SEC change helps small-caps raise cash

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(FORTUNE Small Business) -- A tidal wave of small-cap stock liquidity hits today as changes take effect to the Securities and Exchange Commission's Rule 144, shortening the holding period for investors with restricted securities from one year to six months.

The change, approved late last year by the SEC, is intended to help smaller publicly traded companies raise capital by shortening the lockdown period during which outside investors must hold on to their shares. Such companies often raise cash through "private investment in public equity" (PIPE) deals, which typically involve selling large blocks of stock at a slight discount to outside investors, who are then subject to holding-period rules before they can resell their shares.

Because the Rule 144 change is retroactive, the entire batch of restricted securities issued between Feb. 15 and Aug. 15 of last year are now eligible for sale at once.

Market analysts expect the change to encourage more investors to pursue private investment deals. The timing of the revisions is convenient, given the credit crunch afflicting small businesses

"By making securities liquid in six months instead of a year, that may entice more people to invest in 144 stock," said Eric Marshall, co-manger of a small-cap mutual fund operated by Dallas-based Hodges Capital Management.

Marvin Shannon, owner of Internet services company MetaSwarm (MSWM.PK), recently secured $1 million in financing as a direct result of the changes. MetaSwarm, based in Pasadena, Calif., trades on the Pink Sheets.

"We had spent from June to November talking to [potential investors] who were saying they were interested but were concerned because the market wasn't doing well," Shannon said. Once the SEC announced the new reduced holding period, Shannon saw a complete change of heart.

"Suddenly, we had really serious interest," he said. "It was like a flipping of the switch. Everyone who was on the fence suddenly said, 'We actually like this investment.'"

MetaSwarm plans to negotiate two more private investment deals this year.

The revision could also help companies negotiate better terms. Hodges Capital's Marshall suggested that investors that previously required a 10% discount to market prices to do a PIPE deal that would have locked them into the shares for a full year might consider taking only a 5% discount with the shorter six-month holding period.

"When investors look at a six-month window rather than a year-long one, there's a change in perspective," agreed Chris Johns, CEO of SupportSave Solutions (SSVE.OB). The microcap company, based in Troy, Mich., provides outsourced support services to small companies. When SupportSave went public in September, 25% of the stock it sold was purchased through a PIPE deal.

"People will be more open to investing larger amounts," Johns said. "Potential investors seem much more receptive to restricted stock."

While the revisions could ease the fundraising process for small public firms, there's also fear that the changes will spark a massive sell-off.

"[Friday], when the rule changes go into effect, there really is the potential for billions of dollars to become saleable," said Barry Silbert, founder of Restricted Stock Partners, an online marketplace for restricted securities.

Arthur Marcus, a securities lawyer for New York City firm Gersten Savage, expects any small-cap volatility to be short-lived.

"You may see a large volume of sales of restricted stock within a week or two after Friday, but I think ultimately that will level off," he said.

Several entrepreneurs noted that the new rules raise the performance bar for small cap stocks: Investors can now unload their securities more quickly if they're not convinced a company has a bright future.

"If small companies are not good at managing the cash they bring in through private investments in public equity and don't do things to entice shareholders to stay with them when people dump, you absolutely risk catastrophe," said David Bychkov, CEO of Exmocare, a New York City company that develops medical monitoring technology. "Your stock could drop 85% in one day."

Bychkov doesn't expect immediate fallout for his company from the Rule 144 revisions, but the new terms may affect several private placement deals Exmocare is currently negotiating with potential investors.

"In the past, these small-cap companies had a full year to get their act together," Bychkov said. "Now, you've got six months before you have the risk of someone dumping a very substantial amount of stock. My hope is that this will be a wake-up call to small-cap companies to keep their markets orderly."