When the JOBS (Jumpstart Our Business Startups) Act became law in 2012, one provision allowed firms to reduce the amount of information that they provide to investors before an IPO. This was meant to make it easier for smaller firms to get outside investors. Research co-authored by Wharton accounting professor Daniel Taylor finds that those shortcuts have had some unintended — and costly — consequences. The paper, “The JOBS Act and Information Uncertainty in IPO Firms,” was authored by Taylor, Mary E. Barth of Stanford University’s Graduate School of Business and Wayne R. Landsman of the University of North Carolina’s Kenan-Flagler Business School.
In this interview with Knowledge at Wharton, Taylor discussed the impact of that increased information uncertainty, both on investors and the companies seeking to go public.
An edited transcript of the conversation appears below.
The Cost of Easier IPOs:
In our research, we looked at the IPO market — firms that aren’t publicly traded yet, but are going public on the New York Stock Exchange or the NASDAQ. We look at the price that they go public at, their future returns, and the volatility or risk associated with those companies. And then we correlate those measures with the amount of disclosure that the firm has at the time of its IPO.
There was a rule that came out back in 2012 called the JOBS Act. The JOBS Act allowed firms to reduce the amount of information that they provide to investors. A lot of your viewers or your readers are probably familiar with SEC filings. You’ve got to file several financial statements with the SEC, income statements, balance sheets, etc., and disclosures relating to things like management compensation [before going public].
“When you observe a firm scale back its disclosure, they’re doing that for a reason.”
[One thing] the JOBS Act did was reduce the amount of information that the firm is required to provide to the equity market before going public. And a natural question is, when you reduce the amount of information, are you increasing the risk of [investing in] the company? How do investors respond to that? We try to answer that question by looking at what actually happened after regulation.
What we end up finding in the study is that after the JOBS Act, the IPOs that are going public and reducing their disclosures are actually substantially riskier. Just think about a world in which the SEC requires all IPOs to go through a screening process and provide these mandatory disclosures. And then, the legislative branch of government comes along and says, “Well, let’s actually scale that back. Let’s only require them to do two years’ worth of screening as opposed to the prior three years.”
You can imagine that’s going to have the effect of potentially bringing different companies to the market. The analogy would be, [if] you go to a used car lot: Suppose the government requires that when you purchase a used car, the car dealer had to give you basically a spec sheet on what the car’s been doing, what the car’s life was.
Then the government comes along and says, “Well, we’re not going to require that anymore. Car dealers can do it voluntarily.” Now when you go to the car dealer, some cars have the spec sheet and other cars don’t have the spec sheet. What do you infer about the cars that don’t [have them] — or the car dealers that don’t offer you the spec sheets? This is what we call a “lemons problem” — where you have companies that aren’t disclosing as much anymore. And the question is: Why are they not disclosing much anymore?
We find that those companies that don’t disclose are indeed much, much, much riskier. That’s sort of the key punch line of the study: When you observe a firm scale back its disclosure, they’re doing that for a reason. And investors become more uncertain, and that generates risk for the company.
We were actually surprised by the magnitude of the effect that we saw. There’s really two schools of thought when it comes to reduction of disclosure.
One school of thought is that government requirements and regulations for disclosure are burdensome on firms. They’re excessively costly. You have to hire lawyers. You have to hire accountants. You have to hire auditors to go over and to scrutinize your financial statements. And the purpose of the JOBS Act — at least the stated purpose by the proponents — was to reduce that cost and to allow more small businesses to go public because now they don’t have to pay as much in fees to lawyers and to accountants.
So we expected to see some effect, because you’re going to see smaller firms entering the IPO market. And naturally, those smaller firms will be riskier. But we were surprised at the magnitude of the effect that we found for even very large firms. It wasn’t just the small firms that were taking advantage of these provisions, it was also the firms with close to a billion dollars in revenue. And even there, we found a substantial effect on the order of 6% to 12% change in what we call IPO underpricing. We also found about a 5% increase in equity volatility, which is, in the grand scheme of things, a substantial cost to the company, even though it’s not explicit.
So back to my earlier remark about the used car lot: Now you have a situation where the used car salesman has two cars, both red, same make, same model. One comes with the disclosure of its history; one doesn’t. The used car salesman can’t sell the car that doesn’t come with the disclosure for the same price as the car that comes with the disclosure, so he marks the price of the car without the disclosure down. What we’re measuring with IPO underpricing is how much the investment bankers mark down the price of firms that don’t have the disclosure. And that looks like between a 6% and 12% discount. That’s a substantial amount when you’re thinking about a multi-million dollar company.
That’s a specific cost of the JOBS Act, even though it’s not an explicit cost, and even though it might not have been intended.
Ignoring the Implicit Costs:
Until our study, there hadn’t really been any evidence on what the effect of the JOBS Act was on underpricing or on volatility. If you actually look at what the CEOs are saying in the popular press, a lot of CEOs are coming out in favor of the Act, especially the tech companies.
Twitter was one company that took advantage of this, and what they’re saying is, “It’s saving us lots of money in terms of we don’t have to hire lawyers; we don’t have to hire accountants; we don’t have to have people prepare as many years of financial statements. And so, we can save in terms of the explicit costs of preparing our disclosures with the SEC.”
