Access to Capital

Suppose a small lean company can produce a product with a 25% return on investment, while a large, bloated corporation can produce the same product with a 7% return on investment. Which type of business ends up producing the product? The answer is the big corporation – if the big corporation has access to capital at 5% while the small company can only get money at 30+% (venture capital). Big corporations have access to funds that are far cheaper than those available to smaller businesses and startups. They have ongoing cash flows that they can borrow against. They can use retained earnings. They can float stock or bonds on Wall Street. And the government gives them advantages at every step of the way.

Making Wall Street Work

When was the last time a new U.S. business financed itself by floating stock on the market? I am not talking about new companies going public. I am talking about starting by floating stock. The original idea behind stock markets was to finance new, risky ventures. This function has been taken over by wealthy “angel investors” and by venture capital firms. The stock markets now primarily serve as a secondary capital market to allow these concentrated fund investors to cash out.

What happened? Did the major investment bankers and or major corporation heads get together at their private club retreats and form some kind of conspiracy to keep out the “little guy”? No. The answer is less sinister: the government has grown too fanatical in attempting to prevent fraud.

Wherever there are large concentrations of money and or power, there will be criminals trying to get their unfair share. This includes the capital markets. If it is easy to float a new issue of stock, then some criminals will float bogus corporations which produce nothing and take the capital. For this reason the Securities and Exchange Commission was founded and why they require massive amounts of paperwork in order to float a new stock. Last I checked, the cost is over a million dollars just to do the paperwork!!

Diligence is good, but there is something against overkill. We have a Bill of Rights that is supposed to prevent pro-active law enforcement and excessive punishment. This is a good thing even though it allows some evil criminals to evade justice. The same principle should apply to the markets. In their zeal to prevent fraud, the regulators have killed the stock markets as a tool for starting smaller corporations. This is overkill, just as chopping off the hands of thieves or performing random house searches without warrants to capture thieves is overkill in the quest to stop petty crime. It is better to suffer some crime to avoid hurting the innocent.

That said, it may be possible to prevent the worse abuses of penny stock markets while allowing them to exist by having an alternative channel for floating stocks. Instead of requiring massive documentation and other legalisms to meet SEC approval, those who want to float new stock cheaply could do so under a different set of restrictions that is cheap to track and still preserves investor interest. An example set of regulation could be:

  1. Very tight restrictions on officer salaries.
  2. Indefinite lockout period. Those who float the stock get dividends and voting rights, but cannot sell.

These restrictions would stay in effect until the company meets some objective criteria such as becoming profitable. The second restriction is a huge burden on venture capitalists and investment banks so it may seem impractical. However, I am working on an idea to eliminate the need for investment banking when floating new stock. It is not ready yet for public release, and it may prove to have proprietary value, so I will just have to leave you up in the air on this one.

Another problem with penny stocks is that they can become artificially volatile due to games played by speculators. The worse abuses can be kept in check by placing the following restrictions on penny stocks:

  1. No buying on margin (unless one is fully covered by put options).
  2. No short selling (unless one is fully covered by call options).

Options trading should be allowed as long as those selling the options are fully covered. This allows people to take leveraged positions and short positions without having the dangers of margin calls and/or short squeezes.

Freeing up Cash

For new stocks to be issued cheaply, there must be cash looking for new places to invest. A major source of tied up cash are the retained earnings of the existing big corporations. Our current tax code punishes big corporations who release the cash earned through profits back to the markets. Instead, it rewards corporations who retain their earnings and continue to grow like cancers. Really big business is subsidized by the tax code!

Be forewarned, what I am about to say is going to sound very Republican, but if you read through to the last page of this section, you will find an idea that increases taxes on big corporations, while phenomenally reducing the amount of paperwork.

Consider a big corporation that has a successful product. By selling this product, it produces cash. There are several options of what to do with this cash.

  1. Return it to investors as dividends.
  2. Do a stock buy-back.
  3. Invest in growth in house.
  4. Buy up another corporation.

The first two options allow a corporation to stay at its current size while still creating value to investors. However, they both suffer a tax penalty. First, whenever, a corporation shows a profit, it pays corporate income tax. Then, when the profits are returned to investors, the investors pay tax. If the profits are returned as dividends, the investors pay income tax. If the company buys back the stock, those who sell pay capital gains tax. Because capital gains taxes are lower than income taxes, option 2 is quite popular.

For option 3, investors pay no tax immediately. The company invests in itself and the value of the stock in the company grows, but investors don’t have to pay taxes on this growth until they sell their stock. Buying appreciating stocks is a way to defer personal taxes for years or even decades. For investors whose income tax rate is higher than the current interest rate, it is better to defer capital gains – and this is before taking into account that capital gains are taxed at a lower rate. But, then again, I have failed to take into account inflation. With inflation, capital gains taxes become an erratic property tax as well as a tax on gains, so the picture becomes muddy when inflation is high. Note also for option 3, if the government offers investment tax credits to corporations, it is possible to reduce corporate income taxes as well as individual taxes by investing in house.

Option 4 has the best tax consequence under certain circumstances. Suppose Big Company A has a profit and Big Company B has a loss. If Company A buys Company B, it can write off B’s losses for corporate income tax purposes. Not only do we defer personal taxes and convert them to lower rate capital gains, we eliminate corporate income taxes as well. Let the buyouts begin!

Later on, I will show a better way to tax corporations that eliminates these problems, but first I will cover some other ways in which the government favors big corporations.

Main Street vs. Wall Street

Public corporations are not the only entities that need capital. Private corporations, partnerships and sole proprietors also need capital. But look at your options in your 401(k) plan: are there any car washes, local banks, or other Main Street businesses in the list of investment plans? (Indeed, can you invest in a collection of small cap stocks of your choice or do you have to stick with blue chips and or mutual funds?)

At some point in your career it does make sense to put your money into safe places. But early on, it may make more sense to invest in yourself. [NOTE: there are ways to borrow against tax deferred retirement plans, so some of what I am pointing out can be bypassed. I am not an expert in personal finance. I find it irritating that you have to be an expert in such things in order to access your own money.] It may make more sense to pay off your house early, or put your money into a business, invest in your child’s education, or go back to school yourself. But to do these non Wall Street investments can mean paying more income tax.

But hey, it’s good money for bankers, brokers and financial planners. Gotta feed the suits, ya know.

Homework Assignment

I am not an expert on corporate tax law or finance, so you might find out a few things I don't know. I would appreciate it if you would let me know if you do.

  1. Just what are the tax consequences of a stock buy-back vs. dividends?
  2. Can corporations incorporate the losses of a company they have just purchased or merged with?
  3. How much flexibility do you have to use your 401(k) or IRA money to invest in yourself?
  4. Just what is the current cost of doing an SEC filing on a new stock issue?
  5. How much of an IPO goes to the investment banks underwriting the issue vs. the company being financed?