If you’re an entrepreneur at the head of a young, innovative company, you know that the initial public offering (IPO) process has historically been an important avenue for firms to have broader access to capital. A successful IPO offers funding for much-needed research and development, capital expenditures, and creates a liquid market for investors as well as venture capitalists.
But the shifting landscape of American capital markets has entrepreneurs questioning whether the benefits of going public outweigh the costs. Recent legislative changes, particularly the 2012 Jumpstart Our Business Startups (JOBS) Act, aim to lower the direct cost of IPOs by giving firms the choice to reduce disclosure during the IPO process and their first five years as publicly traded companies.
But does this new legislation actually achieve its goals? What if reductions in disclosure and transparency actually increase the indirect costs of going public? In short, should firms considering an IPO take advantage of reduced disclosure, or does this factor of the modern IPO process cause more harm than good?
If you’re the head of a small firm looking for a successful IPO, you need to decide whether or not to take advantage of the provisions in the JOBS Act. In order to help entrepreneurs weigh their choices, my colleagues and I studied the initial outcomes of Title 1 of the Act as a window into the costs and benefits of reduced disclosure.
THE NEED FOR A NEW ORDER
Since the Dot.com crash of 2000, the number of U.S. IPOs has been in a steady decline, particularly among small firms. Given the choice between going public and selling out to another company, entrepreneurs increasingly have chosen to sell their firms. Concerns about receptivity of public markets to smaller companies and the potential loss of job growth set market commentators and legislators alike looking for a solution.
One prominent explanation for this decline in small IPOs was the “regulatory cascade” of the mid-2000s, which increased reporting requirements. Many companies, entrepreneurs or founders describe these disclosures as onerous. This led market commentators and legislators to worry that these effects increased the costs of going public without increasing commensurately the benefits of being a public company.
In April 2012 the JOBS Act was signed into law in an attempt to reverse this downtrend in smaller company IPOs. Though reduced disclosure requirements were already available to some smaller reporting companies (SRCs), the Act eased mandated disclosure and compliance requirements for emerging growth companies (EGCs), defined as companies with less than $1 billion in revenues in their most recently completed fiscal year. The new law expanded existing reduced disclosure provisions from 11 percent to 87 percent of issuers.
While supporters applauded the Act’s modernization of 100-year-old security regulations, critics charged that it overturned essential investor protections. Given the debate surrounding the efficacy of the Act’s provisions, our team recognized the need to examine the costs and benefits of the Act for small firms going public.
We traced the outcomes of a sample of 213 emerging growth company IPOs issued between 5 April 2012 and 30 April 2014. We examine their draft registration statements (DRSs) and registration statements (S-1s) to determine the frequency with which they chose to file confidentially and take advantage of the other public on-ramp provisions. Unlike other emerging research on the Act, we focused on both the direct and indirect costs of going public and isolate the effects of scaled disclosure only on newly eligible firms.
THE PROMISE OF THE JOBS ACT
At its heart, Title 1 of the JOBS Act was designed to reduce accounting, legal and underwriting fees for EGCs ready to go public. These firms would not only save cash through a reduction in mandated disclosures, they would enjoy the strategic and competitive benefits of reduced transparency.
Title 1 of the JOBS Act made it possible for firms to take advantage of reduced disclosure at two points in the IPO lifecycle: during their filing with the SEC and up to five years after the IPO.
Let’s imagine the founders, Jake and Kelly, of a startup biotech firm named PhysoTech, need capital to support their company’s ongoing research into potential cancer treatments. After several rounds of venture capital funding, they are looking to expand the firm’s access to capital, so they are considering taking their company public.
Because PhysoTech has yet to earn $1 billion in annual revenue, Title 1 of the JOBS Act allows Jake and Kelly to take advantage of reduced disclosure reductions that were previously unavailable to a firm of their size.
After electing EGC status for PhysoTech, the founders file a confidential draft registration with the SEC affording them the opportunity to receive comments from the SEC before making the financial and strategic details of filing public. If the issues raised by the SEC during the review process are difficult to overcome, none of the firm’s information will ever be disclosed. (In the past, this information would become publicly available upon filing.) Once the decision is made to move forward with the offering, however, the confidential draft registration statement becomes public.
Because Jake and Kelly decided to be an EGC, PhysoTech’s registration could provide less information to investors than that of similar IPOs in years past. The firm only needs to include two years of audited financial statements, not three. In the years prior to the Act, the firm would have been obligated to share compensation details for PhysoTech’s CEO, CFO and the three highest-paid executive officers, but now it only shares this information for the CEO and two other highest-paid executives. Thus, at the time of the IPO the firm is also spared the difficulty and cost of providing a full compensation discussion and analysis.
AFTER THE IPO: MORE OPPORTUNITY FOR REDUCED DISCLOSURE
Let’s imagine that Jake and Kelly decide to move forward with PhysoTech’s IPO. In addition to the reduced disclosure required at the time of the IPO, they can also take advantage of other reduced disclosure provisions once the offering is finished and the stock begins trading.
For example, until the passage of the JOBS Act, new issuers were forced, in keeping with their status, to adopt public company effective dates for revisions in accounting standards. Now PhysoTech has the option to adopt private company effective dates for its own compliance with these changes.