The problem with that sort of reasoning is that it ignores the implicit costs. I have these two cars and they’re both red, they’re both the same make and the same model. One comes with a disclosure of the car’s history; the other one doesn’t. I can’t sell the car that doesn’t come with the disclosure for the same price. [All things being equal,] I could sell both cars for $5,000. But that one car that doesn’t come with a disclosure I can’t sell for $5,000. I can only sell it for $4,500. You can think of the difference between those two as a $500 implicit cost.
What we’re finding is that the JOBS Act might actually be increasing the indirect costs of going public because firms can’t do an IPO for the same prices that they could have before. They can’t raise as much money when they disclose less. That creates an indirect cost that I think many practitioners and many managers aren’t necessarily taking into account when they’re making the trade-off about whether to reduce their disclosures.
“It wasn’t just the small firms that were taking advantage of these provisions, it was also the firms with close to a billion dollars in revenue.”
Can Lower Disclosure Be a Winning Strategy?
Potentially. Let’s take the company first. What the company’s concerned about is maximizing its IPO offer price. They want sell the company for as much as they possibly can on the public market.
Let’s just assume that that’s the objective of the managers, and that they’re benevolent, and that’s what they’re trying to do. What we find is that the discount that investors apply to firms that are taking advantage of these reduced disclosure regulations is about an 8% discount.
So, for example, if a firm is going public perhaps it might be able to raise, let’s say hypothetically, $100 million in its IPO. With an 8% discount, it’s only going to be able to raise, say, 92% of that, which means it will only be able to raise $92 million.
The indirect cost of the reduced disclosure for that firm is about $8 million. The managers of that firm have to trade off that $8 million discount that investors apply against the savings that they get from reducing disclosure. Add up all of the costs that you would pay for an additional year of audited financial statements, for an additional year of litigation protection from your lawyers and whatnot, and see if it comes out to about 8% of what you think your market value should be.
That’s under the story of the firm or the managers being benevolent and having shareholders’ interests in mind and trying to sell the firm for the highest price.
Another story, which is more cynical, is that managers take advantage of the reduced disclosures for selfish reasons. One of the provisions of the JOBS Act allows firms to reduce the amount of information about executive compensation that it provides to the market. On the one hand, that might shield the firm from unjust public criticism of how lucrative the compensation deal is, which could be a good thing. But if that compensation is excessive — if the CEO and his team are being paid too much — the market wouldn’t actually know that at the time that the firm goes public.
So, from the company’s perspective, if they’re trying to maximize their offer price, they need to trade off the direct or explicit costs and the indirect or implicit costs. And our paper’s really about the indirect cost, which is somewhere between a 6% and 12% discount. That’s what they need to take into account — a new cost of going public that wasn’t there previously.
On the investors’ side, we can think about there being two broad types of investors: sophisticated investors and unsophisticated investors. Let’s take unsophisticated investors first. These are the people who maybe have a cursory knowledge of financial statements and accounting information, if that. And one can argue whether unsophisticated investors should even be taking part in the IPO or not. But let’s just assume that there are some unsophisticated investors who are investing in IPOs. We certainly saw that during the tech bubble of the 2000s.
These investors are getting less information from the firm. Relative to the sophisticated investors, we think that they’re actually worse off — because the sophisticated investors can make up for any lack in public information by collecting private information, whereas unsophisticated investors can’t go out there and collect private information. They may or may not even realize that the amount of public disclosure that the firm is providing has shrunk.
“Any time you have a reduction in the amount of public information, individual investors generally do worse.”
This is one reason why we think the SEC was pushing back on making these new rules that Congress mandated them to do, because the SEC’s mission is really to protect the individual investor. And any time you have a reduction in the amount of public information, individual investors generally do worse. This is why we had these rules in the first place — to mandate firms to disclose as much as they could.
Let’s go back to the car example. You’ve got an auto mechanic who’s going to the car dealership lot. He’s your sophisticated investor. He sees the two cars. They’re the same make, same model, same color. The mechanic sees one with the disclosure, and sees the other one without the disclosure. The mechanic is very skilled, he can detect –– without the disclosure –– whether the car is actually a good car or not, whereas, if I go to the used car lot, I would not be able to tell the difference between a good car and a bad car. I’m going to rely on the disclosure to tell me that.
So sophisticated investors don’t rely on the disclosures as much as the unsophisticated investors. Consequently, sophisticated investors aren’t hurt as much when the disclosure gets removed.
Next Steps in the Research:
The JOBS Act has many, many different titles and covers more than just disclosure by IPO firms. It does a lot of different things. It changes the rules for crowd-sourcing and crowd-funding of projects. There are a lot of different faces of the JOBS Act that we don’t really examine. We just picked out this one provision, or one title, of the JOBS Act and examined its effect. So I don’t want to say that the entirety of the Act is necessarily harmful or beneficial. We’re just picking one little aspect of the Act and looking at how that affected the IPO market, and documenting that there are perhaps unintended consequences of the Act.
The Act has been relatively new, so the body of literature is just starting. Looking forward, any time you have a firm that reduces or chooses to reduce the amount of information it provides — whether it be about its compensation arrangements with executives, accounting performance, management discussion and analysis of risk factor — that’s going to have a ripple effect on all kinds of other intermediaries that rely on public information. Are now credit rating agencies going to have to rely on different sets of information? Are equity analysts going to have to rely on different sets of information? We just looked at the market consequences, how it gets into price and how it gets into volatility. But we haven’t actually looked at how it affects all of these different intermediaries that are relying on the firm’s disclosures and public information. I think that’s where the next step would be.