US Regulations and Laws Inhibit Growth

Posted by Jeff Carter
on March 19th, 2012

There is an editorial you must read today. It happens to be in the Wall Street Journal. It deals with the left wing’s continued assault on corporations.

A few years ago, a shareholders rights bill was passed and signed into law. Personally, I supported the bill with some hesitation. I think that transparency is a good feature of financial markets, and public corporations ought to be disclosing some of their expenses related to salaries and capital expenditures. As a shareholder, it gives me some dollars spent vision to company strategy. Many times it is tough to decipher the real intent of a company from their annual report. Annual reports are fancy private placement memorandum’s (PPM). They are sales brochures.

Before the law, there wasn’t enough disclosure. Small investors had no chance, and large pension funds had no clarity to try and either understand the business, or to try and make a change when they felt the business was headed in the wrong strategic direction.

Post law, the left picked it up and ran with it. Now corporations are tied up in knots appeasing stupid far left policy on labor law, green energy, political donations and other strategic initiatives that have nothing to do with running the day to day operations of the business.

Corporate disclosure is another disincentive for companies to go public. Along with Sarbanes-Oxley and Dodd-Frank, the left is using existing law as a cudgel to permanently impair the capital markets. This will kill the productive capability of the United States. Follow the logic.

Dave and Jill (DJ) start a company making widgets. They go to raise capital to start it up.

The Securities and Exchange Commission (SEC) only allows accredited investors to invest in start up companies based on Internal Revenue Service (IRS) standards. That regulation limits the pool of capital available to seed stage companies. Out of the 50,000 to 60,000 companies that get started each year, only ten percent of them get seed stage money from angel investors. Of that ten percent, only around ten percent of them will make it to become an operating company. Accredited investors assume a huge amount of risk.

Let’s assume the widget catches on, and starts to grow. DJ have a company that grows big and hires a lot of people, gives away stock options. It gets more investment from venture capital firms and other large investors. DJ part with some of their equity in the firm at each stage of financing, but it’s okay because they are doing it at higher and higher valuations. Virtually all the money that’s invested doesn’t go into Dave and Jill’s pocket, it goes into the company.

Now DJ has a problem. They have more than 500 investors in their company. The SEC regulations force them to go public. But DJ knows that when they go public, their accounting costs will triple under the weight of Sarbanes-Oxley. They also will be subject to meaningless reporting requirements that have nothing to do with the operation of the business. They don’t really want to go public yet.

Additionally, DJ make all of their widgets in an outsourced factory in Asia. They have no control over the factory practices, nor the laws of the country. They chose the factory because it best fit their needs of production, and more importantly, their customers. The factory likes doing business with DJ. However, if Dave and Jill were to leave because they didn’t like some internal factory business practice, the factory could retool quickly and fill the vacant capacity with some other companies production. DJ and the factory have a great transactional relationship.

If DJ sold out to another company today, they could realize some upside value. However, they wouldn’t be maximizing the value for their shareholders or themselves. The Board of Directors doesn’t want to sell. However, if they go public (IPO), they might cripple their company with costs. They would prefer to continue operating as is, but the SEC won’t let them. What do you do?

Throughout the whole value creation process from start to finish, the heavy hand of big government is involved. Once the company goes public, the hard left wing circles like vultures to a carcass and begins feeding on it. At each step of the way, the company is economically has adverse economic incentives placed in its path.

At the critical point of whether to go public or stay private, it’s not the economics of the marketplace that determine the outcome, but the artificial standards put in place by regulation from government.

These regulations kill capital formation, which limits job creation. They kill company growth, which limits job creation and GDP. They kill exchanges, which limits transparency. They kill the ability of average Americans to invest their capital in start up companies, but more importantly in more mature, less risky, public companies, which limits the amount of wealth that can be created. Once companies do go public, the trading rules administered by the SEC slant the playing field in favor of the big banks and the playing field isn’t level for the average investor, which causes investors to sit in cash when they should be investing.

On the rare case when a company does do an IPO, the investor demand is generally outsized. Instead of realizing a transparent valuation to the company, the company is overbought. If the company can’t meet the expectations of the marketplace, investors sell. This can affect the attitude of company management and materially affect the operations of the company. Many companies trip up after an IPO.

Real life example, Groupon ($GRPN)
Groupon Stock Chart

Groupon Stock Chart by YCharts

Groupon has lost 30% since it’s IPO. Much of that over eager demand can be traced to the laws on IPO’s and the laws on transparency. Too many investors are chasing too little supply. That forces prices higher.

I am all for transparency and disclosure. However, we need to bear in mind there is a segment of the US and world population that will do anything in its power to kill capitalism. Their sole mission is to have a totalitarian environment where a central planner makes all the decisions.

The WSJ editorial is great. But in order to really understand the deeper meaning behind it, you need to extrapolate it to the bigger picture of what is affected. The political left isn’t interested in free markets. They want markets directed by them and done their way. That’s not a market.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.