On April 5, 2012, four years after the 2008 financial crisis and in the midst of a still-sluggish economy, President Barack Obama signed into law the Jumpstart Our Business Startups (JOBS) Act. Passed with bipartisan support, the legislation was intended to encourage the growth of small businesses by making it easier for them to go public.
The law allows smaller companies that file for an initial public offering (IPO) under the newly created Emerging Growth Company (EGC) status to use a streamlined registration process and, in their initial years as a public company, to disclose less information publicly than larger companies are required to report.
Policymakers hoped that unburdening startups of costly and complicated financial reporting requirements for a limited period would translate into more public company filings and, ultimately, a boom in economic growth.
At the five-year anniversary of the JOBS Act, we are seeing considerable commentary on the degree to which the law achieved its intended objectives of creating more public companies and jobs and “jumpstarting” economic growth.
The anniversary also marks a deadline for the first companies that became public using JOBS Act provisions to transition to full public-company status, which brings a corresponding increase in compliance and reporting obligations.
This transition provides an opportunity for EGCs to establish best practices in financial communications and shareholder relations and to build goodwill with shareholders, regulators, analysts and other stakeholders.
Beginning this process early and approaching disclosure as a way to tell the company’s story clearly will help EGCs transition smoothly and effectively.
IPO Market Growth
The data show that the number of IPOs did, indeed, shoot up in the two years following the Act’s passage — but by 2015, IPOs had begun to decline precipitously. Reasons for the decline include increased regulation, structural changes in the equities markets, and pre-IPO companies being swallowed up through acquisitions.
And, while unemployment reached a 10-year low of 4.3% in July 2017, it did so with little help from startup companies, according to the Bureau of Labor Statistics.
According to Renaissance Capital’s U.S. IPO Market of 2017 Review, initial public offerings rose in the second quarter, with 52 priced IPOs (compared to 34 in the year-earlier period). And halfway through 2017, IPO activity has raised more capital than in all of 2016. With robust activity in the IPO markets, it appears the second half of 2017 may begin the reversal of these downward trends in U.S. public offerings.
While the economic impact of the JOBS Act can be debated, what’s indisputable is that IPO companies have embraced the legislation’s EGC designation to take advantage of less onerous disclosure requirements.
The Emergence of Emerging Growth Companies
According to the WilmerHale 2017 IPO report, based on combined data for all U.S. IPOs from 2013 through 2016, 85% of IPO companies qualified for EGC status under the JOBS Act. While the overwhelming majority of all IPOs qualify as EGCs, the extent to which EGC standards are being applied in IPOs varies.
Tracking a company’s EGC filing status has been difficult, but this is changing thanks to technical amendments and inflation adjustments to the JOBS Act that became effective on April 12, 2017. Here is an overview of some of the changes:
- The gross revenue threshold for an issuer to define its status as an EGC has increased from $1 billion to $1.07 billion.
- Regulation Crowdfunding thresholds also increased. The maximum amount an issuer can raise under Regulation Crowdfunding was raised from $1 million to $1.07 million.
- Various scaled disclosure and exemptions permitted to EGCs were amended on certain rules and forms. For instance, EGCs can omit selected financial data for certain periods and are exempted from “say on pay” and other shareholder votes.
- Check boxes have been added to the cover pages of certain documents so issuers can indicate if they want to be considered an EGC. A company that qualifies to be an EGC can indicate whether it elects not to use the extended transition period for complying with any new or revised financial accounting standards pursuant to Section 13(a) of the Securities and Exchange Act of 1934.
Under the new rule, companies must identify if they are an EGC by checking a box on the cover of selected required forms, such as 8-K, 10-Q, and 10-K filings. The new check box on the cover of periodic reports will help investors identify companies filing using EGC status.
“It seems like a lot of companies have taken advantage of being an EGC,” says Reena Aggarwal, a professor of finance at Georgetown University and director of the Georgetown Center for Financial Markets and Policy. “Think about the audited financial statements that you’re required to file every two years, not three years. Almost 70% of companies have used that. A very large proportion, almost all of the companies, have adopted the limited executive compensation disclosure.”
Laura Anthony, attorney and founding partner of the law firm Legal & Compliance, agrees that EGC status has been helpful to newly public companies. “I think that the vast majority of companies that go public now are emerging growth companies, and it’s been very helpful for them to be able to take advantage of some of the rules — especially the two-year instead of three-year audit, and some of the other scaled-down reporting requirements,” she notes.
