How over-regulation is shackling the next Facebook

John Berlau Senior Fellow, CEI
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Today, Facebook finally went public. Its initial public offering (IPO) is the capstone of its amazing ascent, which changed the way the world communicates.

By contrast, other top American companies went public at much earlier stages in their growth. Barely anyone outside of the Atlanta area had heard of Home Depot when it went public in 1981 with just four stores in its name. The difference? Much of it has to do with the layers of regulation from the past decade that have made going and staying public so costly for smaller companies.

These rules are always justified as needed to go after “fat cats.” When George W. Bush signed Sarbanes-Oxley in 2002 and Barack Obama signed Dodd-Frank in 2010, both men cited scandals involving large corporations. After the JP Morgan Chase loss of $2 billion, the Beltway elites are painting any criticism of financial regulation as siding with the “big banks.”

But it’s smaller firms and smaller investors that have been the most burdened by these costly and complex rules. Home Depot co-founder Bernie Marcus has said many times that his company likely never could have gotten off the ground if Sarbanes-Oxley and Dodd-Frank had been in effect in the early 1980s. “We could never succeed today,” Marcus bluntly told radio host Hugh Hewitt last June.

Even Facebook, a large company with enormous resources, had a hard time navigating the regulatory maze. The company stated in its initial IPO filing that “compliance with these rules and regulations will increase our legal and financial compliance costs, make some activities more difficult, time-consuming, or costly, and increase demand on our systems and resources.”

But the biggest costs may be the lost innovations that firms would have produced if they’d been able to raise money through IPOs.

Regulatory red tape has also robbed ordinary investors of the opportunity to grow wealthy with Facebook in its early stages. The same is true of the recent IPOs from other big firms like LinkedIn, Pandora, and Zynga. IPOs of the past few years can be called “Cheers IPOs” because, to paraphrase the theme song of the 1980s television sitcom, everybody knows their names. What a healthy economy needs is IPOs of companies you have never heard of, which go public not to realize market value for the shares of their founders, but to raise money to expand operations and add jobs.

When Starbucks and PetSmart went public in the early 1990s, they were regional companies that few people outside of their regions had heard of. They used the money they raised from their IPOs to become the dominant national chains they are today, creating thousands of jobs along the way.

Such companies could never go public today, not with the costs of Sarbanes-Oxley and Dodd-Frank weighing them down. The SEC has calculated that the average annual cost of one Sarbanes-Oxley provision alone — the “internal control” mandates of Section 404 — comes to $2.3 million per company.

Statistics on both the reduced number and increased size of IPOs show the dramatic effects of these regulatory costs. In the years since Sarbanes-Oxley was passed in 2002 — a span that included good economic times as well as bad — not once has the number of IPOs come close to the numbers recorded during the slow-growth years of the early 1990s, let alone the boom years of the latter part of that decade. As I noted in February testimony to the House Energy and Commerce Committee, there were about 50 more IPOs in 1991 than there were in 2006 or 2007, relatively good years for economic growth.

The decline has been especially severe among small firms. Even Obama’s Council on Jobs and Competitiveness has noted that “the share of IPOs that were smaller [in market capitalization] than $50 million fell from 80 percent in the 1990s to 20 percent in the 2000s.” In fact, in addition to Facebook, which had a $104 billion market capitalization on the eve of its IPO, LinkedIn, Zynga, and Pandora all had market capitalizations that exceeded $1 billion when they went public.

But there is some good news. Since the slightly deregulatory Jumpstart Our Business Startups (JOBS) Act passed Congress and was signed by President Obama in early April — after much stalling from statist liberals in the Democratic-controlled Senate — there has been a trickle of smaller firms returning to the IPO market. Among other things, the JOBS Act creates a five-year “on-ramp” for most firms going public in which they are exempt from the Sarbanes-Oxley internal control mandates, the Dodd-Frank proxy provisions, and other burdensome regulations.

Despite Obama’s signature, the JOBS Act has been bashed by the usual suspects to whom regulation is religion — i.e., The New York Times editorial page and Rolling Stone’s Matt Taibbi — as somehow benefiting giant corporations and the “big banks.” But the data shows the first firms taking advantage of this law are the small, growing firms that supporters of the law had pointed to as beneficiaries. ClearSign Combustion, a Seattle-based firm that makes energy-efficient furnaces, launched an IPO with a market cap of just $12 million and cited the JOBS Act as allowing it to do that.

This is good news, because every dollar a smaller firm can raise by going public is one less dollar that firm has to beg and grovel for from a bank. This extra cash can be used to expand the business faster and hire more employees. As the Obama jobs council and others have noted, 90 percent of a public company’s job creation occurs after it goes public.

For ordinary investors, small-cap stocks are high risk but potentially high return. Ordinary investors should be able to invest in them. Right now they often can’t, thanks to burdensome regulations that are ironically designed to rein in the “big guys.”

Facebook’s stock market launch should be celebrated, but the mini-IPOs enabled by the JOBS Act are the wave of our entrepreneurial future.

John Berlau is Senior Fellow for Finance and Access to Capital at the Competitive Enterprise Institute.