Much Ado About the JOBS Act: Fear Mongering vs. Idealism Cloud
We warn our children to fear the Boogyman, the Big Bad Wolf, and strangers with candy. For would-be-investors the same warning is issued for charlatans, conmen, fraudsters, and people from Boca Raton.The Jumpstart Our Business Startups Act (JOBS), passed overwhelmingly by Congress and signed into law by President Obama last week, is meant to jumpstart the growth of small and “emerging growth companies.” But the only thing it has succeeded in doing thus far is stirring up conflicting opinions and a bounty of predictions.
By many, it’s being billed as the end of the world as we know it. As if Washington has hand delivered a personally addressed invitation to every unsavory character to creep out from the shadows and steal your poor grandmother’s last nickel. That is, unless you’re talking to someone who thinks Crowdfunding will save the Western economy and that the meager IPO markets over the last decade are a big part of the reason we’re currently in this mess. For these people, salvation has arrived at last.
The reality is that the JOBS Act is neither of these things, and we won’t know its true implications, positive or negative, for years to come. In its current form (which is still somewhat incomplete, but more on this later), the final bill is a bit of a Frankenstein created by politicians who predictably couldn’t agree on much but wanted to release a statement piece of legislation that they could pat themselves on the back about, while on the campaign trail.
The details of the bill are countless (for a simple and laymen’s summary written by a law firm, go here), but at the end of the day there are five basic takeaways.
For simplicity's sake, they are the institution of Crowdfunding (very limited and still vague); reduced regulations and increased size limits for unregistered private offerings; increased thresholds before companies must report publicly (aka the “Facebook 500 Shareholder Rule”); an IPO “On-Ramp;” and an easing of Sarbanes Oxley requirements for small public companies (which were bullshit to begin with).
The following is a more detailed discussion of the implications of each with regard to companies and individual investors:
The biggest lightning rod in the bunch is the Crowdfunding provision. Unfortunately, it was also the most neutered of all, based on the comparison of the earlier proposed versions and the one signed by President Obama. Regardless of what may have been the “right” course of action, the types of half measures and ill-thought out compromises that we got have rarely if ever led to favorable results.
First, all companies raising money in this manner (“issuers”) must do so through a SEC registered “Funding Portal” (think Kickstarter for investments) or worse yet a full blown Broker Dealer. The introduction of this intermediary and its associated registration requirements, although seemingly logical for protecting ever-vulnerable investors, just adds cost and bureaucracy and therefore erodes most of the economic and efficiency benefits that make crowd-funding intriguing.
Even worse, the SEC has yet to determine the potential liability of the intermediary (we’re in a 270-day waiting period before we get these and other final details). If they end up being responsible for validating the accuracy of the issuer’s disclosure documents — business plan, financial statements, capital structure, use of the financing proceeds, and risk disclosures — which is likely given prevailing sentiment, this just adds more costs, delays, and obstacles to the pile preventing crowd-funding from emerging as a desirable alternative to traditional capital sources.
In addition to these onerous procedural details, limits on the percentage of annual income each investor can direct to crowd-funding (the greater of $2K or 5% for under $100K/year income OR 10% up to $100K for over $100K/year), and the total amount each company can raise (up to $1 million per year), will likely mute the overall effects of the measure. Essentially, companies don’t really win, but investors can’t lose too big.
This aside, the fact remains that the government has no business telling people what to do with their money. Our fictitious grandma above can gamble to her heart’s content in Las Vegas, she can day trade penny stocks in her e-trade account, or she can donate her last dollar to a cat orphanage all without government interference. Hell, she could even buy Groupon stock on the day of its IPO (an “ultra-safe traditional” investment). The prospect of earning a return through investing in an early-stage business doesn’t deserve special treatment. What happened to caveat emptor?
Will some investors lose money? Of course. Will the imaginative and unethical try to game the system? They’re working on it as you read this! But it won’t be the first or last time, regardless of asset class or government regulation. The stocks of Enron and Lehman Brothers along with millions of underwater home mortgages and failed pyramid schemes prove this point.
Investment size restrictions aside, Crowdfunding deserves as frictionless and inexpensive of a regulatory environment as can safely be created, otherwise it will end up nothing more than a relic of beltway dysfunction. Too bad all we got were symbolic half-measures.
Reduced Regulations and Increased Size of Private Offerings
Reversing a well-known but largely ignored regulation on “solicitation,” issuers can finally advertise their private offerings to potential investors as long as they’re Accredited (rich and sophisticated based on the government’s assessment) or qualified institutions. While this provision is subject to a 90-day review by the SEC before going into effect, since it has long been a common occurrence, and companies couldn’t legally accept investments from unqualified investors — and for the most part haven’t — it should really be a moot point.