But public companies cannot remain EGC filers forever. As soon as an EGC company crosses one of four thresholds — reaching $1.07 billion in gross annual revenue, the fifth anniversary of its IPO, issuing more than $1 billion of non-convertible debt within a three-year period, or the date on which the issuer is deemed to be a large accelerated filer — it must transition into one of the following:
- Full-disclosure status as a large accelerated filer, for companies with a public float of $700 million or more
- An accelerated filer for companies that have at least $75 million, but less than $700 million, in public float
- A small business reporting company or non-accelerated filer, which is a reporting company that, as a result of having a public float of less than $75 million, has not had to accelerate its periodic reporting deadlines.
For early EGC adopters, the legislation’s sun-setting of disclosure and financial filing exemptions begins this year (i.e., for a calendar year issuer that went public in 2012, EGC status will be lost at the end of 2017). The transition from EGC to full filer can be overwhelming as these companies gear up to meet rigorous audit standards and to disclose up to 33% percent more information than is required under ECG status.
All EGCs must have a plan to transition to full disclosure. Many take advantage of the transition period to establish best practices in the company’s financial communications and shareholder relations and to garner goodwill from shareholders and regulators.
The key to making the transition as smooth and successful as practicable, according to industry professionals interviewed for this report, is planning, securing the proper resources, and approaching disclosure not just as a compliance exercise, but, more importantly, as an opportunity to tell the company’s story clearly and convincingly.
Planning early for the transition is the key to success, says Megan Arthur Schilling, an attorney with Cooley LLP.
“I don’t think someone who’s planning to transition at five years needs to be making changes right after IPO, but it should be an evolving process where the education and the knowledge of the future changes begins early, in some cases even pre-IPO.” Schilling says. “They need to decide this is where we’re going to have to be going, so they’ll be in a better position and reassess each year.”
Schilling points to the example of compensation disclosure.
“I definitely encourage companies, as they go through each year of various EGC status, to consider whether it makes sense to gradually evolve that disclosure to include more and more detail that might not be required per the SEC rules,” she explains. “That will help them so that then in the year when they have full [compensation discussion and analysis] disclosure, which I think is one of the biggest pain points, they’re in a much better place, and they’re not taking a huge jump.
“Additionally, investors and proxy advisory firms continue to evaluate an EGC’s compensation and governance practices and they only have the information provided publicly to make these assessments. Including additional disclosure early will provide more meaningful information to investors and proxy advisory firms, who have come to expect enhanced disclosure, to better understand and evaluate the company’s pay and governance practices.”
According to Schilling, how early a company should begin laying the groundwork for full-filer status can vary considerably. A company that has done little to no additional disclosure in the past and has limited internal resources may find it necessary to begin a year ahead of its proxy filing date. Companies that have been evolving their disclosures and have a good handle on their compensation story and process can begin significant work in the three to six months leading up to proxy filing.
An internal checklist and timeline, including all parties involved, can be extremely helpful.
Make It Efficient: Financial and Technology Innovation
EGCs that are now evolving to full-disclosure requirements are doing so at a time when technology tools are innovating ways to help, create, manage, and communicate financial and nonfinancial data internally and externally.
CEOs, CFOs, and the boards and management of innovative companies are using financial technology to streamline audit delivery, reduce the time to prepare financial statements, enhance the quality of their disclosures, and communicate the value of their company to investors.
Auditor attestation of internal controls, including risk assessment of existing controls, requires consultation with auditors and adoption of new solutions that help management and internal and external auditors conduct more effective and efficient audits.
Such solutions also analyze large data sets to provide insights that can lead to efficiency gains in the overall business. For example, the users of some of these analytic solutions can use the platform to look for anomalies, such as duplicate payments, or to ask specific questions. Thus, auditors can use data analytics to look at an entire data set, rather than reviewing a statistical sample manually.
In addition to making audits more efficient and productive, financial technology solutions can reduce a company’s Sarbanes-Oxley Act administrative burdens. SOX compliance solutions help internal audit, accounting, finance, and IT teams manage SOX and internal controls documentation, testing and certifications, as well as detect, evaluate, and mitigate risks across the organization.
Cloud-based document management, collaboration,n and reporting tools help companies streamline the creation of financial disclosures such as 10-Qs, 10-Ks and annual proxy statements. Key functions of cloud-based reporting systems typically include:
- Role-based access to delegate work to multiple individuals and monitor the process easily with version control and audit trail functionality.
