In this report, Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public, eight organizations—the American Securities Association, Biotechnology Innovation Organization, Equity Dealers of America, Nasdaq, National Venture Capital Association, Securities Industry and Financial Markets Association, TechNet and the U.S. Chamber of Commerce—joined forces to make recommendations about how to revitalize the IPO market and make public company status more appealing. Many of these recommendations have in the past been the subject of legislation or proposed rulemaking or have otherwise been floated in the ether but, nevertheless, have not advanced. Will the weight of these groups propel any of these recommendations forward?
The report begins by reminding us of the benefits to the economy that result from an environment that would induce companies to go public: according to one study, “the 2,766 companies that went public from 1996 to 2010 collectively employed 2.2 million more people in 2010 than they did before they went public, while total sales among these companies increased by over $1 trillion during the same period. Another study… in 2010 found that 92% of a company’s job growth occurs after it completes an IPO.”
See also this speech from new SEC Commissioner Hester Peirce, who advocated that we need “to look at the bigger picture. I worry that we can be too myopic when considering capital formation. Discussions often focus on the issuers, or maybe on the jobs the issuers might create, or on the money investors can earn. These things are extremely important to any discussion of capital formation, of course, but none is the reason we actually need robust capital formation. We need it because of what the companies create. Perhaps it sounds a bit like an advertising slogan, but vibrant capital markets fund the good ideas that make life better. It’s not too much to say that how well our markets work is a matter of life and death; markets fund new cancer drugs, car safety features, and medical devices. When companies doing good things can’t access the money they need, we lose out and we will never know just how much we’re losing. We don’t know what new invention was waiting to be created that now never will be. I realize this may be an obvious point, but I worry that it often gets lost in the conversation.”
However, the report continues with a familiar lament: these benefits notwithstanding,
“the public company model has become increasingly unattractive to businesses: the United States is now home to roughly half the number of public companies than existed 20 years ago, while the number of public companies in the United States is little changed from 1982. Not only are fewer companies going public, but the companies that do are typically doing so much later in their lifecycle. When companies go public at a relatively mature age, many of the early stage returns generated by those businesses accrue to institutional investors such as private equity funds or wealthy individuals who are allowed and able to invest in private offerings. Main Street investors thus have limited opportunities to participate early on in a company’s growth cycle. All too often, Main Street investors are simply left out.”
The report recognizes that the problem is complex and that there are no easy solutions. Some of the reasons for the reluctance of companies to go public—such as the availability of capital through the currently vibrant private markets—are not, the report concludes, within the control of policymakers. What policymakers can control, the report asserts, are laws and regulations, and those need to be updated.
But will easing the regulatory burden really make a big difference here? Many commentators view the issue of the decline in IPOs as more complex than just the volume of red tape. Among the factors commonly cited for the decline in IPOs and public companies are the availability of capital in the private markets, the greater maturity expected of IPO candidates, more opportunities for liquidity for investors and employees through secondary trading in the private markets, changes to the Exchange Act registration threshold that permit companies to stay private longer and concerns regarding hedge-fund activists with short-term views, among other reasons.
According to EY, the decline in the number of public companies—largely the result of acquisitions and delistings—happened primarily by 2002; it’s not just a recent phenomenon. And much of the decline may reflect the popping of the dot-com bubble in the first years of the new millennium. Accordingly, some would argue that a number of those companies should not have gone public in the first place and that measuring against the height of the bubble is wrong-headed.
As observed at a 2017 meeting of the SEC’s Investor Advisory Committee, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from opportunistic hedge-fund activists (fka corporate raiders, now successfully rebranded as “activists”). Hence the recent prevalence of dual-class capital structures, which one panelist characterized as merging some private company benefits into a public company structure. Perhaps dual-class structures are a blunt instrument, the panelist indicated, but it’s one tool that is available. At the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance. (See this PubCo post.)
The report does recognize that the need to maintain decision-making control is a factor for companies considering an IPO, but its recommendations in that regard, while important, are limited to advocating a regulatory hands-off approach:
“Another trend that has developed recently is companies adopting corporate structures that help founders maintain control. For example, dual class or multi-class share structures retain voting rights only for certain shareholders. While such structures have received criticism from some observers, policymakers should recognize that this trend has coincided with a steady rise in shareholder activism, and that companies should be free to choose a corporate structure that they believe will best enhance long-term performance. Instead of contemplating whether to prohibit or limit the use of such structures, policymakers should instead focus on the underlying causes of the trend and whether it is merely a symptom of a broken public company model. A broad focus on encouraging investor choice while assuring that issuer disclosure keeps investors sufficiently informed is necessary to prevent prescriptive regulations that harm market dynamism.”
JOBS Act 2.0
While the report views the JOBS Act as a beginning, it contends that now is the right time for policymakers to “seriously address the impediments both to launching IPOs and to reverse the increase in costs associated with remaining a public company.” Accordingly, the report recommends:
- For issuers that continue to meet the definition of an EGC, extend certain JOBS Act Title I “on-ramp” provisions from five years to ten years, including streamlined financial and compensation disclosure and exemptions from say-on-pay, say-on-frequency, say-on-golden parachutes, pay-for-performance and pay-ratio disclosure.
