New England Biz Law Update
The past two years have created an increasingly challenging business environment for companies with a market cap of under $200 million. In addition to new regulatory requirements, liabilities, and other legal scrutiny, these companies face fundamental market changes that are driving many to rethink the value of being public.
Sell-side research and trading support of public companies has eroded, which in turn makes it more difficult for those companies to gain institutional investor interest – a critical driver of long-term shareholder value.
For attorneys who counsel small-and micro-cap public companies, understanding the new market and trading situation provides an invaluable perspective that can be critical to the go-private decision-making process.
Market Realities
The universe of public companies with market capitalizations of under $200 million represents 64 percent of the 2,642 companies currently listed on the NASDAQ National Market System (NMS).1 Many of these companies have been “orphaned” by the traditional investment community due to a convergence of recent market and industry trends. What does this mean and why is it an important driver of a public company’s ability to remain viable?
The institutional investment community drives a large percentage of the volume on the NASDAQ, and sustainable valuations for a company are directly correlated with institutional interest and participation. However, the past several years have seen a steady decline of Wall Street support for small-and micro-cap company stocks. Currently, 38 percent of NASDAQ stocks with a market cap of less than $200 million have no active analyst coverage, while 27 percent have only one active analyst covering the company.2
How did this happen? Two key trends have led to the orphaning of small- and micro-cap companies.
First, consolidations and downsizing in the investment banking industry have forced many firms to cut the number of companies they cover and are able to service. For the bulge bracket and mid-sized investment banks, much of that reduction has occurred in their least profitable sectors – including companies with low market capitalizations.
As a result, small-cap stocks have lost a significant amount of Wall Street sponsorship and the institutional investor interest has dried up. Without these factors, companies are forced to wonder why they are even public.
There are numerous small-cap stocks, and entire growth sectors, that are not being recognized in the current market rebound. A return to the fundamentals for investors means that more buy decisions are based on solid research and performance tracking and analysis. Without dedicated institutional resources and coverage, investors have a hard time finding and evaluating these small-cap stocks.
The second change has been the growth of Electronic Communications Networks (ECNs) and other Alternative Trading Systems (ATS) as the backbone of the NASDAQ marketplace. Alternative trading systems, primarily ECNs, currently facilitate much of the NASDAQ NMS’s trading volume, leaving less share of market for the full service banking community that make markets in small-and micro-cap stocks.
Prior to the advent of ECNs, a stock that traded 100,000 shares per day would have a handful of dedicated market makers who possessed a deep understanding of the company, its stock, and its sector. Today, that trading is fragmented through the ATS venues with traditional NASDAQ market makers executing only 20 percent of an already limited trading opportunity.
Trading small-cap stocks has always been challenging because of the usually small float. Illiquid stocks now face additional obstacles to success in this electronic trading environment.
Regulatory Costs
Fundamental changes in the way NASDAQ operates are compounded for small-cap public companies by the increasing regulatory costs and liabilities they now face. The Sarbanes-Oxley Act of 2002, designed to rein in corporate governance and accounting improprieties, has unintentionally levied a host of new costs and risks that are unrealistic for many small-cap companies. Increasingly, then, these companies feel many of the negative effects of being a public company while receiving very few of the benefits.
An understanding of the evolving small-cap regulatory and trading environment can greatly enhance the legal community’s overall perspective and counsel for companies that are struggling for viability in the public market. This knowledge can add a dynamic dimension to the legal options and documentation that accompany the go-private process.
It is important for small public companies to understand the legal and regulatory changes that have occurred in the last few years, as well as the altered market trading characteristics. By working with corporate counsel and investment bankers, it is possible to determine the proper course as a public company – namely to find ways to improve the prospects of being public or taking the company private.
1. www.Nasdaqnews.com, FactSet.
2. Id.
Russ Landon is a managing director and head of investment banking at Adams, Harkness and Hill in Boston. Adams, Harkness & Hill is a privately held institutional investment bank focused on growth companies in the technology, health care and consumer sectors. With a focus on research-driven investment ideas, it offers investment banking, institutional sales and trading, asset management, and corporate services. More information is available at www.ahh.com.
