you can't make money trading or underwriting small companies, 'Why work with them at all?' has been the attitude adopted by many securities firms," says Kamen.

For companies like Spunky Productions, there's a real risk of getting caught up in the vortex of the changing marketplace. The diminished likelihood of an IPO results in diminished opportunities for private capital. "Unfortunately," says Kronenberger, "we can't control the market or the appetite for investment in companies like ours. It's scary to have a large part of your destiny outside of your control." And although the search for capital continues, there's no sense of urgency just yet.

Still, the forces shaping the market are much larger than any of its constituents. The real force is that if current trends continue, small businesses, the engines of job growth and innovation, will have nowhere to go.



		Tiers For Fears The Over-the-Counter Stock Market is divided into several tiers: The Nasdaq National Market. This is the trading venue for the largest, most liquid stocks. Among them are Dell Computer, Intel, Microsoft and Yahoo!. Nasdaq Smallcap market. This market hosts up-and-coming companies, but there are few, if any, household names. Both this and the National Market offer wide distribution of quotes, news and company information. In addition, they offer traders and institutional investors efficient electronic access to companies. The OTC Bulletin Board. While the Bulletin Board offers electronic distribution of quotes, many investors consider it a lower-tier venue. Many securities professionals, venture capitalists and entrepreneurs feel that the Bulletin Board should be beefed up with the latest technology to provide a state-of-the-art incubator stock market. The Pink Sheets. At the lowest level of the OTC market are so-called Pink Sheet stocks, so named for the color of the one daily publication that tracks the prices of companies that trade here. There's a limited distribution of electronic quotes, and companies that trade here don't necessarily file financial information with the FCC.