With inauguration day behind us and the hopes of a business-friendly administration in front of us, I'd like to make a case for what could spur more capital formation for small capitalization public companies (i.e., those roughly falling below a $2 billion market cap).

Afterall, small businesses make up most our country’s economy, so supporting their growth and encouraging public company formation would seem to be an attractive agenda item.

The Setup

The number of publicly traded companies has dropped significantly over the past two decades. In 1996, that number peaked at 8,090 but as of August 2024, it had fallen to around 4,600.

The number of small IPOs averaged 401 each year in the ‘90s but then dropped to only 105 annually from 2000 to 2017. In the ‘90s, small IPOs made up 27% of all capital raised in public markets, but from 2000 to 2017 that metric was down to 7%.

That trend has worsened since. From 2018 to today, there have only been roughly 300 public listings.

Drivers of the Dry Up?

This is likely caused by a confluence of events.

#1) High Cost of Being Public

Increased regulatory requirements, such as the Sarbanes-Oxley Act of 2002, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and others, have burdened companies with added costs of being public.

Layer in financial reporting, audit fees and investor relations, and the cost of being public can be $5-$10 million per year. This isn’t an issue for a $10 billion market cap, but a company one-tenth of that size may find this number tough to absorb.

#2) Investment Banks Are Disincentivized

Investment banks have different lines of business, but the Trading side of the house can be very profitable. This revenue model runs on commissions (i.e., spreads) that are often quoted in pennies per share traded. With the proliferation of electronic market making, smart order routing and speed, the spread has been significantly whittled down.

For example, the average commission per share in 1998 was $0.05 per share. Today it can be a couple pennies or less. Lower spreads equal lower revenue, and this is exacerbated by smaller companies with smaller share counts and lower trading volume.

As a result, many investment banks have allocated resources to higher market caps where trading can be more lucrative or prioritized other high fee areas like mergers & acquisitions.

Another “tax” on investment banks is a regulation called Markets in Financial Instruments Directive (MiFID II) which went into effect in 2014. While it only applies directly to U.K. and EU-regulated investment firms, global investment banks, and even smaller players, have followed suit.

MiFID II states that asset managers are required to document and justify their research spending and separate payment for research from trade execution payments. So, instead of writing one check to an investment bank for all the services they provide, asset managers must itemize and ascribe value to each service they pay for.

Under this lens, many asset managers are choosing to pay for only the areas they think are of highest value, and it’s well understood the research department, especially for small caps, has been impacted.

These market forces, and others, have caused many investment banks to move up-market.

#3) The Investor Landscape Has Changed

For most of the 20th century, retail investors were the primary buyers of stocks. Imagine the traditional Wall Street model with thousands of individual traders yelling orders on the exchange floor for their broker clients.

Today, however, many of the brokerage houses have migrated their business models to pooled asset products like ETFs or mutual funds at the expense of individual stock recommendations.

The institutional investor landscape has changed as well. The big active managers like BlackRock have only gotten bigger, which means they must put larger check sizes to work.

And over the past decade, there has been rapid growth in passive investment funds, which don’t participate in IPOs at all.

It’s no wonder that we’ve experienced a dearth of public company formation.

#4) The Rise of Private Equity and Other Private Solutions

Since 2000, private equity-backed U.S. companies climbed from roughly 2,000 companies to more than 11,500, a 400%+ increase. Couple this with the decline in public company formation and you can see companies have clearly had other funding alternatives.

Why? Pension plans, foundations and endowment funds have increased their exposure to private equity. So have family offices and private wealth managers. And the recent rise of private credit has allowed companies to access capital privately that wasn’t available the past.

Recommendations

I believe the best way to spur growth for small company capital formation is the reduction of regulations. Cutting red tape for every player in this ecosystem is possible, so here are some ideas:

•Company Level

Reduce the Sarbanes Oxley testing period from once a year to every two or three years for small cap companies (or what the SEC defines as “emerging growth companies").

•Trading Venues

The existing stock exchanges, or perhaps a new one, could create a product where only small caps are allowed to trade at that venue, which could funnel liquidity and improve trading volume and lower spreads (a benefit to the whole ecosystem).

•Investment Banks

Put in place anti-MiFID II rules for banks working with domestic companies or come up with an alternative set of rules that doesn’t punish small banks.

•Institutional Investors

Relax certain rules and compliance costs for smaller funds, fostering new fund formation.

According to a January 2025 PitchBook article, there are more than 1,300 VC-backed companies last valued at $500 million or above in the US. Only 40 of them made some type of exit in 2024 (i.e., private to private or private to public). At that clip, it would take 30 years for the portfolios to be emptied.

Incentivizing owners of private companies to think of the public markets as a viable exit option would certainly stimulate public capital formation, which has historically been a hallmark of our great country.

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