THE DEVELOPMENT OF MICRO-CAP SECURITIES
SUB-SAHARAN AFRICA: NEW APPROACHES TO FOSTERING ENTERPRISE GROWTH
by Professor Stuart
Reference: Document No.18, November 2002)
Current Impediments to SME Securities
Several reasons exist that preclude SME's from going into the public
market to raise capital through the sale of securities. The principal
1. Company Law Limitations
Company law throughout most of SAA is
similar, owing their common inheritance from English and colonial statutes.
The principal division in the company laws is between private and joint
stock companies. Private companies are limited to no more than 50 shareholders,
the securities are non-transferable, and private companies cannot offer
any shares or debentures to the public. Joint stock companies, by contrast,
can issue transferable securities and have any number of shareholders.
The dichotomy between private and joint stock companies is a long accepted
construct but on close examination does not have any basic justification
other than tradition. There is no reason why the structure, rights,
and obligations of all companies that have equity shareholders should
not be the same. That is the situation in the United States, where one
corporate law applies to all companies, large or small. There is no
compelling reason to support the prohibitions against selling securities
and against the transfer of securities that apply to private companies.
Such prohibitions preclude effective capital raising by private companies
and have no inherent justification.
As a result of current company laws, private companies are limited to
trying to attract investors who will be locked into their investment
for an indefinite period of time. This is an extremely difficult task
and should not be necessary from either a legal or economic perspective.
If a shareholder of a so-called private company desires to sell his
or her shares, the transaction should be governed by the securities
laws, similar to any other stock transaction. Full disclosure is the
key, and that applies to all companies, large and small. One might argue
that the shareholder can sell his or her shares when (and if) the private
company eventually becomes a joint stock company, but the timing of
such transformation is uncertain and meanwhile investors hold an illiquid
More significant as impediments to capital raising are the public offering
provisions of most company and securities laws. Any offering of securities,
regardless of size or number of purchasers, must comply with the full
registration process set forth in a schedule to the company law statute.
The registration requirements are essentially the same in those countries
that have adopted securities legislation to replace or supplement the
traditional company law. There are no "private" or "limited"
offering exceptions. SME's desiring to raise a relatively small amount
of capital must go through the same costly, time-consuming process of
registration as if it were a multi-million dollar offering. SME capital
requirements are often too low, too sporadic, and too immediate to warrant
the required registration process. I have not examined all of such statutes,
but ones that I have reviewed do not provide meaningful exceptions to
the registration process. In a recent workshop in Harare, Zimbabwe,
attended by representatives of 12 different African countries, not one
participant was aware of any private or limited offering exception to
the registration process.
2. The Problems of Listing
on Stock Exchanges
Even if an SME was willing and able to
undertake a full registration process for the sale of securities, there
is likely to be very little investor interest because of the lack of
a secondary market. A secondary market is the trading forum for buying
and selling shares by shareholders. A stock exchange provides a secondary
market for shareholders of companies listed on the exchange. Potential
investors are not inclined to purchase securities if no secondary market
exists for subsequent resale. Or, if they are willing to buy illiquid
securities, they will do so only at depressed prices. For shares that
have no trading market, a shareholder would have to find his own buyer,
determine a price, and negotiate all elements of the transaction. This
is highly inefficient and not an attractive prospect to potential investors.
Thus, companies selling their shares to the public announce their intention
to list the shares on the exchange so that a secondary market forum
can exist. The promised existence of a secondary market makes the initial
offering of securities more attractive.
Two serious problems exist in this area for SME's. The first is that
many SME's, even
after the sale of shares in a public offering, will be too small to
meet exchange listing standards. Stock exchanges listing requirements
are usually quite high with regard to company assets, number of shareholders,
and market capitalization. SME's in their early years of development
are unlikely to meet listing requirements. Hence, such companies cannot
provide an stock exchange listing to potential investors.