In an effort to provide capital to private companies who need more than the $1 million per year allowed under Crowd-Funding, the JOBS Act also raises the limit from $5 million to $50 million on the amount companies can raise through unregistered offerings each year. ("Unregistered" simply means that the SEC doesn’t review and publicize their offering materials.)
This is all well and good for companies, but is it worth investors and regulators getting upset over? Not really. These “mini-public offerings,” as they’re sometimes called, are only available to Accredited Investors, which in SEC-speak means you’re rich enough, and somehow therefore automatically sophisticated enough, to be able to make your own decisions and suffer the consequences. Also, the exemption is not available to “development stage companies” or those classified as “investment companies,” meaning, among other things, that issuers must have a very specific business plan.
The increase in the limit on these offerings likely won’t affect the size of check individual investors write, and therefore the risk to “the public.” In the case of most offerings reaching the upper limits of this extended range, the investors will be mostly institutional funds anyway. The primary result will be limiting the burden on companies raising larger rounds of growth financing.
“Facebook 500 Shareholder Rule”
The second most widely known aspect of the JOBS Act, due to its famous corporate poster child, is related to increasing the number of shareholders a company may have prior to registering and reporting publicly from 500 to 2,000 (excluding employees and crowd-funders). This rule has been attributed as the reason many companies such as Facebook, and Google before it, were forced to go public in spite of the wishes of management and investors.
At the same time, the desire to stay under the 500 Shareholder Rule has led to the usage of Restricted Stock Units rather than traditional Options in employee compensations packages. The lifting of this ceiling may lead to a rethinking of this strategy, with some interesting tax and valuation implications. Another thing that this rule will likely promote is the existence of secondary markets as a place where early employees and investors can achieve liquidity prior to an IPO or sale.
As Sarah pointed out previously, this newly relaxed rule could actually allow immature but large and fast growing companies, such as Groupon, to take a more conservative route and put off going public for as long as possible. The reality though is that it will impact very, very few companies. That notwithstanding, by allowing a little more time in the oven, the companies that ultimately reach the public markets are more likely to be fully-baked and therefore better equipped to thrive on the bigger stage with its intense scrutiny.
For companies wishing to go public but which have been unable to due to draconian regulations, the JOBS Act creates an exemption for emerging growth companies (those with less than $1 billion in revenue) to include only two, rather than three years of audited financial statements in their IPO registration statement, saving both money and time.
Also, companies can now file their registration statements confidentially until shortly prior to their offering road show, effectively eliminating any embarrassment due to inevitable corrections made after the initial submission (ahem, Groupon) and also reducing the time competitors get to inspect this private information.
Also, would-be IPO candidates can for the first time “test-the-waters” prior to filing the registration statement by holding meetings with institutional accredited investors and qualified institutional buyers. This is analogous to a collegiate athlete declaring for the professional draft. If there are no buyers (they don’t get picked), they don’t lose their amateur status. This is simple common sense in both cases and should be no cause for concern.
Finally, the bill also permits investment banks to publish research related to emerging growth companies around the time of their IPO or other offerings and the expiration of related lock-up periods. This is actually a huge win for small companies which have typically been left out of analyst coverage in all but the rarest cases. Individual investors benefit in this case as well based on the premise that information is power. While the walls erected between the brokerage and research desks of investment banks were created for valid reasons, in the case of smaller public companies the result was a near deafening silence to the detriment of all involved.
Easing of Sarbanes Oxley for Small-Cap Companies
Under the JOBS Act, publicly traded “emerging growth companies” will enjoy a variety of relaxed reporting requirements for up to five years. They will not be required to have an auditor attest to internal financial reporting controls or comply with any rules requiring audit firm rotation. Additionally, these often resource-constrained companies will not have to comply with any new or revised financial accounting standards (these things change as often as underwear). Lastly, emerging growth companies will be exempt from having separate shareholder votes on executive compensation or providing some of the compensation disclosures and industry comparisons otherwise required.
Since Sarbanes Oxley was instituted a decade ago, its heavy handed requirements have been an albatross around the neck of all but the largest public companies. These relaxed standards have been a very long time coming and will result in a healthier overall marketplace.
For too long, companies who have needed money to grow have had trouble accessing it and those companies forced to list publicly have then been punished upon their arrival. The Financial Services Committee laid out a worthy goal in approaching the JOBS Act, which was to make it easier for startups to grow, hire employees, and contribute to the economic recovery by easing access to U.S. capital markets and making it more attractive for companies to list publicly.
Fear mongers and idealists aside, the rational jury is still out on true impact of the JOBS Act. For companies considering an IPO, the changes seem to reduce friction to a significant degree, but do not dramatically change the incentives of going public. Unfortunately, for private companies seeking to raise capital and for investors looking to participate in the growth of small and emerging growth companies, the uncertainty and onerous regulation accompanying these provisions take away a bit of the luster.