More importantly, PhysoTech is now exempt from two disclosure requirements that have been considered very costly by the business community: Sarbanes-Oxley Section 404(b) (SOX) and Dodd-Frank. PhysoTech can delay compliance with external auditor attestation of internal controls over financial reporting for up to five years or until it earns $1 billion in annual revenue and ceases to be an EGC.
The firm is also released from Dodd-Frank requirements to hold separate non-binding advisory votes on executive compensation. Specifically, PhysoTech no longer needs to discuss named executive officer pay or “golden parachute” arrangements for those officers in the event of a merger, acquisition or similar transaction.
PhysoTech executive pay information is further protected because as long as the firm remains an EGC, it no longer needs to disclose the relationship between executive compensation and the company’s financial performance, nor the ratio of annual CEO compensation and the median salary of all employees. All of these choices have potential consequences for the firm in the form of the fees paid to prepare the registration statement and the securities sold (underwriting fees), as well as the expected value of the shares.
When my co-authors and I isolate the choices of EGCs like PhysoTech, we find that 92 percent choose to reduce disclosure on executive compensation, while only 12 percent choose to adopt private company compliance dates for new accounting rules. Only 40 percent were unequivocal in their intention to delay compliance with SOX, and just 36 percent were likewise committed to delay compliance Dodd-Frank advisory votes for as long as they remain EGCs.
Given the wide variety of choices made by the first EGCs, we wondered, would the savings in underwriting, accounting and legal fees outweigh the expected underpricing of the share price by investors?
THE OUTCOMES OF THE JOBS ACT
We find that the direct costs for new IPO firms, namely accounting, legal and underwriting fees, are either insignificantly different or significantly higher compared to control groups of similar IPOs. In all cases, we found that the indirect costs (underpricing) of EGC IPOs are significantly higher. We interpret our findings to mean that investors require a higher discount on the firm’s offer price to compensate them for the lack of disclosure. In other words, the intended benefits of the Act came at the expense of a higher cost of capital.
Moreover, we found that investors required a larger discount on their share price when EGCs that were not definitive about whether or not they would take advantage of the new exemption choices. It appears that the market penalizes issuers for greater uncertainty about their disclosure choices with higher underpricing at the time of the IPO.
We found increased underpricing only for issuers that were not eligible for reduced disclosure before the Act: those with more than $75 million in proceeds. This suggests that extending reduced disclosure to a broader set of issuers is costly, as investors require a higher rate of return to compensate for the loss of transparency.
Ultimately, the Act was designed to increase the total volume of American IPOs. Even controlling for macroeconomic and market conditions, we find no evidence that the total number of IPOs increased significantly following passage. Consistent with commentators and other academic research, we do find that more companies in the biotech/pharma industries have decided to go public recently. However, the majority of these companies are small, unprofitable and recently exited by traditional VC backers. Since our study only looked at the first two years of IPOs under the JOBS Act, we noted that during this period stock market conditions have generally been favorable. It will take a longer period of time with more varied market conditions to ascertain how the Act ultimately affects the volume of IPOs.
Since reduced disclosure requirements means that it takes less effort for accountants, lawyers and underwriters to draft the registration statement, why don’t we find that their fees go down?
Because there is less information in the prospectus, for example, underwriters may be worried about litigation costs. For example, if PhysoTech’s stock price declines after it goes public because the firm had an omission in its prospectus due to reduced disclosure, then the underwriter may be sued by investors. In order to protect themselves from this possibility, the underwriter may charge higher fees.
As a result, it appears that at least for the first uses of the Act, overall costs increase. Collectively, our findings suggest that investors see EGCs as a group as having higher overall risk profiles after the Act than before. While the Act intended for the direct costs of going public to decline, we believe the framers did not fully take account of the impact of reduced disclosure on the issuing firm’s cost of capital.
WHY THE CONVERSATION ISN’T OVER
Not every outcome in our study was negative, however.
Within the collective of EGCs, firms that chose to delay SOX reporting enjoyed lower relative underpricing. Therefore, this particular aspect of Title 1 may indicate cost savings in investors’ minds and effectively lower the penalty of EGC status on firms.
We found no negative outcome or penalty for firms that choose to file confidentially. In fact, the increase of confidential filing among issuers — from 10 percent to 92 percent over the period of our research — indicates market acceptance of this trend.
Enabling companies to better predict IPO success is a benefit of the JOBS Act beyond Title 1. One provision that we did not study, called “Testing the Waters,” allows potential issuers to go out through investment bank representatives, talk to institutional investors like Fidelity or Vanguard, and attempt to gauge whether there will be enough demand for the offer when it goes to market.
This provision, which eliminates the traditional “quiet period” before company roadshows, along with confidential filing, reduces an EGC’s uncertainty about market demand and the scope of SEC review. These two provisions expand the issuing firm’s ability to make intelligent predictions about its success before committing to the substantial costs of issuance.
The JOBS Act gives issuers more choice about the information they choose to disclose. Since those closest to the decision often have the greatest incentive to weigh the costs and benefits of their disclosures, it may reduce some of the impediments that smaller and younger firms held about the IPO process. Additional research will be required to know whether the other benefits of the JOBS Act, such as job creation, will follow in the wake of passage of the Act.
Susan Chaplinsky co-authored the paper “The JOBS Act and the Costs of Going Public” with colleagues Kathleen Weiss Hanley of the Robert H. Smith School of Business at the University of Maryland — College Park and S. Katie Moon of Marshall School of Business at the University of Southern California.