|Congress moves full speed ahead with a bill it says will spur the IPO market, but critics see legislation written by financial firms.|
NEW YORK ( TheStreet) -- When Kathleen Shelton Smith, principal at independent IPO research and investment company Renaissance Capital, was invited to testify on Capitol Hill this week about legislation to spur the public offerings of small companies, she was surprised by the level of interest from politicians. "They were almost too receptive, almost too interested," Smith said. "I hope they wouldn't have called me to testify if they weren't genuinely interested in writing a good piece of legislation, but there is big momentum to move this through," Smith said. There's a good reason why, too. The U.S. government is attempting to rush a piece of "jobs" legislation into law that would weaken transparency of trading markets, roll back investor disclosure norms, and provide a convenient means for companies wanting to do an end-run around Sarbanes Oxley. "In the name of job creation they are reforming the entire IPO market," Smith said.
The JOBS Act (Jumpstart Our Business Startups), which the House of Representatives approved on Thursday, won't necessarily spur the IPO market with small company offerings or create nearly the number of jobs that its backers claim. The House patted itself on the back for showing its bipartisan drive to solve the unemployment problem and reduce regulatory burdens, but according to its critics, the government is doing the bidding of the venture capital and banking industries and masking it as a bipartisan job creation bill. The support for the legislation goes all the way to the top, with President Obama voicing support for a streamlining of the IPO market in his recent State of the Union address. Among the more egregious "job creation" provisions in the JOBS Act is one that would allow companies to withhold executive compensation data -- including golden parachute clauses that provide hefty termination packages for executives -- a type of disclosure that has been a staple shareholder protection since the Exchange Act of 1934. Jay Ritter, a finance professor at the University of Florida who specializes in research on the IPO market, and also testified before the Senate this week, said there are always tradeoffs in writing legislation, but there was only one logical reason he can think of to support this provision in particular: "If executives were concerned about local kidnappers knowing how much money they have, and kidnapping them for ransom was a major problem in the U.S. and a reason for companies to not go public, I could see the logic in this. But that's not why companies aren't going public here. As a state university employee, my salary is a matter of public record. I would prefer privacy, but the disclosure of my compensation is not something that I obsess over." Much of the logic that is being positioned as a job creating act is similar to this executive compensation dodge that seems written by the venture capital lobby. The JOBS Act would also create a definition of emerging companies that allows any company going public with under $1 billion in revenue in the prior fiscal year to be afforded these exclusions. Lynn Turner, a former Securities and Exchange Commission chief accountant who also testified before the Senate, noted that 98% of all IPOs since 1970 were companies with $1 billion or less in annual revenue. On an inflation-adjusted basis, Ritter puts the same number at 94% going back to 1980.
"Almost every company going public would qualify as an emerging-growth company," Ritter said. "The notion is that Sarbanes Oxley is a huge burden for small companies, but this is an end-run around Sarb Oxley for almost everyone." Smith urged the Senate this week to change the emerging-company definition to any company seeking to raise up to $50 million, which would imply a market capitalization of $200 million. "If we really want to help start-up companies it is those looking to raise $50 million or less," Smith said. "They are very anxious to pass this and there isn't anyone who disagrees with the idea that we need more jobs and this has the positive headline impact of doing that, but is the intention to relax rules for the entire market?" Smith asked. The JOBS Act would exempt emerging companies from having to provide at least three years of audited financial statements. The legislation would also allow Wall Street firms that are involved in IPOs to provide their sell-side analysts with nonpublic information about companies in the pre-IPO period to selectively offer clients interested in the offerings, a provision that on the surface seems to be a flagrant violation of the SEC Regulation Fair Disclosure. "They want to go back to the older Wall Street Research 1.0 model as opposed to moving ahead," Smith said. "Reg FD is being gutted. To some degree this does provide an opportunity for the bad old days to be resurrected," Ritter added. The JOBS Act also seems to be at odds with its stated goal of spurring IPOs in its attempt to increase the shadow trading market made famous by Facebook in its pre-IPO phase. Currently, companies trading in the private share market are required to disclose information to the SEC if they have more than 500 shareholders. In practice, the 500 shareholder limit doesn't entirely work, since many individual shareholder accounts can be combined into one "Street" shareholder of record. Yet the JOBS Act would increase the shareholder limit for private market trading to 1,000 shareholders.
