Equity Regulation and U.S. Venture Capital Investment

Abstract

There is a growing consensus that the long-run per capita growth rate of the U.S. economy has drifted lower since the early 2000s, consistent with a perceived slowdown in business dynamism. One factor that may have contributed to this is a downshift in venture capital investment and its failure to recover in line with stock prices, as pre-2003 patterns would suggest. Critics have argued that this is associated with the increased regulatory burden for publically traded firms to comply with the Sarbanes-Oxley Act of 2002 (SOX). There is inconclusive evidence of SOX deterring firms from becoming publically traded as indicated by IPO activity, a proxy reflecting several factors that may not be as tied to innovation as venture capital. Earlier tests of SOX's impact on venture capital activity, which tended to focus on cross-sectional evidence, were hampered by a short time-series sample following the Internet-stock bust of the early 2000s. Taking advantage of the large-sized rise, fall, and recovery in stock prices since then, this study assesses whether the time-series behavior of venture capital investment shifted following SOX. We find evidence of a time-series break in the middle of our sample, consistent with the passage of SOX. Estimates indicate that the slower post-SOX pace of venture capital investment is mainly attributed to a reduced elasticity of such investment with respect to stock prices rather than to a simple downshift in the level of investment. Our estimates suggest that a cost-benefit analysis of SOX could be worthwhile, especially given concerns that the long-run growth rate of U.S. productivity and GDP has been unusually sluggish and the emerging consensus that excessive debt financing-not equity financing-is more tied to the subset of financial crises associated with severe macroeconomic downturns.JEL codes: G24, 047

The Impact of the Dodd-Frank Act on Small Business

“…This is especially the case when we also account for the effects of SOX. In particular, Atkinson and Duca (2017) and the current study are analogous in finding that recent financial reforms-SOX of 2003 in the case of the former and the DFA of 2010 in the case of each-can sometimes have the unintended consequence of reducing the availability of finance to small firms. More broadly, these findings suggest that these financial reform acts have significantly contributed to increasing the fixed costs of starting firms, thereby slowing the pace of business formation in the U.S.…”

“…Two are DFASB1 and DFASB2, which track the impact of the two phases of the DFA on the overall availability of bank credit to entrepreneurs that may stem from the effects of regulations not only on C&I lending, but also on access to consumer and real estate loans which small businesses might also use for funding. We supplement these terms with the regulatory regime shift variable, SOX, which equals 1 since the passage of the Sarbanes-Oxley Act) in 2002:q3, which we and Atkinson and Duca (2017) argue has increased the fixed costs of forming businesses with the eventual aim of publicly incorporating. This hypothesis is consistent with recent studies.…”

“…As discussed by Atkinson and Duca (2017), SOX raised the fixed and variable costs of firms to shift from being privately held to being publicly traded. This lowers the present value of young firms that would seek to become public, thereby reducing the incentives for venture capitalists to fund startups and young companies with the eventual goal of cashing out of their positions following an initial public offering.…”

“…In contrast, the SOX appears to persistently restrain business formation (and venture capital investment according to Atkinson and Duca, 2017). Taken together, these results indicate that it may be fruitful to carefully reassess and perhaps tailor the regulation of equity markets under SOX, whereas there may be less scope for further reviving business formation by additional modifications to the DFA.…”

The Impact of the Dodd-Frank Act on Small Business

“…In examining detailed CPS data, Kozeniauskas (2017) finds that entrepreneurship rates among households have fallen across all age groups, and in a calibrated model of endogenous business formation, he demonstrates that higher fixed entry costs could plausibly for much of the slowdown in business entry rates. As discussed by Atkinson and Duca (2017), SOX raised the fixed and variable costs of firms to shift from being privately held to being publicly traded. This lowers the present value of young firms that would seek to become public, thereby reducing the incentives for venture capitalists to fund startups and young companies with the eventual goal of cashing out of their positions following an initial public offering.…”