It’s been a decade since the Jumpstart Our Business Startups (JOBS) Act relaxed initial public offering requirements for companies with revenues under $1 billion, and a growing number of them have taken advantage of the option to disclose less financial information in their IPOs.
But while this reduced-disclosure provision may have helped stimulate the market, it came at the cost of lower IPO quality and more risk exposure for individual investors, suggests a new study by Berkeley Haas professors Omri Even-Tov and Panos Patatoukas, along with PhD candidate Young Yoon.
“The evidence shows that nearly two-thirds of the reduced-disclosure issuers underperform the market in the three years after they go public,” said Even-Tov, an assistant professor of accounting. “While we find evidence that institutional investors use publicly available information to avoid the worst-performing IPO stocks, individual investors tend to ignore fundamentals when investing in IPO stocks and are more exposed to the risks.”
Even as Senate Republicans have unveiled a new set of relaxed rules dubbed JOBS Act 4.0 to spur business and ensure retail investors have access to young ventures, “the evidence questions that the SEC’s objective to increase the quantity of IPOs came at the expense of quality,” said Patatoukas, associate professor and L.H. Penney Chair in Accounting. Based on their findings, the researchers argue that the SEC should ratchet back and require all IPO issuers to disclose at least three years of audited financial information—up from the two years allowed under the JOBS Act.
“We recommend that regulators balance the benefits of increasing the number of IPO registrants against the costs of enabling speculative issuers to go public with reduced financial disclosures,” Patatoukas said. “With respect to investor protection in the IPO aftermarket, the quality of IPOs is as important, if not more so, than the quantity.”
Stimulating the IPO market
When the JOBS Act was signed into law on April 5, 2012, the goal was to invigorate the IPO market by making the process less risky and burdensome for smaller companies. The Act created a new category called emerging growth companies (EGCs), defined as issuers with pre-IPO revenues of less than $1 billion.
The new rules gave companies the option of presenting just two years of audited financial statements and selected financial data in their IPO filing, rather than the three years of audited financials and five years of selected financial data required previously.
By the end of 2015, almost half of emerging growth companies with an operating history of more than two years opted for reduced disclosures. By 2018, it was over 80%.
Quantity vs. quality
While prior studies have found that the JOBS Act did lead to an increase in the number IPOs—which had dropped off following the dot-com bust—the Berkeley Haas researchers questioned their quality.
They looked closely at EGCs that went public before and after the JOBS Act took effect, and also compared them to companies with revenues over $1 billion that went public during the same time period and did not have the option of reduced disclosures.
The EGCs that had been operating more than two years, yet opted to release only two years of financials, had more speculative valuation profiles and lower institutional ownership, they found. These companies’ stocks tended to become overpriced in the aftermarket, and after three years, 66% of them underperformed a broad market index—compared with 49% of emerging growth companies that chose to disclose three years of financials.
They also found that individual investors were more attracted than institutions to the speculative, “lottery-type” companies that went public under the new rules, implying that individual investors were more exposed to the downsides.
Their findings contradict prior research suggesting that the Act led smaller companies to underprice their IPOs. Rather, the analysis found that the bigger average jumps in share prices relative to offering prices after the Act was passed were due to overall market conditions, and weren’t limited to EGCs.
Enhancing companies’ access to the public capital market, and their ability to conduct successful IPOs, gives investors more opportunities to invest in public companies, the researchers agreed. Yet the increased risk that the reduced accounting rule brings to individual investors led them to recommend that the SEC remove the provision and require issuers to disclose at least three years of audited financial statements.
“Having three years of data rather than two will enable investors to gauge the trend in company growth leading to the IPO,” Even-Tov said. “This has the potential to help level the playing field for Main Street investors, and the incremental cost to companies of providing another year of historical information should be small.”
Patatoukas added that the findings have direct relevance for both the SEC and for retail investors.
“Our evidence that individual investors may have been disproportionately exposed to shareholder value destruction post-JOBS Act could inform the SEC’s efforts to facilitate capital formation while protecting the interests of Main Street investors,” he said. “On the part of Main Street investors, our evidence calls attention to the risks of actively targeting IPO stocks with speculative valuation profiles.”
Read the study
Laura Counts, Berkeley Haas media relations