This increase in what is known as the "crowdfunding" approach to raising capital for smaller companies would allow companies to remain private for a longer period of time without having to pursue an IPO and without having to provide investors with the level of transparency required of public companies. While backers of the legislation say it is just the kind of rationalization of Sarbanes Oxley for smaller companies that needs to occur, Frances Gaskins, of independent IPO research firm IPO Desktop, said that this would really encourage the "shadow" market to the detriment of the public market and allow companies that aren't smaller to shield themselves from disclosure. If some of the provisions included in JOBS act are an end run around Sarbanes Oxley, this shadow market push is an end run around the entire IPO process, Smith says. "The IPO market is intended to be a market open to everybody. Why can't the same insiders buying in this non-transparent market buy during the IPO process?" "One thousand shareholders is actually quite a lot for a small company, and larger companies could do just fine with 'bundlers' like what Goldman did for Facebook. If the limit now were 1,000, then Facebook, for example, could have an even more active trading market without doing an IPO," Gaskins noted. The proposed legislation requires the capital sought in the raise to be limited to $50 million -- an increase from $5 million, but Smith says a company can do multiple $50 million equity deals. In an interview with Bloomberg Television this week, Marc Andreessen, the co-founder of Netscape and an investor in Twitter said, "The really interesting thing in the last five years is there is now this completely parallel capital ecosystem on the private side. And so, you've got these companies, including actually Groupon and Zynga, that are able to be extremely well-financed without actually going public, or before they go public. And so, in some cases, now you have companies raising billions of dollars of equity capital on the private side, and, in fact, even doing secondaries and, in fact, even doing tender offers, for their early employees to be able to get a certain amount of liquidity without actually going public. So, the IPO is actually not as critical as it used to be for all of these new companies." Ritter said if the goal is to make it easier for companies to raise money -- and in a less transparent way -- this provision would accomplish that goal, but it will not spur IPOs generally, or IPOs of small companies in particular. "One argument is that for the venture capital and private equity guys these companies aren't worth their time but I don't have confidence that dentists will be better at distinguishing good from bad investments when they are part of the crowd throwing in a thousand dollars each," Ritter said, referring to a proposal that allows raising up to $1 million in chunks of no more than $1,000 per investor. A cynical reading of this crowdfunding provision implies that venture capital is being provided with a convenient way to dump some of their portfolio dogs into the shadow market. "That's a little cynical, but not outrageous," Ritter said. The University of Florida finance professor takes comfort in one important belief: The reason the IPO market has stalled and smaller companies have not successfully gone public in recent years has almost nothing to do with regulation. Smaller companies are increasingly selling out to larger companies before going public, particularly in the technology sector, because the company is more valuable as part of a larger organization than as a small stand-alone company, or because they simply haven't had the performance to merit a public offering. From 1980 to 2009, there were about equal numbers of small and large company IPOs, and the small companies underperformed the market by an average of 36% in the three years after going public. For smaller company IPOs from the 2001-2009 period, the performance was negative 20% for three years. "Investors aren't enthusiastic because so few have done well, and weakening disclosure won't make investors more enthusiastic," Ritter said. Gaskins said the IPO market typically closes when the major averages decline, as in a bear market, and that's because the IPO market is the tail behind the dog (the major averages). Gaskins also noted that it's very hard to get institutional interest in IPOs less than $50 million, the pool of retail investors looking for IPOs less than $50 million is much smaller than before 2008, and even if a company can IPO to raise $50 million or less, there is no 'sponsoring' system for those companies, which quickly become 'orphans'. All of these points relate to the Renaissance Capital case that the focus should be on helping start-ups specifically, something this legislation is not designed to do. Ritter said he believes this legislation will be a pyrrhic victory for venture capital and Wall Street interests. Even if the Senate waters down the legislation from the current House version, the biggest problem for smaller companies remains the market and not regulation.
"This is wishful thinking on the part of the VCs. They are betting this will allow them to take more companies public, and also do more cashing out before companies are formally public, but I don't think this will result in the number of deals they think it will. Wall Street also wants companies to go public and pay the spreads for going public. But the fundamental problem is not enough of portfolio companies becoming profitable." Ritter said there will be some fraud, and some dentists who lose money in the expansion of crowdfunding, but fraud always finds its way into the capital markets in one form or another. He is cautiously optimistic that investors by and large are smart enough to know that a lack of transparency should not encourage investment, and companies operating under these provisions, if approved, will be wise enough to take the high road if they want to have a successful capital raise, meaning a deal that includes institutional investors. Companies that fit the definition of "emerging growth" provided in the legislation have the option to opt-in or opt-out of its provisions at the time of an offering. Just because they build it, "Investors won't necessarily come," Smith said. "My impression is that Republicans and Democrats are in favor of this so they can say to constituents that they voted in favor of this job creation bill and this is bipartisan legislation," Ritter said. What it won't necessarily do, though, is create a boom in jobs or small company IPOs. -- Written by Eric Rosenbaum from New York. >To contact the writer of this article, click here: Eric Rosenbaum. >To follow the writer on Twitter, go to Eric Rosenbaum. Follow TheStreet on Twitter and become a fan on Facebook.