Some exchanges, recognizing the problem and seeking to attract smaller
companies into their fold, create listing tiers. Tier I is composed
of large companies that meet the regular listing requirements. Tier
II is composed of smaller companies who qualify under modified listing
standards. Although this arrangement has the merit of allowing smaller
companies to be listed on the exchange, in practice the two tier system
has generally not been successful. Many investors regard second tier
companies with skepticism. A Tier II label is like a badge of demerit
---- a Tier II listing connotes a public company that is not "good
enough" to make it to the "big board." Hence, trading
in Tier II stocks tends to be sparse. This adversely affects both stock
prices and liquidity (the two are linked). The potential of a Tier II
listing is thus a meager inducement for SME's and potential investors.
3. Lack of An Over-The-Counter Market
The inability to meet exchange listing requirements would not be a serious
impediment to a public offering by SMEs if those companies could assure
potential investors that an over-the-counter ("OTC") market
would be created for secondary trading. An OTC market provides a liquidity
function for shareholders similar to that of an exchange. The OTC market
can be as active and efficient as an exchange.
Most secondary trading in the U.S. occurs in the OTC market. Indeed,
some companies prefer to remain in the OTC market even if they have
the size and configuration to be eligible for exchange listing. These
are often companies that started small, developed an active OTC market
for their shares, and now see no benefit to listing their shares on
an exchange despite their qualification to do so.
Unfortunately, an OTC market does not exist in most SSA countries. Zimbabwe,
Nigeria, and a number of other countries actually prohibit an OTC market,
for their stock exchange rules preclude brokers from trading in any
securities not listed on the exchange. Other countries that do not have
such a prohibition have not established any rules on requirements for
OTC trading, which effectively results in brokers avoiding trading activity
because of the absence of standards.
It would be wrong to suggest that the mere act of creating the mechanism
for an OTC market is a panacea for SME liquidity problems. An OTC market
requires brokerage firms willing to undertake the time and cost in its
development, it requires a regulatory agency willing to adopt trading
and disclosure rules, and it requires a sufficient number of companies
on the OTC market to make the whole endeavor worthwhile. None of this
will happen overnight. But it will never happen without changes in statutes
and other rules to allow SME's to more readily solicit capital from
If standards are put in place for an OTC market, that will also facilitate
trading of securities through the Internet. The Internet is becoming
the trading vehicle of choice for many investors. Although many investors
might avoid SMEs because of risk and liquidity concerns, the ability
of SMEs to have their shares traded over the Internet creates an additional
marketing tool for capital raising.
4. Tax and Financial
An oft-stated major impediment to attracting SME's to make public offerings
is the concern that the required disclosure of audited financial statements
will alert government authorities to possible prior under-reporting
of taxable income. The two sets of books phenomenon is frequently noted
in discussions. The tax collector sees a set of books that show little
if any profit, while the owners' set of books shows the true condition
of the company. If the company were to make a public offering that requires
audited financial statements, prior under-reported income might be disclosed.
Visions of fines and jail terms for tax evasion dance in the heads of
SME owners who are being encouraged to undertake public offerings. For
owners of SMEs who are at risk in such a situation, the decision to
forego the offering is an easy one, even if the result is a foregoing
of much needed capital for the company.
The idea of a tax amnesty has been floated from time to time as a means
of encouraging companies to sell and list their shares on the exchange.
Strong legal and political reasons, however, militate against the adoption
of any forgiveness program. And so the problem remains. A number of
countries offer a reduction in the corporate tax rate (such as from
35% to 30%) for companies listed on the national stock exchange. In
light of the relatively low number of private companies that have chosen
to list on stock exchanges, current tax inducements do not appear to
be very effective. More thinking needs to be done to resolve this very
practical problem. Several suggestions are discussed below in the Proposals
portion of this article.
5. Control Concerns
Owners of SMEs are understandably reluctant to sell securities to the
public if the result is a diminution or loss of management control.
This is a very real personal problem, especially for SME's developed
and nurtured within family units. It is a problem, however, that can
be addressed through education of company owners as to alternative offering
techniques, and through changes to existing statutes and regulations
to permit more diversified ownership interests.
for Development of Micro-Cap Markets
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