My colleague Amar Bhide, now a professor at Tufts, in a 1994 Harvard Business Review article, pointed out that the reason the US stock market was so successful by global standards was the Great Depression securities laws that among other things criminalized front-running and required companies to make extensive disclosures, including not withholding material information and providing audited financial statements.
Bhide argued that the reason such strict rules had to be in place was that equity was a very unnatural security to be traded on an arm’s length basis. By contrast, a bond is a promise to pay interest and principal on specific dates. You know what cash flows you are supposed to get; the investor needs to evaluate the odds of actually getting them (credit risk) and whether they will be worth what he thinks they will be worth in inflation-adjusted terms. By contrast, a share of a company at best is “We’ll pay you a dividend if we have the earnings and are in the mood, and you can vote on directors, mergers, and other big matters, but we can still dilute your vote.” Historically, the people who invested in equities had a venture-capitalist-like relationship with the founders; they evaluated them personally and were actively involved in the oversight of the enterprise. Bhide also pointed out that having detached investors who could readily sell their stake led inherently to deficient corporate governance: a company could never disclose enough information about its strategies, operations, and growth plans to transient owners, since it was competitively sensitive and could be shared only with trusted insiders.
Despite considerable weakening of disclosure and various “fairness” rules, America’s love affair with stocks remains intact, so much so that the SEC decided that the stock market was the answer to what was never demonstrated to be a problem: the idea that promising companies were having trouble getting capital. Bhide has for many years examined Inc 500 companies, and has found that only 25% were funded by venture capitalists (and that included late-state pre IPO rounds, which were more to assure an attractive sales price than necessary for the company’s success as an enterprise). One of the corollaries of the rise in wealth of the 1% and 0.1% is the number of angel investors hunting for early stage investments.
Nevertheless, in 2012, the Administration pressed for the passage of the JOBS Act. From our write-up:
We and numerous others have railed about how absolutely awful the JOBS Act is. It’s going to do perilous little to help small businesses raise dough; in fact, the number of frauds that will arise will almost certainly raise the cost of capital for small ventures over time. The JOBS Act was a wet dream for bucket shop operators.
And indeed, as the Wall Street Journal reports today, very little has in fact been raised by companies using the new filings established by the JOBS Act. It’s not hard to imagine that one big deterrent is the fact that these firms are exempt from having their financial statements audited. Honestly, you need to have your head examined if you are going to make an investment to people you do not know personally and would not (from a practical standpoint) be able to sue if you suspected misconduct. The Journal attributes the meager level of JOBS Act fundraising to the fact that many states have so-called blue sky laws that also require that securities offerings include audited financial statement. But I have to believe that at least as big an obstacle is friends, family, and professional advisors of prospective investors in these ventures warning them that the risks are far too large to justify taking the plunge.
Roughly a year after the passage of new rules making it easier for fledgling businesses to tap U.S. capital markets, just a handful of them have succeeded in doing so…
The new rules, known as Reg A+, reduce the legal and reporting requirements for making these offerings. The rules, which took effect last June, grew out of the 2012 Jumpstart Our Business Startups Act, or JOBS Act, aimed at spurring business growth and employment….
According to the Securities and Exchange Commission, 94 companies had filed to raise a total of $1.7 billion under Reg A+ as of early June. Of those, 45 offerings seeking to raise a total of $785 million have qualified to raise funds, and just a few have actually completed their offerings…
Among the biggest problems for the companies trying to raise funds is that they aren’t prepared for the amount of marketing needed to attract a big enough pool of potential investors…
Many other companies have found it tougher than expected to attract investor interest. “There has been some level of magical thinking,” said Ron Miller, chief executive of StartEngine, an online platform that hosts Reg A+ offerings. “Founders have perceived that there is this pent-up demand for investment in startup and tech companies” and that investors “would come out of the woodwork.”…
The new rule “very definitely is something that would work well for somebody who doesn’t need it, a company with a really big brand name,” said ralliBox founder David Kneusel. “But it is not something that is startup-oriented.”
It looks like a lot of magical thinking was also behind the law itself.
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The fact that the law has largely floppped sounds like a damn fine thing to me. Thanks for the coverage Yves.
The whole premise of the JOBS Act is that you can increase capital formation by weakening protections for the providers of capital. Turns out that there aren’t masses of people interested in investing in start-ups with a high likelihood of failure based on inadequate information and with inadequate protections against dilution. Seriously, who could have predicted that? Oh wait, we did.
The problem, of course, is that the promoters of the JOBS Act won’t take its failure as a sign that their fundamental premise is flawed. Instead, they’ll take it as a sign that they didn’t do enough to “remove the barriers” to capital formation. That will send them back to the drawing board to think up new deregulatory proposals. You can already see them at work, both with their comments about the state blue sky laws in the Journal article and in the legislation that’s been marked up in House Financial Services Committee recently.
So that leaves the question of how these deregulatory proposals will be received in a Clinton Administration, since a Trump Administration would almost certainly embrace them. Will the Clinton financial team follow the Obama Administration’s lead and lend support to the notion that regulation is a barrier to capital formation? It is frankly cause for concern that a few of the JOBS Act architects from the Obama team appear to be playing an influential role in the Clinton campaign. If Bernie is weighing how best to use his influence, making sure we get financial regulators appointed who believe in the benefits of regulation would be a helpful place to focus his attention.
“The problem, of course, is that the promoters of the JOBS Act won’t take its failure as a sign that their fundamental premise is flawed. Instead, they’ll take it as a sign that they didn’t do enough to “remove the barriers” to capital formation.”
The magical thinking of financial “experts” in a nutshell.
We are so fortunate that you provide this level of analysis in plain English to matters that many Naked Capitalism readers might otherwise not even know of, let alone be able to understand. Thank you, Yves.
+1
I think the JOBS Act has run into problems because many of the ‘Unicorn’ high tech companies (Uber, AirBnB, Slack, Sanpchat, ect.) it helped finance have not been profitable, and as a result cannot IPO.
The Securities Exchange Act of 1934 requires companies with >$10 million in Assets, and securities held by >500 investors to publicly file audited periodic financial reports. In other words, with >500 shareholders, public financial reporting of profits, revenue, executive compensation, ect. is required. The Jumpstart Our Business Startups (JOBS Act) of 2012 raised this limit to 2,000 accredited investors, or 500 un-accredited investors. The result is that private companies can raise more money with no public financial reporting requirements (describing GAAP profitability).
Getting large investor groups to pay high prices for small shares in your company by limiting financial reporting is why ‘Unicorns’ have multi $billion valuations. My suspicion is that many investment managers (Fidelity, Blackrock, T. Rowe) saw the JOBS act as an opportunity to collectively get in early on venture investments, without the annoyance of financial reporting, and cash out with the IPO at maximum hype. Previous regulations limited the number of investors that could profit this way. Unfortunately investors will need substance more than hype to ultimately cash out.
Let us also not forget the Small Company Reporting requirements. Another way to reduce disclosures of small companies and also not require them to be in accordance with SOX. Just another way for investors to lose money. I hardly believe most audited financial statements. I could imagine the nightmares hidden in unaudited statements. Besides, I would think that a company that was not audited would also have real shortfalls in the quantity and quality of accounting personnel.
Has anyone looked into private equity abuse of Reg. A+? This is really a question based wholly on suspicion, but it would not surprise me.