Last week, I wrote about the Crowdfunding portion of the JOBS (Jumpstart Our Business Startups) Act, which was. This week, I will try to review the rest of the Act in a series of posts. Today: an overview and Title V (Private Company Flexibility and Growth). Tomorrow, I’ll cover Titles II and IV, which give Regulations A and D makeovers, making Reg D more appealing to private issuers and making Reg A appealing for the first time, kinda like those teen movies where the nerdy girl takes off her glasses and lets down her hair and BAM she’s drop-dead gorgeous. Only with securities law. After that, I’ll finish with Title I, which gives “Emerging Growth Companies” a break on some of the ’34 Act’s reporting requirements.
The JOBS Act, despite its clever title, is not actually about jobs. It’s a bill about capital markets. I acknowledge that more efficient capital markets lead to more effective use of capital and eventually to more employment. But that’s a bit too indirect to be able to say with a straight face that the Act is designed to boost payrolls; when I tip the UArts student serving me at Starbucks, I don’t get to call myself a patron of the arts.
So, that being said, the question about the JOBS Act isn’t whether it will create new jobs. The question is whether it will improve capital markets by removing needlessly cumbersome regulations and lead to the optimal allocation of capital, or whether it will cry havoc and unleash the dogs of warrantless deregulation upon the unwitting masses of potential fraud victims. (I’m pretty sure these are the only two options, judging by the rhetoric of the bill’s supporters and detractors.)
As a sub-goal, the JOBS Act is designed to address the decline in IPOs over the past decade, which many blame on Sarbanes-Oxley’s (SOX) more onerous auditing and reporting requirements. (Then again, the US had more IPOs than any other country, so maybe it’s a problem with IPOs generally, not American regulations on them.) More American-based IPOs means, in theory, more SEC-required disclosures. More disclosures means more information available for the market, which will mean more optimal pricing. And that’s a good thing.
Unfortunately, I don’t see how the JOBS act will increase the number of IPOs. If anything, I think this Act will be a death knell for smaller IPOs, and Title V (Private Company Flexibility and Growth) will be to blame.
First off, a bill purporting to promote initial public offerings probably shouldn’t have a provision entitled “Private Company Flexibility and Growth”. Title V increases the number of record holders a company may have before it must go public from 500 to 2000. Before, only 35 of those 500 could be “non-accredited investors”, but now 500 of the 2000 can be non-accredited. (An accredited investor is basically someone with so much money that the SEC assumes they know what they are doing, so they don’t need as much protection in the form of disclosures.) On top of all that: employees who receive stock under a stock plan won’t count towards the total. That would include former employees who left with their stock. The takeaway: private companies will be able to stay private longer.
One of the reasons why Facebook is going public is because they are pressed up against that 500 person limit. On top of that, there are enough current Facebook shareholders – employees and investors – who want to cash out (Mark Zuckerberg said as much in his letter to potential shareholders), but they have a pretty illiquid and limited market. By increasing the threshold to 2000, both of these issues are ameliorated: another 1,500 potential investors not just pushes the go-public threshold back, it also adds a lot of liquidity in the form of a deeper pool of investors. And that 1,500 figure is probably a lot higher, given that individuals who received shares purusant to employee stock plans won’t count towards the threshold. That small provision, alone, might have been enough to keep Facebook private.
At this point, a quick tangential aside about private v. public is in order. Going public means more regulations, stricter audits, more potential for lawsuits, and giving up some company secrets. It’s not a terribly appealing process for a company, and it can cost quite a bit of cash. Old corporate finance theory taught that companies go public to gain access to the capital needed to grow. But that’s bunk. A successful private company will have no trouble financing its expansion using debt. Let’s consider Facebook again: would you give them a loan? I know I would. And so would pretty much any bank out there. Facebook doesn’t need more investors in order for it to grow. Moreover, there are tax benefits to taking on debt instead of issuing equity: a company can deduct interest payments from its income. On top of that, higher leverage means greater return on equity, and fewer shareholders means fewer people you need to split the profits with. Many companies only go public because they simply get too big (in terms of shareholders) to stay private. The JOBS Act makes it a lot easier to hold out longer now.
Like the rest of the JOBS Act, Title V is less about creating jobs and more about making it cheaper and easier for companies to raise money. Cheaper and easier might sound good, but it doesn’t come free. Cheaper and easier means less disclosure and less public information, and that leads to misallocated capital. So while cheaper and easier means more deserving companies will be able to raise funds, it also means that more awful companies and fraudsters will be able to raise funds, too.