There’s a great story in the Journal this morning about how the JOBS Act, which allows small new public companies to do various lazy things in their financial reporting, actually isn’t having that effect, because the companies hold themselves to a higher standard. Here is a representative passage:
Thanks to the law, Vienna, Va.-based software company Eloqua Inc.met with a large mutual-fund company to gauge interest in its stock about a month before its August IPO. The JOBS Act allows smaller companies to engage in such discussions with select investors before the SEC gives companies its approval to market an offering.
The meeting helped executives hone their pitch to investors ahead of the company's "roadshow" to market its shares, Eloqua Chief Executive Joseph Payne said. But the company won't take advantage of another provision allowing it to put off hiring a public accounting firm to audit its internal controls, though Eloqua estimates the audit could cost up to $400,000 each year. "We might look like a little-boy company when we worked really hard to be a big-boy company," he said.
ISN’T THAT ADORABLE? I want to give Eloqua a hug.
This story fills me with warm feelings about not just Eloqua but also America and our capital markets and our investors and our regulators and, just, everyone, group hug guys. One story you could tell about IPOs is that they are a thing that unscrupulous stock promoters do to trick dumb investors into giving them money to support their frauds, and that without strict SEC standards for accounting and offering-document review all of our grandmothers would be losing their money on ideas that sounded great but were actually not great. An alternative story is that the investors who drive the success and pricing of IPOs tend to be big intelligent institutions and are unlikely to be conned into parting with their money by a few lame magic tricks. Evidence is perhaps somewhat mixed - things about Facebook go here1 - but little - sorry! big! - Eloqua is good evidence for story #2.
A while back I said that the JOBS Act seems a little silly “because either the SEC registration process is necessary to protect investors, in which case it’s especially necessary for smaller newer companies, or it’s not, in which case it’s no more necessary for large companies than for small ones.” And far be it from me to argue with me on the specific point. But! It’s possible to appreciate the JOBS Act for providing a natural experiment. Turns out, some aspects of the SEC registration process - in particular, "is your accounting fraudulent?" aspects like using current GAAP standards, 3 years of pre-IPO audited financials, and external auditor reviews of your internal controls - really are necessary, especially for smaller newer companies.
The Journal leaves somewhat unexplored what it is that makes those things necessary, just saying that companies “are shunning the law's relaxed financial reporting and accounting standards because they believe there is a stigma attached to them.” I say unto you that the companies didn’t come to that conclusion on their own: their lawyers or VCs or, much more probably, bankers told them that, and you could ask what the bankers were thinking. Some possibilities include:
- Investors have credibly told them that they will pay less for JOBS-y-type companies. The Journal quotes Andrew Shapiro of small-company-focused hedge fund Lawndale Capital saying exactly that, but then, he would say it wouldn’t he? A good rule is that, if there’s even a slightly plausible argument that Thing X could reduce some investor’s valuation of a securities offering, a hundred investors will shout at the issuer and underwriter and everyone else within earshot about how horrible Thing X is and how much it will reduce their valuation. Talk about valuation is cheap.
- Investors don’t actually care at the time of the IPO, but the banks would be sad if they underwrite companies that turn out to be the sorts of fraud that could have been caught by more intense auditor review, and their clients would get mad at them and their reputation would suffer, so they don’t want to do that (and tell their issuer clients “investors demand this”).
- Investors don’t actually care at the time of the IPOI, but the banks would be sued if they underwrite companies that turn out to etc.
So maybe this is the invisible hand of the free market, or maybe it’s the grubby hand of the securities-plaintiff bar, or maybe it’s some combination: but in any case it’s operating through the gatekeeping work of the investment bank underwriters, and those gatekeepers are, for the benefit of investors, mostly holding their issuer clients to a higher standard than the law, strictly speaking, requires. So group hug for them too.
But! While the JOBS Act’s experiment at least suggests that some things really are necessary for capital markets access,2 it also suggests that some are not. Remember how Eloqua met with a large mutual-fund company to gauge interest before launching its roadshow, and how it was allowed to do that? Facebook wasn’t.3 How important does that rule look now? (How important did it ever look?) Might it be time to look into revising that rule for everyone?
Of course the SEC shouldn’t regulate with an eye purely toward investor (or underwriter) desires: its role is largely to stop investors from buying all the stupid shit they’d otherwise be tricked into buying, and give them the information they need to make good choices. Investors don’t demand auditor checks on internal controls because that’s just stuff that investors naturally love: they demand it because the SEC mandated it after Enron, and they sort of got used to it and decided it was a good idea. Similarly, perhaps if larger IPO companies were allowed to meet with large mutual funds before their registration statement is declared effective, or if they were allowed to file early draft registration statements with the SEC confidentially, havoc would ensue.
But probably not. If the JOBS Act teaches lessons, it would be nice if those lessons had an effect. If big investors require that IPO candidates follow the same accounting and auditing rules as established public companies, then maybe it makes sense for the law to go back to requiring the same of all IPO candidates - even the ones that don’t aspire to make the big investors’ radar.4 (Especially those ones) And if some changes to the procedural aspects of securities offerings make life easier for companies, are acceptable to investors, and don’t actually lead to massive fraud, then maybe it makes sense to expand those changes more broadly?
1.Mobile revenues! Selective disclosure to some analysts! Stock went down! I dunno, whatever, Facebook.
2.Though the Journal finds that 15% of eligible companies do take advantage of the permissible shoddy accounting and internal controls rules. What does this tell you? What would additional information about who buys those IPOs, versus the other 85%, tell you? What would you make of the fact that Great Idea Corp. “has irrevocably opted out of the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the Act”, just like Eloqua and its upstanding ilk?
3.Typically you can’t offer securities without a registration statement being effective; it’s especially bad if you’re in the quiet period where your registration statement is filed but not effective. The JOBS Act lets you “test the waters” with institutional investors even before your registration statement is effective, if you’re an emerging growth company, which Facebook wasn’t because it was well over the revenue threshold.
4.Especially those ones! Obviously! If you’re looking to invest in an IPO and the company is all “yeah, we’re not really looking for mutual-fund money, we’re more indie, y'know, it's all about the mom and pop investors,” run!