- Permit all issuers to “test the waters” with QIBs and institutional accredited investors to determine interest in a securities offering.
In February, the WSJ reported that “people familiar with the matter”—every reporter’s favorite source—said that the SEC was “weighing” expanding “test the waters” beyond just EGCs. You might recall that, in 2012, the JOBS Act allowed IPO candidates that were EGCs to take preliminary steps to determine the potential level of investor interest before committing to the expensive and time-consuming prospectus drafting and SEC review process. (See this PubCo post.) The testing-the waters provisions in the JOBS Act significantly relaxed “gun-jumping” restrictions by permitting an EGC, and any person acting on its behalf, to engage in pre-filing communications with qualified institutional buyers and institutional accredited investors. This relaxation of the gun-jumping rules allowed companies to reduce risk by gauging in advance investor interest in a potential offering. (See this Cooley Alert.) Prior to the JOBS Act, only WKSIs could engage in similar testing-the-waters communications. A 2017 Treasury report also recommended expanding this provision of the JOBS Act to allow all companies, not just EGCs, to get their toes wet. (See this PubCo post.) See also HR 3903 and Senate Bill 2347, which would expand the test-the-waters provision beyond EGCs.
- Extend the JOBS Act exemption from SOX 404(b), the requirement to have an auditor attestation and report on management’s assessment of internal control over financial reporting, from five years to ten years for EGCs that have less than $50 million in revenue and less than $700 million in public float. The report contends that costs associated with SOX 404(b) “have not been scalable for small and midsize public companies” and that there is “no evidence” that the JOBS Act exemptions from SOX 404(b) “have compromised investor protection or market confidence.”
Those same people familiar with the matter also told the WSJ that the SEC was looking at exempting smaller companies from SOX 404(b). The auditor attestation requirement has recently been much maligned as time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D. However, many see value in these controls audits. According to a GAO study, companies exempt from controls audits had more restatements. In addition, another study showed that companies that had controls audits had higher valuation premiums and lower cost of debt. See this PubCo post. In her speech cited above, Commissioner Peirce cited SOX 404(b) along with conflict minerals and pay-ratio disclosures as examples of burdensome regulation that she believed deterred companies from going public.
- Remove “phase-out” rules that “increase the complexity and uncertainty regarding EGC status,” thus allowing EGCs to retain their EGC status even if they crossed a market cap threshold (although the report allows that the SEC could still set a public float cap.) The report indicates that, for example, in 2014, about 30% of EGCs that went public in 2012 found that they had to comply with SOX 404(b) because they had become large accelerated filers and, as a result, therefore ceased to qualify as EGCs.
Recommendations to Encourage More Research of EGCs and Other Small Public Companies
One widely recognized problem for smaller public companies is the dearth of analyst coverage, which can affect the liquidity and trading environment. The report cites a study showing that, for exchange-listed companies with less than a $100 million market cap, about 61% of have no research coverage at all. The report recommends:
- Amend Rule 139 to provide that continuing coverage by research analysts of any issuer would not be deemed to constitute an offer or sale of a security of that issuer before, during or after an offering by such issuer, regardless of whether the issuer was S-3 eligible.
- Allow investment banking and research analysts to jointly attend “pitch” meetings in order to have open and direct dialogue with EGCs. A holistic review of the Global Research Analyst Settlement should also be conducted, the report recommends. Currently, the JOBS Act permits joint attendance, but SEC guidance limits what may be discussed. The report recommends that the SEC expand the scope of permitted content that can be discussed “so long as no direct or indirect promises of favorable research are given.”
- The SEC should examine why pre-IPO research has not materialized notwithstanding liberalization of the gun-jumping rules under the JOBS Act to permit publication of pre-IPO research. Are there other regulatory or liability concerns that should be addressed in this context?
Improvements to Certain Corporate Governance, Disclosure and Other Regulatory Requirements
The reports cites a 2011 report of an IPO Task Force for the proposition that “92% of public company CEOs found the ‘administrative burden of public reporting’ to be a significant barrier to completing an IPO.” In addition, the report contends that companies are distracted by pressures from governance activists, bolstered by proxy advisors, over matters that are often immaterial. The report recommends:
- Institute reasonable and effective SEC oversight of proxy advisory firms. The report notes that ISS and Glass-Lewis have over 97% of market share and have become “de facto standard setters for corporate governance.” But there’s a “startling lack of transparency and significant conflicts of interest, and [proxy advisors] have been prone to making errors in analysis….These issues are exacerbated by the lack of communication between the firms and small and midsize companies….” Congress should enact legislation (passed by the House in 2017) (see, e.g., this PubCo post and also R. 4015) that would require proxy advisors to register with the SEC, and the SEC should withdraw two old no-action letters that, through no-actions positions regarding investment advisors’ use of third-party recommendations, allowed proxy advisors to bypass “case-by-case scrutiny of their own conflicts of interest.”