More Information, Less Publicity: New Research Shows that Startups are Less Myopic When They Can Provide Private Disclosure
Published: December 14, 2021 / Author: Michael Hardy
Among the effects of the 2008 financial crisis was a precipitous drop in initial public offerings, or IPOs. In 2007, 268 companies made their Wall Street debut, including cloud computing company VMware, accounting software maker NetSuite and VOIP vendor ShoreTel; in 2008, with credit markets drying up and investors running scared, just 62 companies went public. Worried that smaller companies were getting squeezed out of capital markets, economists and business lobbyists called on Congress to relax SEC regulations governing IPO launches.
In 2012, a bipartisan group of lawmakers responded by passing the JOBS Act, whose acronym stood for the Jump-start Our Business Start-Ups. President Barack Obama signed it into law, proclaiming that it would “help entrepreneurs raise the capital they need to put Americans back to work and create an economy that’s built to last.” The bill reduced public disclosure requirements for companies with annual gross revenue of less than $1 billion, which the bill termed “emerging growth companies.”
“Before the JOBS Act, companies had to put everything in written form, and file it with the SEC, where all could see it, including competitors,” said Hal White, the Vincent and Rose Lizzardo Professor of Accountancy at the Mendoza College of Business. In a new paper, “Private Disclosure and Myopia: Evidence from the JOBS Act,” forthcoming in the Review of Accounting Studies, White and co-authors Badryah Alhusaini (Arizona State University) and Kimball Chapman (Washington University in St. Louis) examine the impact of the JOBS Act on both firm behavior and market performance.
Most media coverage of the bill focused on a provision that allowed startups to raise capital through crowdfunding, but the bill also introduced a number of important changes to IPO disclosure regulation. Previously, the Securities and Exchange Commission required pre-IPO companies to provide information about themselves — their strategy, proprietary technologies, and internal financial data — in a public prospectus.
But requiring this kind of public disclosure led to unintended consequences. In practice, many firms, especially software and biotech startups, omitted details about their proprietary technology from their IPO prospectus out of concern that rival firms would gain an unfair advantage. “Their concern was that competitors would exploit the information, so they typically chose to withhold some of it,” White said.
Withholding that information led to information asymmetry between firms and their investors, deterring some long-term investors who typically require extensive knowledge about a firm before investing in it. Instead, these IPO companies tended to attract shorter-term investors who demand immediate returns, sometimes at the expense of long-term strategy. To keep these investors happy, firm managers were forced to focus on meeting quarterly earnings goals rather than growing the business.
“When there is information asymmetry, uninformed investors are less able to determine the firm’s valuation,” White said. “They fixate on short-term results as a proxy for the long-term value of the firm, and tend to sell if earnings disappoint.” The JOBS Act allows emerging growth companies to give private presentations to large investment firms rather than divulge everything to the public. In these presentations, firms could offer much more detailed information about their strategies and technologies than they felt comfortable divulging to the general public.
White and his co-authors argue that pre-IPO companies that provide more information to investors through private briefings give these investors more confidence in the companies, leading them to hold the stock longer. Because they enjoy greater investor confidence, the firms behave less myopically, focusing on long-term growth rather than on quarterly earnings. The investors also behave less myopically, showing a greater patience with short-term losses because they had better insight into the firms’ strategy and technology.
“By providing more detailed information to investors privately (with less concern of competitive harm), firms can attract more long-term investors that support management and weather the storm of chopping earnings,” White explained. “Investors benefit because they get a better match between their investment goals and the firms they invest in.”
In addition to performing quantitative analyses of company behavior and market performance, White and his co-authors spoke to the managers of six startups that had gone through an IPO both before and after the JOBS Act, at different companies. The managers said they felt more comfortable discussing their companies during private investor briefings, and had divulged more information than when they had been subject to public disclosure requirements. Those discussions bolstered the researchers’ findings that private investor meetings lead to less myopic focus by the IPO firms and their investors.
More private disclosure from pre-IPO firms may also benefit the public. To the extent private disclosure leads to less myopic investment, and thus better performance, retail investors in those firms also gain via higher stock price valuation. Mutual fund and retirement account investors benefit from their fund managers’ access to proprietary information about these pre-IPO firms. “The investing public can benefit through the better performance of the firm,” White noted. “More generally, there is a positive impact on the economy through more efficient capital allocation.”
The JOBS Act appears to have had the desired result. A 2015 Wall Street Journal analysis found that the 454 U.S. companies that completed an IPO under the JOBS Act created about 82,000 jobs — an increase of 30% from their pre-IPO employment. In the three years since the law’s passage, a total of 660 companies (U.S. and foreign) went public; 539 of them took advantage of the JOBS Act’s private disclosure provision. The global consultant firm PwC found that the number of IPOs are up nearly 25% since the JOBS Act was passed, and that more than 80% of all U.S. IPOs have been conducted by firms that qualify as emerging growth companies.
As the researchers acknowledge in their paper, their findings challenge one of the central tenets of economics — that public disclosure requirements lead to more efficient capital markets. Especially in the case of companies with valuable proprietary technology, like biotech and software firms, greater public disclosure doesn’t necessarily produce positive outcomes. When it comes to investing, in other words, any publicity is not good publicity.