The venture end of the initial public offering market is typically the most vibrant. There is always an audience for its numerous small deals, regardless of prevailing market conditions. But the junior market may not be fulfilling its potential because a disproportionate regulatory burden weighs heavily on small firms.

The past year was pretty typical for IPOs on the Toronto Stock Exchange and the TSX Venture Exchange. Taking everything the TSX considers an IPO, there were almost 270 deals that generated more than $11.1 billion of new capital. There were no megadeals of $1 billion or more, but there were 30-odd deals that each raised at least $100 million. As usual, most of the big IPOs were income trust-type issues on the TSX.

There were also many tiny deals, mostly on the TSXV, including more than 100 involving capital pool companies that together raised slightly less than $95 million. There were also 81 IPOs in the $1 million-$20 million range on the TSXV, with the majority in the resources sectors. Overall, $620 million was raised on the TSXV in 2006 — up from 2005, when 143 deals raised just $252 million (including 74 capital pools that raised $49.4 million).

On the face of it, there’s a pretty active public market for small but growing companies that are looking to raise capital. Some critics argue, however, that it could be an even more dynamic sector if the companies didn’t face so many regulatory hurdles. Consider the London Stock Exchange’s Alternative In-vestment Market (AIM), which is often held up as an example of a relatively lightly regulated market. PricewaterhouseCoopers LLP Canada says Canadian firms raised $425 million on the AIM last year, which is about two-thirds of the total IPO action on the TSXV.

While that’s a significant level of new capital, it may not yet represent a trend. Only 13 new Canadian firms joined the AIM in 2006, and just seven raised capital there. The rest were simply adding a listing.

Nevertheless, while it may prove to be an aberration, it is notable that Canadian companies are raising a significant amount of money on a foreign market. One of the primary competitive advantages of the AIM is its modest regulatory regime, leading some to question whether the Canadian market shouldn’t introduce a similar system to remain competitive.

Yet a paper for an industry task force published last year recommended against attempting to replicate the AIM model, because it would also require the implementation of its “nomad” system (in which AIM brokers take responsibility for issuers’ ongoing compliance), which would be a very challenging prospect in Canada.

Still, there are certainly reforms that could improve the competitiveness of Canadian exchanges. The task force paper recommends more flexible admissions processes, responsive continuous disclosure requirements, reassessing corporate governance requirements and revising hold periods.

There are other reforms that could help improve the environment for small domestic companies. New research by the Canadian Bankers Association suggests that the structure of the Canadian regulatory system imposes a cost on all public firms, but that the burden falls disproportionately on smaller companies.

The CBA argues that small issuers would benefit from the adoption of a national regulator. The CBA’s research found that the chore of registering in all 13 jurisdictions, rather than just one, doubles the regulation-related costs of an offering.

There are also efficiencies of scale in corporate finance. Specifically, the CBA found that the offering expenses borne by a company that is raising $1 million are four times as much as a company raising $10 million, relative to the size of the capital raised. So, regulatory costs would eat up an estimated 16% of a $1-million offering that was registered in all 13 jurisdictions, vs about 4% of a $10-million deal. In practice, this typically means that firms don’t bother to register their deals in multiple jurisdictions.

The CBA study looked at all prospectuses published between January 2002 and May 2006, comparing actual regulatory expenses incurred in the offerings with both the size of the deal and number of jurisdictions in which the issuer chose to register. The study found that firms registering in three or more jurisdictions faced, on average, regulatory costs that were 27% higher than those that registered their deals in only two jurisdictions. The CBA’s analysis suggests that each additional jurisdiction raises regulatory costs by about 7% on average.

@page_break@For smaller offerings, the magnitude of added expenses was greater. For example, on a $2.5-million offering, the study found that the added costs to go from two jurisdictions to three or more were, on average, 37% higher. For three of the firms in the study, the costs to make such a move were as much as 70% higher.

Ultimately, the CBA concludes, the data show there were added costs in maintaining and complying with a multiplicity of securities regulators, and such costs are disproportionately felt by the smallest firms in the market.

The CBA’s research empirically validates the claims by smaller firms that they bear an unfairly hefty regulatory bur-den. The data also support comments by Bank of Canada Governor David Dodge, who has often argued that the inefficient Canadian regulatory system hurts small firms in particular.

A study published last fall by the Certified General Accountants Association of Canada found that there’s a feeling among smaller firms that the pendulum has swung too far in favour of excessive regulation. The association asked small and medium-sized public companies for their views of regulation — securities, taxes, environmental, human resources and employment — and found that, by far, securities regulation was considered the most unreasonable.

Almost 60% of smaller firms said they considered securities regulation as not being reasonable. In contrast, the second-most objectionable oversight, tax regulation, was labelled unreasonable by less than 22%. These feelings were even stronger in Western Canada. In British Columbia, 65% said securities regulations are not reasonable; 62% of Alberta-based firms said the same, compared with 58% in Ontario and 48.5% in Quebec.

In the past, regulators in B.C. and Alberta have argued in favour of the existing regulatory system, citing the fortunes of small firms. The argument is that regulators in provinces with more junior companies are more sensitive to the needs of those companies, leading to the development of such plans as the capital pool program, which lets the firms raise money in a more efficient way. The CBA’s research refutes this line of reasoning.

Moreover, the study lends credence to Dodge’s assertion that the existing system doesn’t do enough to facilitate the functioning of small firms. In a speech last December to the Economic Club of Toronto, Dodge argued that Canada should try to develop a comparative advantage in securities regulation for smaller firms. He pointed to Britain’s move toward more principles-based regulation and efforts to improve U.S. regulation, suggesting that the Canadian regulatory environment remains stagnant.

“Against this backdrop, we in Canada increasingly look as if we are stuck in the middle of the 20th century, and are not positioning ourselves well to compete in the 21st century,” he said. “For the sake of efficiency, we need a single, uniform framework for securities regulation. Rules need to be applied in a uniform way across the country, and tailored to be appropriate for firms of all sizes, while providing appropriate protection for investors.”

Dodge reiterated his point in a speech to the Calgary Chamber of Commerce in early March, in which he also called on Albertans to push for improved securities regulation: “From the analysis that we have done at the Bank of Canada, it’s clearly in the interests of all Canadians, but particularly in the interests of Calgarians, to establish a uniform Canadian regulatory framework. This must be based on uniform principles that are applied appropriately, taking into account the size and complexity of the issuer.”

It appears Dodge is advocating a form of two-tier regulation, which could have unintended and undesirable consequences of its own. For instance, applying a lower level of regulation to smaller firms could undermine investor confidence. Alternatively, it could create perverse incentives for companies, since smaller issuers may find themselves reluctant to cross a bright line that distinguishes between two very different regulatory burdens.

Yet, consolidating the existing system into a more efficient one would benefit all firms. If such change relieves a disproportionate burden on smaller players and foments capital formation among the firms, then so much the better. IE