- Intuitive user interfaces designed to comply with creating high-quality disclosure documents, including XBRL tagging of financial statements and notes to financial statements, along with validation, review, and SEC EDGAR system filing.
- Multiple output options to PDF, Word, Excel, and HTML formats.
Make It Compliant: Legal and Compensation Advice
Law firms and compensation consultants are key professionals to engage when moving to full disclosure. These advisers work with management teams and boards to identify company-specific material elements that must be reported as well as items a company may want to disclose voluntarily, or to highlight to investors and/or proxy advisory groups.
This is important, as a public company’s “audience” reading the proxy statement often changes, sometimes dramatically, from the time of the IPO; more large institutional investors, proxy advisors and activist investors may influence voting decisions.
Make it Clear: Communication Advice
Increased disclosure can mean increased investor and regulator understanding of a company’s strategy, performance, risks, and potential — if that disclosure is clear and well-organized.
Unfortunately, corporate filings have become much longer since 2008, but not much clearer. In many cases, they’ve become harder for stakeholders to read and understand, as SEC chairman Jay Clayton points out: “Over this period [the last two decades], studies show the median word-count for SEC filings has more than doubled, yet readability of those documents is at an all- time low.”
Expanding regulatory requirements are partly to blame. As Joseph Hall of law firm Davis Polk notes, “The SEC has for a while been engaged in the process of asking themselves how to modernize the disclosure regime, and Congress, in both the JOBS Act and the Fixing America’s Surface Transportation (FAST) Act, gave a pretty clear direction to the SEC to … look through their disclosure mandates and see where they can be simplified or eliminating duplicative disclosures. There’s a lot there. The SEC’s rule book tends to grow; they don’t really go back in and prune it very often.”
As a result, over the years many companies have seen their financial reports grow into unwieldy amalgams of data driven by the SEC, remnants of past corporate communications initiatives, and more or less successful efforts to inform the financial community.
Much can be done to improve the readability and usefulness of corporate disclosures. A focus on audience engagement and basic principles of good communication can make the difference between an uninviting reporting document and a useful, compelling communication for stakeholders.
Basic guidelines to craft documents for maximum clarity and impact include:
- Focus on communication, not just compliance: Shifting the mindset from “disclosure as pure compliance exercise” to “disclosure as a communication tool” is an essential first step in creating shareholder-friendly documents.
- Organize information rationally: Present the information in a logical, accessible way, providing context and clear and adequate explanation for the data’s materiality and its relevance to investor and regulators. Cut extraneous detail.
- Summarize key information in prose and pictures: Use executive summaries at the front of the document and within longer sections of the document. Use visual elements like fonts, color, tables, and charts to clarify and highlight key points.
- Adhere to classic hallmarks of good writing: Use short sentences, active voice, uncomplicated grammar, plain English, and recognizable terminology.
With fewer public companies for investors to assess, all public companies should be prepared for more rigorous scrutiny from a range of market participants: shareholders, including large pension funds and other institutional investors; regulators; proxy advisors; and rating agencies.
Since the peak of the IPO market in 1996, the number of public companies being traded in the United States declined 50% to just 3,671 in 2016. Don’t expect this trend to reverse significantly any time soon.
Fundamentally transitioning from EGC to full public-company filing status requires a shift in mindset.
By approaching full disclosure not only as a compliance task but as a powerful tool for shareholder engagement, for example, issuers can send a strong message that they are committed to giving their shareholders the clear and useful information they need to make informed investing and voting decisions.
As Cooley’s Megan Schilling puts it, “I think the shift often drives fundamental change in a company’s internal practices, processes and culture. Take compensation, for example: you’re going from basically doing what you want, with little to no explanation as to why, to having to really justify and explain why you do what you do, how you arrived at those decisions, and why they were the right ones for the company,” she says.
“It forces companies and boards to think very critically and, sometimes in a new way, about their practices, philosophies, and processes. Getting board members, management teams, outside counsel, comp consultants, and other advisers involved, who are familiar with the public disclosures, public company ‘best practices,’ and shareholder engagement, is a real shift. It could look very different than how the company was operating before its IPO.”
Change is never easy, and becoming a “grown-up” public company is a big change. Early planning and a strategic investment in appropriate resources — internal personnel, outside experts, and technology — can yield meaningful returns in efficiency and in investor relations for years to come.
This Financial Executives Research Foundation report was sponsored by RR Donnelley and republished here with permission from FERF.