JOBS Act Good for Startups, Bad for Investors

On April 5, President Obama signed the Jumpstart Our Business Startups (JOBS) Act, a bipartisan bill that is intended to help small companies raise capital more easily. The bill also eases the regulatory burden for "emerging growth businesses," defined as those with less than $1 billion in annual revenue (this applies to more than 90% of U.S. companies), that wish to have their shares trade on a public exchange. Although this is arguably a positive development for startups, we take issue with two elements of the bill: less disclosure required for firms wishing to go public, and the easing of rules which currently separate research analysts from investment bankers.

Why We Take Issue With the Act
We think less stringent disclosure requirements will make it even more difficult for investors to make informed decisions and could lead to material misrepresentations or outright fraud. For instance, qualified companies will now only have to provide investors with two years of audited financial results before they go public, instead of three previously. In our view, this move will limit an investor's ability to ascertain underlying growth trends, normalized profitability, and performance across economic cycles. Furthermore, an issuing firm won't have to publicly share its registration statements (Form S-1) until 21 days before the date on which the issuer conducts its road show, which typically kicks off seven to 10 days prior to the IPO. As such, investors will only have about a month versus the typical three to four months to scour the documents.

Also dropped is the requirement for auditors to attest to qualified companies' internal controls. We expect that situations of accounting irregularities, such as was the case with Groupon (GRPN) recently, will only increase in frequency as a result of this new law. Numerous disclosures on compensation will soon be absent from IPO documents, as well. The Compensation Discussion and Analysis (CD&A) section of the S-1 will no longer be required and will be replaced with fewer disclosures, including compensation of the three top-paid executives (versus five currently) and full compensation for the last two completed fiscal years (versus three currently). 

Furthermore, qualified companies will be exempt from compensation-related requirements under the Dodd-Frank Act, including rules on say-for-pay votes, pay for performance, and internal pay equity. Any company that completed an IPO after Dec. 8, 2011, or would like to IPO will face lighter regulation for up to five years after the IPO, as long as the firm doesn't reach $1 billion in total annual gross revenue in the most recently completed fiscal year. CFA charterholders overwhelmingly believe the JOBS Act is harmful for investors: According to a March 2012 CFA Institute member survey, 63% of responders expected that the bill would create additional gaps in investor protection and transparency, while only 3% said it would improve investor protection.

Perhaps equally as disconcerting is the rolling back of the 2002 settlement that separated Wall Street research analysts from their investment banking counterparts. In the wake of hyped, but often privately disparaged, Internet IPOs of the late 1990s (most of which subsequently collapsed), regulators passed the now famous Sarbanes-Oxley law. Among other provisions, the law established a 40-day quiet period where research analysts from underwriting investment banks were prohibited from issuing what is often positive, and arguably biased, research on the newly public company. Once the JOBS Act goes into effect, analysts will be allowed to publish research on emerging growth businesses at any point leading up to or after an initial offering. Proponents of the bill note that investors will be able to make more informed investment decisions from expanded research versus today's relative dearth of IPO research. We beg to differ.

More Overvalued IPOs? 
We think reliance on research from underwriting companies could inflate a public company's true prospects and lead to greater shareholder losses. Investment banks already work extremely hard to market an investment in their client, the firm going public, in the most favorable light possible. Their peddling efforts often work; most stocks seem to underperform the market in the weeks and months after first day's frantic trade. Research analysts on said companies undoubtedly will feel the implicit pressure to publish favorable research so investment banks collect maximum fees and develop a reputation for offering optimism on their client's investment merits. Stock cheerleading from analysts could pump the initial share prices of IPOs further and lead to greater losses when investors realize that the company is unlikely to live up to its illustrated potential.

As the JOBS Act rolls out and is adopted in the marketplace, we believe the risks surrounding investing in IPOs will materially increase for investors. As it stands now, we only find favorable investment prospects in a minority percentage of IPOs, based on our independent research, and we expect this proportion will decline as a result of this bill.