This post is the second in a series examining the impact of the JOBS Act one year after its passage. The post focuses on the IPO On-Ramp.
In my previous post, I discussed the disappointment experienced by many proponents of loosened securities regulations with implementation of the Jumpstart Our Business Startups Act (or JOBS Act). While some provisions of the JOBS Act went into effect immediately, implementation of many of the core provisions of the law has been excruciatingly slow while the SEC goes through the rulemaking process. In this second post, we’ll look at the first set of provisions of the JOBS Act: “the IPO On-Ramp.”
Summary of the IPO On-Ramp Provisions
Unlike some of the other provisions of the JOBS Act, Title I went into effect immediately. It adds the concept of an “emerging growth company” (referred to as an “EGC” in this post) to federal securities laws. An EGC is defined as an issuer of securities that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year, if the first registered sale of the issuer’s common equity securities occurred or will occur after December 8, 2011. The designation continues until one of certain milestones of growth is met, such as when the issuer hits annual revenues of $1 billion or more.
One of the most important benefits to being an EGC is that before an initial public offering, EGCs may submit a draft registration statement, the lengthy and detailed content of which is prescribed by volumes of intricate regulations, for confidential nonpublic review by SEC staff before public filing, as long as the initial submission and all amendments are publicly filed not later than 21 days before the company begins pitch meetings with prospective investors (called “road shows”). Before the enactment of this provision, all companies were required to publicly file their registration statements prior to the commencement of the IPO, even if it turned out later that an IPO was not feasible. EGCs are also allowed to communicate with certain institutional investors to determine whether they might be interested in a contemplated securities offering before or after filing a registration statement (called “testing-the-waters communications”).
After the IPO, an EGC has scaled-down securities compliance obligations. For instance, EGCs are exempt from certain requirements governing the content of materials sent to shareholders relating to shareholders meetings, including disclosure of “golden parachute” agreements (compensation agreements with executives based on an acquisition, merger, consolidation, or asset sale) and the relationship between executive compensation actually paid and the company’s financial performance, as well as the requirement to disclose employee compensation, CEO compensation, and the ratio of those amounts in various filings. EGCs are only required to present two years of audited financial statements in an IPO registration statement and two years of accompanying financial data in any registration statement (in contrast to the three years and five years, respectively, that are required of non-EGCs). In addition, the JOBS Act eases the SEC reporting rules that apply to EGCs on various topics including executive compensation and allows EGCs to delay complying with any new or revised financial accounting standard that applies to public companies until private companies must also comply. EGCs are not required to have accounting firms attest to their management’s internal control assessment, and are not subject to rules requiring mandatory audit firm rotation or a supplement to the auditor’s report.
The JOBS Act also allows a brokers-dealer to publish research reports about an EGC that is proposing an offering without this being deemed an offer for sale or offer to sell a security (which would complicate or even prevent the IPO), even if the broker-dealer in question is participating in the offering. Title I also prevents the SEC and FINRA from restricting certain securities analyst communications in connection with EGC IPOs.
Impact of the IPO On-Ramp
Unlike many of the other provisions of the JOBS Act, the IPO On-Ramp is generally favored by the venture capital community because they believe that it will help make the process of going through an IPO easier, less expensive, and less risky for the company, consequently making it easier for a VC to exit from its investment (which in the end, is the way VCs actually make money). In contrast, many of the other provisions of the JOBS Act, like crowdfunding and Regulation D reform, are aimed at benefitting much smaller companies. Thus, in a sense, the IPO On-Ramp should probably be viewed as a measure that deregulates big business, rather than a provision that attempts to strike a new balance between the competing public policy concerns of preventing fraud via securities laws and spurring the innovation of entrepreneurs by making it easier to raise money. Nonetheless, there has already been at least one fraud investigation involving the IPO On-Ramp, though it is unclear if the passage of the JOBS Act actually facilitated the fraud in any way.
The large international law firm Skadden, Arps, Slate, Meagher & Flom LLP did a comprehensive study on the effects of the IPO On-Ramp in January 2013. The found that EGCs made considerable use of the confidential submissions process. This makes sense since it allows the EGC to avoid publicly disclosing potentially sensitive strategic confidential information in the event of a failed IPO (and avoiding the adverse publicity of a failed IPO). When combined with the provisions allowing “testing the waters” communications, EGCs have been able to mitigate some of the risks associated with the IPO process. For instance, before the JOBS Act, if there was insufficient investor interest in the IPO, (i) the company would be out a lot of money, (ii) there would be negative publicity as a result of the failed IPO, and (iii) it would be difficult to immediately do a private placement after the IPO attempt because of the public nature of the IPO process (thus violating the general solicitation restrictions).
The Skadden study also found the provisions relaxing disclosure on executive compensation and compliance with some of the Sarbanes-Oxley provisions to also be very useful to EGCs and commonly used. Conversely, the Skadden study found that the relaxed requirement to include only 2 years of financial statements was rarely used, since most companies by that point have enough financial statements to more than cover the normally required 3-year and 5-year periods.
Overall, I’d characterize the IPO On-Ramp as a modest success. Some of the provisions, such as confidential submission of IPO registration statement to the SEC have been used by a number of companies going public. It does not appear, at least as of yet, that these provisions have increased the likelihood of fraud in any substantial way. Therefore, the IPO On-Ramp seems to provide for some level of deregulation (and thus reduced compliance costs) without harming the governmental policy interest of preventing fraud.
 Many in the VC community actually are opposed to crowdfunding for many of the reasons I described in part 1 of this series. Cynics might argue that VCs oppose these provisions because they create additional competition for them when it comes to finding quality investments.
© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.