Regulations Force the Rise of Private Stock Markets

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There was a time when the engine of entrepreneurship was neatly hitched to the broader American Dream. Thanks to the NASDAQ, the advent of mutual funds, and the deregulation of brokerage fees ordinary Americans were able to invest a bit of their savings in promising young companies like Apple, Microsoft, and Dell, thereby spreading the wealth created by these upstart businesses.

Yes, we all learned that stock markets can go down as well as up, making prudence and diversification the key to sound investing. And bad actors like Enron and WorldCom certainly helped caveat emptor lose its charm. So Congress, in its wisdom, laid down thousands of pages of complex rules and regulations purportedly designed to protect the integrity of public stock markets.

Alas, like French generals fighting the last war, none of these regulations prevented the meltdown we just went through. So Sarbanes-Oxley begat Dodd-Frank which will no doubt beget another 2000 pages of futile rules when the next crisis proves these latest attempts as ineffective as the last.

All this comes at a cost. Businesses wishing to access public markets must pay for the thousands of consultants, lawyers, and accountants promising to provide compliance. Unintended consequences also take their toll, an inevitable byproduct of legislation crafted by career politicians that have never so much as run a candy store. There is one profession, though, that keeps booking gains. Wielding the threat of new regulations politicians are more adept than ever at extracting tribute and protection money from widening swaths of the business community.

It was only a matter of time before the entrepreneurial engine decided it was too hard to pull the train.

Profitable, high flying startups like Facebook and Zynga don't bother going public anymore. Why put up with the expense, scrutiny, and distraction? Why risk exposure to class action shareholder suits every time a stock blips? Why kowtow to the whims of grandstanding Congressmen each time one of these potentates feels like holding a hearing to beat up on CEOs? These days the IPOs the public has a chance to participate in are mostly companies bleeding money so profusely that they can no longer be supported by their venture capitalists. Going public is their best alternative to going broke.

But wait a minute - how do top tier startups achieve liquidity if they don't go public? Isn't getting rich the main objective of entrepreneurship after founders and early employees succeed in changing the world? Can't Uncle Sam force successful entrepreneurs to bend to the rules before they buy those yachts?

Nope. The modern way to cash out is by selling stock on a shadowy collection of unregulated private markets. Emerging exchanges like Second Market and SharesPost as well as innumerable bilateral secondary transactions arranged on the old-boy network offer a free-market escape from the tender protections of Congress.

Yes, these private markets are opaque, thin, and bereft of both pricing and company performance information. Which is why by law only the rich and well connected can participate. What do the Income Inequality mongerers have to say about that? By trying to eliminate risk from our public markets, Congress is on its way to eliminating reward. I guess the unwashed masses who don't qualify as accredited investors will have to content themselves with buying shares of Government Motors.

Undeterred, a second generation of former Facebook founders and employees are cashing out and starting new companies. This is extremely healthy, but what are the implications for the broader investment economy when the entire cycle can be turned with private money? If you want to ensure that only the rich have a chance to get richer, cutting the public out of the entrepreneurial economy is one great way to do it.

Meanwhile Uncle Sam pours hundreds of millions in grants and loan guarantees into half-baked "green" startups, an industrial policy tailor-made to attract charlatans and losers. Why are we content allowing Washington to replace the judgment of millions of private investors with the whims of a handful of bureaucrats trying to score political points playing with taxpayers' money?

Perhaps the recent tsunami that hit Congress will wake Washington up to the disastrous choices they've made. Marginalizing the entrepreneurial ecosystem, cutting it off from both Main Street and Wall Street, can hardly help our national competitiveness.

Bill Frezza is a fellow at the Competitive Enterprise Institute, and a Boston-based venture capitalist. You can find all of his columns, TV, and radio interviews here.  If you would like to have his weekly columns delivered to you by e-mail, click here or follow him on Twitter @BillFrezza.

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