The public/private company dichotomy has been a perennial discussion topic. (See, e.g., this PubCo post, this PubCo post, this PubCo post and this PubCo post.) A statistic frequently tossed around is that there are about half as many public companies today as there were in 1996, and those that are around today are older and larger. And while the IPO market was in a bit of funk last year, the private markets have been viewed as consistently vibrant, with more capital raised in the private markets than in the public. But the question of why and how to address the decline in the number of public companies has been a point of contention: is excessive regulation of public companies a deterrent to going public or has deregulation of the private markets juiced their appeal, but sacrificed investor protection in the bargain? At the end of January, we heard from SEC Commissioner Caroline Crenshaw addressing the question of whether the securities laws governing private capital raises might be too lax. Now, SEC Commissioner Mark Uyeda is speaking his mind on the topic, presenting remarks at the at the “Going Public in the 2020s” conference at Columbia Law School.
Uyeda begins with some stats: in the 1990s, there were just over 4,000 IPOs by U.S. operating companies, while in the 21st century, that number was cut almost in half, suggesting that private companies “no longer see them as a cost-effective method of raising capital.” Why is that? Uyeda recognizes that many factors are usually taken into account in making the decision to go public. For example, private companies may decide that it is more beneficial to be acquired than to conduct IPOs. After examining market conditions, private companies typically go through a cost-benefit analysis in determining whether to go public. Notably, one of the costs that factors into the equation is the burden of regulation as a public company, and, in some circumstances, he suggests, it can be a deterrent.
How should this issue be addressed? To be sure, Uyeda contends, “the answer to fewer companies going public is not to overregulate the private markets through prescriptive disclosure and governance requirements” (a retort perhaps, to Crenshaw’s recommendation). In Uyeda’s view, the answer is straightforward: the SEC should “create a regulatory environment that appropriately balances the costs and benefits associated with any required disclosures, while considering its investor protection mission.” To find this balance, the SEC “can encourage capital formation by promulgating rules that: (i) are grounded in financial materiality and (ii) adequately consider smaller public companies’ ability to pay for the compliance costs.”
First, Uyeda maintains that the SEC should mandate disclosure based on financial materiality—that’s an objective criterion that virtually all reasonable investors would consider, he contends. But there’s much less consensus on disclosure “without an apparent financial impact. This is because there may be significant differences among investors’ views of the importance of any given non-financial factor. As a result, it may be difficult to establish a reasonable investor standard for non-financial factors. The costs of providing such disclosure, however, are quite real.”
Although topics now on the SEC’s agenda, such as climate change and human capital, “may be important to particular investors, the Supreme Court has held that materiality turns on an objective standard of the reasonable investor. However, for the rulemakings where the Commission has issued proposals, the required disclosure is often one-size-fits-all and prescriptive. The disclosure requirements do not appear to be rooted in whether a reasonable investor would consider the information important in his or her decision to invest in a company’s stock.” Disclosures not based on financial materiality, perhaps added at the “whims of the Commission,” Uyeda suggests, could be costly to prepare, “but provide limited or no use to a reasonable investor making an investment decision.” They could also lead to expensive litigation, with costs passed on to customers. These regulatory costs—as well as the prospect of future burdensome requirements—could, in his view, deter companies from going public.
Second, Uyeda observes that the impact of regulation on smaller companies has been more pronounced, with a steeper decline in the number of public companies and IPOs. Why? Because, Uyeda suggests, they have fewer resources to pay for public company regulatory compliance. To address these issues, Uyeda recommends that the SEC should again revise the definition of “smaller reporting company“ (see this Cooley Alert) to include a “test based on revenue or gross profit, either in addition to, or in lieu of, public float,” which he contends “is better suited to determine whether a company can qualify for the ability to provide scaled disclosure.” Moreover, he advocates that all SEC disclosure rules should provide for both scaled disclosure and delayed compliance dates of at least one year for smaller reporting companies, allowing smaller companies to benefit from the models and other work performed by larger companies to comply with new rules.
Why does the decline in IPOs and public companies matter? In Uyeda’s view, as IPOs have become more a vehicle for mature companies to provide liquidity events for their insiders, “the pool of potential growth-stage investments available to Main Street investors” has declined, with the result that “Main Street investors—but not wealthy investors or venture funds—lose out on the ability to participate in the potential upside associated with some growth-stage companies and the diversification that investments in such companies can provide.” He found that trend to be “concerning.”
But the answer is not “to force those companies to undertake some form of public offering. So long as the burdens of being a public company remain significant,” efforts to limit private capital raising or otherwise increase costs of remaining private will not cause them to go public. Rather, he observes, “such restrictions could prevent new companies with innovative ideas from being started in the first place.”
Instead, the SEC should revisit “the binary ‘all or nothing’ approach to accredited investors,” by, for example, “allowing an individual to invest a certain percentage of his or her income or net worth in one or more private companies during a year.” Financial thresholds can be problematic for several reasons: they do not take into account geographic cost-of-living differences, disadvantage younger people who may have “longer investment horizons and greater risk tolerance,” and ignore the investment diversification opportunity that may be appropriate for diversified portfolios. (Whether to propose amendments to Reg D, including updates to the accredited investor definition and to Form D, is on the SEC agenda with a target date for a proposal of April 2023.)
Happy International Women’s Day!