Depending on whom you ask, a public company with less than $300 million market cap could be considered a micro-cap company, a penny stock (unless their share price is over $5.00), a lower middle market company or even middle market. Divestopedia defines “lower middle market” as “the lower end of the middle market segment of the economy, as measured in terms of annual revenue of the firms. Firms with an annual revenue in the range of $5 million to $50 million are grouped under the lower middle market category.” Wikipedia defines “middle market” as “companies larger than small businesses but smaller than big businesses that account for the middle third of the U.S. economy’s revenue. Each of these companies earns an annual revenue of between $100 million and $3 billion.” In a speech to the Greater Cleveland Middle Market Forum, SEC Commissioner Robert J. Jackson, Jr. defined a middle market company as those with trailing twelve-month sales of $50 million to $1 billion.
As I’ve written about previously, Bank of America, and their brokerage, Merrill Lynch, will not transact business in the securities of companies with less than a $300 million market cap and less than a $5.00-per-share stock price. Moreover, even if the stock price is over $5.00, such transactions or requested trades will face increased scrutiny and may not be processed right away. See HERE .Bank of America clearly thinks that under $300 million is a micro-cap company.
I realize that I am interchanging between market cap and revenue, but that is also common. For example, SEC rules define a smaller reporting company (SRC) as those with less than a $250 million public float or if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. A Google search for definitions of micro-cap, small-cap, lower middle market and middle market resulted in as many variations to the definition, based on both revenues and market cap, as Google pages I took the time to peruse.
Last summer the Investor Responsibility Research Center (IRRC) Institute published a report titled “Microcap Board Governance” providing some interesting information on public companies with less than $300 million in market capitalization. Leaving aside the semantics of the class size of these companies, this blog will summarize some of the information in the IRRC Report and add my usual commentary.
The IRRC Report
Since most companies with less than a $300 million market cap are not included in any major indices nor receive widespread analyst coverage, there is less aggregated information on their board composition and governance practices. The IRRC Report examined 160 companies representing approximately 10% of this company class which are traded on U.S. stock exchanges. Seventy-three percent (73%) trade on the Nasdaq, and the balance are on the NYSE or NYSE American.
Of the 160 companies, three-quarters have been public for more than 5 years, illustrating that not all small public companies are early-stage growth companies. Only 14% of the companies were still led by their founder. Although the IRRC report didn’t address the reasons or meaning behind these numbers, I think it makes sense in the overall corporate ecosystem. Very few companies will successfully grow to large-cap entities, nor should they. High-growth models come with great risk and can often lead to a total business failure. For instance, a company that goes public with a $50 million market cap and then grows 10%-20% year over year would still be in the under $300 million market cap class after 5 years, but also will likely have strong infrastructure and internal controls and provide steady growth to its investors.
Furthermore, the majority of the companies are in industry sectors that lend themselves to either slow growth or have seen dramatic industry change over the last decade. Thirty percent (30%) of the companies were in the healthcare sector, which notoriously has a very long research and development, pre-revenue lifecycle. Finance companies comprised another 18%, which sector has transformed post-Dodd-Frank, which was enacted in 2010 (see HERE). Rounding out the industries were consumer goods and services (15%), energy and utilities (11%), basic industries and transportation (10%), capital goods (9%) and technology (7%).
More than half the companies went public in the first 10 years of their founding. Although private equity has become more readily available for some companies (technology companies in particular), postponing a public offering, in my experience smaller companies have more opportunity to access capital through public markets then private sources. In fact, I believe the benefits of public capital markets are even more pronounced for small companies because they tend to be more innovative than large companies and they account for a substantial percentage of the jobs created every year. Public markets give an opportunity for some recouping of early-stage investments, incentivize employees through stock options and grants, add economic exposure and, of course, enhance access to capital for continued growth.
The under $300 million class tends to have smaller boards (five or less) than larger companies (nine or more). Men dominate the boards in this class even more so than in larger companies. The majority (61%) of the under $300 million market cap companies studied have no female directors serving on their boards, compared to less than one-quarter (21%) of the Russell 3000 boards. Furthermore, only 12% of these companies have more than one female director, while nearly half (45%) of the Russell 3000 companies have more than one female director. Not surprisingly, the under $300 million class pays their CEO’s less than larger companies (with as much shareholder scrutiny), though the average CEO age (in their 50’s) is the same for other classes of public companies. Directors are also paid much less than their larger cap counterparties, with the average being $90,000 for the under $300 million class and $180,000 for serving on a Russell 3000 company.
With smaller boards come fewer independent directors, more variability in the number and timing of meetings, and a less complex committee structure with many electing not to appoint a chairman of the board. In a period of shareholder activism and socially motivated investing, the board composition of the under $300 million class could be a hindrance to some institutional investments. In reading this study, I see an opportunity for these companies to stand out from the average by putting more attention into their board composition as well as governance and process.
To further illustrate the importance of these factors, on February 6, 2019, the SEC issued two new identical C&DI related to disclosure of board diversity, and in particular:
Question: In connection with preparing Item 401 disclosure relating to director qualifications, certain board members or nominees have provided for inclusion in the company’s disclosure certain self-identified specific diversity characteristics, such as their race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background. What disclosure of self-identified diversity characteristics is required under Item 401 or, with respect to nominees, under Item 407?
Answer: Item 401(e) requires a brief discussion of the specific experience, qualifications, attributes, or skills that led to the conclusion that a person should serve as a director. Item 407(c)(2)(vi) requires a description of how a board implements any policies it follows with regard to the consideration of diversity in identifying director nominees. To the extent a board or nominating committee in determining the specific experience, qualifications, attributes, or skills of an individual for board membership has considered the self-identified diversity characteristics referred to above (e.g., race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background) of an individual who has consented to the company’s disclosure of those characteristics, we would expect that the company’s discussion required by Item 401 would include, but not necessarily be limited to, identifying those characteristics and how they were considered. Similarly, in these circumstances, we would expect any description of diversity policies followed by the company under Item 407 would include a discussion of how the company considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics.
As with all public companies, the majority of the under $300 million class is incorporated in Delaware (59%) followed by Nevada (16%) and Maryland (7%). I note that as you move up the chain, Delaware comprises a larger and larger percentage of all public companies.
Not surprisingly, a greater majority of these companies tend to be owned by management and insiders than the larger companies. Management tends to face greater and greater dilution as a company grows and continues to access capital markets for financing or issues equity for mergers and acquisitions and employee stock grants. Also, the control ownership of this group tends to be in straight common stock, with only 7% of the companies examined having a dual stock class structure.
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