Capital and the Small Businessman:

A Proposal for an International Entrepreneurial Exchange

Stephen A. Boyko

The mission of an Entrepreneurial Exchange (EntEx) is to create a global capital market for small-to-medium enterprises (SMEs). Entrepreneurs around the world face a common problem—obtaining the "sliver of equity" to enable operations to achieve positive cash flow. The United States has the only capital market that is able to provide this funding to any degree of scale.

While the bull market at the end of the 20th century witnessed the globalization of capital markets, much of the benefit was confined primarily to the top-tier U.S. markets (NYSE and NASDAQ). The dilemma that SMEs face is whether to join forces with a large international concern and face the risk of being acquired; or to form an alliance with a foreign, emerging-growth company and face the development risk. EntEx’s premise is that companies of a similar size, corporate culture, and product development stage are the preferred choice to become strategic partners. What SMEs have lacked to date is a suitable platform on which to operate.

SMEs are vital to the economic growth process, especially given their potential for job creation, innovation, and a source of commercial aggregation and integration of global capital markets. In the United States, while the S&P500 companies were exporting jobs, the very smallest firms (those with between one and four employees) created 450,000 jobs in 1995, equal to 35 percent of the jobs created in that year. They are essential agents of change in a market economy. SMEs drive the efficient use of resources and facilitate trade between parties with different comparative advantages that accelerate the generation, dissemination, and application of innovative ideas, as a February 2003 study commissioned by the Small Business Administration discovered. In modern, global markets, it is not size but creative capability that is the key to success.

There are two generic categories of securities: event-driven stocks that are "sold" and earnings-driven stocks that are "bought." The existing regulatory regime of the Securities and Exchange Commission (SEC), however, places a disproportionate focus on financial capacity relative to financial capability that is biased towards top-tier stocks that are “bought”. The top-tier firms can absorb these regulatory costs; smaller firms cannot. (The capitalization profile of publicly traded securities in the micro-cap market is defined as less than $100 million. The top-tier¹s small-cap market range is $100 million to $500 million in capitalization and its large-cap market¹s capitalization is more than $500 million.)

Top-tier stocks tend to be earnings-driven and are categorized as "bought". They are priced as a multiple of their cash flow, earnings, and/or dividend. Conversely, stocks that are "sold" tend to be event-driven (i.e., new contract). Their valuation is a function of either their corporate mission, percentage of market share, or price-to-sales ratio relative to their evolutionary stage of development. Top-tier sales practices measure "risk" in an actuarial sense for stocks that are "bought" based on predictions from financial statements. This compares to micro-cap sales practices that attempt to reduce "uncertainty" relative to a lack of measurable knowledge for stocks that are "sold." The presence of positive cash flow separates top-tier stocks that are “bought’’ from micro-cap stocks that are “sold”.

The SEC contends that its one-size-fits-all regulatory regime is appropriate to manage the regulatory divide between "sold" and "bought" securities. The commission believes that its considerable regulatory experience with the use of the term "accredited investor" strikes the appropriate balance between the necessity for investor protection and meaningful relief for small business offerings. Yet the "accredited investor" test is primarily a measure of self-insurance that neither addresses an investor¹s financial sophistication, nor differentiates financial knowledge relative to securities that are "sold" from securities that are "bought." Since many high-net-worth individuals earned their wealth in activities other than investments, it does not necessarily follow that they would possess financial sophistication relative to the micro-cap market. This false regulatory construct results in micro-cap commands that are excessive and/or inappropriate relative to SME incentives.

The proposed Entrepreneur Exchange would be a web-based trading system with delivery-versus-payment settlement and clearance. Its regulatory regime would be based upon investor knowledge that is specifically tailored for the micro-cap market, thus shifting the regulatory emphasis from investor financial capacity (net worth and income) to investor financial capability (specific micro-cap knowledge and investor sophistication).

Under this system, a micro-cap Association would maintain a registry of investors who satisfactorily completed their coursework and/or who are "grandfathered" pursuant to demonstrated prior expertise. This registry would serve, absent fraud, as a safe harbor to the provisions of the 1933 Securities Act and 1934 Securities Exchange Act. Investors who do not meet the above criteria could still transact micro-cap issues subject to the current regulatory regime. It should be noted that the SEC is currently studying a similar approach with regard to investor sophistication/accreditation relative to the hedge fund industry. Similarly, the Association would qualify and maintain a registry for all financial intermediaries not subject to prior statutory disqualification. These intermediaries would, among other things, help obtain financing, facilitate secondary market activity, and disseminate corporate information of micro-cap issuers.

EntEx provides a forum for greater transparency to enable investors and issuers to select an appropriate form of micro-cap sponsorship. EntEx’s scalable sponsorship enables foreign emerging and U.S. micro-cap issuers to form strategic alliances in a network that generates an exponential wealth effect. Issuers have an obligation to be factually accurate with what they disclose. How much they choose to disclose is determined by issuer discretion. Information asymmetries then become the first analytical screen.

Micro-cap informational profiles are an additive supply chain process. Each increment of information is a value-added input that contributes an additional unit of wealth for each increment of information provided. An issuer interested in corporate governance and transparency relative to prospective corporate finance has incentives to put forth an appropriate level of disclosure that is scalable to the perceived benefit. Interested issuer agents and certified investors reciprocate by providing incremental, scalable sponsorship. As the micro-cap issuer's critical event approaches, investors and intermediaries will "scale" investment analytics from a "sold pro forma" to a "bought" format.

The Entrepreneur Exchange reduces the cost of being a public company by substituting investor intellectual capital for financial capital. EntEx’s registry of certified investors employ core competencies based upon their specific knowledge relative to the CEO’s capability, the specific innovative product/process, general industry expertise, and/or SME capital formation metrics to attain a comparative advantage for reducing micro-cap investment uncertainty. EntEx’s regulatory exemption creates a niche market for sophisticated investors where compliance costs are priced more efficiently at the margin for only those services actually needed.

Although against prevailing regulatory trends, a securities regime that emphasizes regulating investors would enable a low-cost, market-driven approach to governance. For those investors with good information on issuers in the market, no mandatory regulations are necessary. A core principle of the Entrepreneur Exchange¹s transactional process is that investors should be financially sophisticated and therefore not in need of regulatory protection when they are offered or sold securities of micro-cap issuers. EntEx would create a "preferred shoppers" network for participants in the micro-cap market through consumer education and market infrastructure enhancements. In turn, lower regulatory-related costs and liability considerations would encourage the conduct of business on-shore

All private sector decisions are made in the margin. As markets become more robust, the granularity of consumer preferences becomes more refined. As the demand for housing increased in the latter half of the 20th century, the thirty-year, fixed-rate mortgage was tailored to accommodate different maturities, variable interest rates, negative amortization and balloon payments. Similarly, consumer choices rather than top-tier government regulations should determine the degree of global micro-cap commerce.



Stephen A. Boyko is President of Global Market Thoughtware, Inc., an international consulting company. He has over twenty-five years of business and financial experience in a broad range of industries.