[Senate Hearing 112-482]
[From the U.S. Government Publishing Office]
S. Hrg. 112-482
SPURRING JOB GROWTH THROUGH CAPITAL FORMATION WHILE PROTECTING
INVESTORS--PART II
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HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
CONSIDERING PROPOSED CHANGES TO THE SECURITIES LAWS THAT ARE INTENDED
TO STIMULATE INITIAL PUBLIC OFFERINGS (``IPO'') OF SECURITIES AND HELP
STARTUPS AND EXISTING BUSINESSES TO RAISE CAPITAL WHILE PROMOTING JOB
GROWTH AND PROTECTING INVESTORS
__________
MARCH 6, 2012
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dean Shahinian, Senior Counsel
Kara Stein, Counsel
Laura Swanson, Policy Director
Erin Barry, Professional Staff Member
Levon Bagramian, Legislative Assistant
Andrew Olmem, Republican Chief Counsel
Michelle Adams, Republican Counsel
Mike Piwowar, Republican Chief Economist
Gregg Richard, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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TUESDAY, MARCH 6, 2012
Page
Opening statement of Senator Reed................................ 1
Opening statements, comments, or prepared statements of:
Chairman Johnson
Prepared statement....................................... 34
Senator Crapo................................................ 2
Senator Schumer.............................................. 3
Senator Moran................................................ 5
Senator Bennet............................................... 6
WITNESSES
William D. Waddill, Senior Vice President and Chief Financial
Officer, OncoMed Pharmaceuticals, Inc., on behalf of the
Biotechnology Industry Organization............................ 7
Prepared statement........................................... 34
Responses to written questions of:
Chairman Johnson......................................... 70
Jay R. Ritter, Cordell Professor of Finance, Warrington College
of Business Administration, University of Florida.............. 8
Prepared statement........................................... 39
Responses to written questions of:
Chairman Johnson......................................... 71
Kathleen Shelton Smith, Co-Founder and Chairman, Renaissance
Capital, LLC................................................... 10
Prepared statement........................................... 43
Responses to written questions of:
Chairman Johnson......................................... 72
Timothy Rowe, Founder and CEO, Cambridge Innovation Center....... 11
Prepared statement........................................... 48
Responses to written questions of:
Chairman Johnson......................................... 79
Lynn E. Turner, Former Chief Accountant of the Securities and
Exchange Commission, and Managing Director, Litinomics, Inc.... 13
Prepared statement........................................... 56
Responses to written questions of:
Chairman Johnson......................................... 81
Additional Material Supplied for the Record
Exhibits 1-10 submitted by Lynn E. Turner........................ 82
SPURRING JOB GROWTH THROUGH CAPITAL FORMATION WHILE PROTECTING
INVESTORS--PART II
----------
TUESDAY, MARCH 6, 2012
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:04 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, presiding.
OPENING STATEMENT OF SENATOR JACK REED
Senator Reed. Good morning. I call the hearing to order the
hearing this morning, entitled ``Spurring Job Growth through
Capital Formation while Protecting Investors, Part II.''
Unfortunately, Chairman Johnson had a prior commitment with the
Energy Committee today and will not be able to attend. I
understand also that Senator Shelby will not be able to attend.
So Senator Crapo and I will do our best. We want to thank you
all for the valuable time and valuable insights that you will
provide us this morning.
Senator Johnson also asked that I submit his statement for
the record, and without objection, his statement and all the
statements will be submitted for the record.
Senator Reed. When I conclude my remarks, I will recognize
Senator Crapo, then ask my colleagues if they have any opening
remarks also.
This is the fourth in a series of hearings by the Banking
Committee on capital formation issues, including one held by
Senator Tester in the Subcommittee on Economic Policy and one
held by the Subcommittee that I chair on Securities, Insurance,
and Investment.
Job creation and revitalizing the growth of American
businesses are two of the top issues facing our country right
now. These are the issues that Americans are rightfully urging
us to find ways to address. Entrepreneurial businesses need
access to capital to fund the search for new ideas, the
development of new products, and ultimately the hiring of new
workers. At the same time, as we know from our country's own
history, investors are more willing to invest when they are
appropriately protected, so raising capital and assuring
investors go hand in hand.
This morning, we will focus on some of the legislative
proposals introduced in this area, including creating an on-
ramp for emerging-growth companies, Regulation A and its
offering limit, Regulation D and its requirements on
solicitation, the 500 shareholders of record threshold for
private banks and other companies to become public, and the
issue of crowdfunding.
The first Federal securities laws followed in the wake of
the stock market crash of 1929, and the Securities Act of 1933,
enacted as the ``Truth in Securities Act,'' required
disclosures. As President Roosevelt stated at the time, ``This
proposal adds to the ancient rule of `caveat emptor,' the
further doctrine `let the seller also beware.' '' It puts the
burden for telling the whole truth on the seller. It should
give impetus to honest dealing in securities and thereby bring
back public confidence.
With the fragile economic recovery and continued high
unemployment, directing the flow of capital to enterprises that
would improve the economy is vital to putting people back to
work. However, we must not forget that gaps in regulation and
lack of transparency were contributing factors to the enormous
losses suffered as a result of the financial crisis.
As we consider these capital formation bills, we must be
mindful to not re-create the very problems that we just tried
to solve when we enacted the Dodd-Frank Wall Street Reform and
Consumer Protection Act. Indeed, even with these steps, as we
go forward, unfortunately, we are seeing incidents of market
irregularities, from insider trading to micro stock capital
fraud schemes. There remains the potential for investors to be
harmed, and we have to recognize that potential.
Today's hearing will continue the Banking Committee's
examination of different proposals to update and streamline our
capital-raising process. This process requires finding the
right balance between ensuring entrepreneurial businesses have
access to capital to fund new products and provide jobs while
providing accurate information to investors so they have the
opportunity to make sound investment choices. And I look
forward to our witnesses' and to my colleagues' presentations.
With that, let me recognize Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman. I
appreciate the fact that we are holding this hearing, and I
look forward to the information that our witnesses will provide
to us, and I welcome the witnesses.
As the December 1st and 14th hearings highlighted, we can
do more to expand economic activity by removing unnecessary
restrictions on capital formation to enhance access to capital
for early stage startups as well as later-stage growth
companies. Later this week, the House of Representatives is
expected to pass a package of reforms that include increasing
the 500-shareholder registration threshold, expanding the scope
of Regulation A offerings to $50 million, permitting general
solicitation of investors in Regulation D offerings, allowing
small businesses and startups to raise capital from small-
dollar investors through crowdfunding, and, finally, providing
an on-ramp that would provide emerging-growth companies up to 5
years to scale up to IPO regulation and disclosure compliance.
In the Securities Subcommittee hearing in December, Kate
Mitchell of Scale Venture Partners talked about the fact that
during the past 15 years, the number of emerging-growth
companies entering capital markets through IPOs has plummeted
relative to historical norms. From 1990 to 1996, 1,272 U.S.
venture-backed companies went public on U.S. exchanges, yet
from 2004 to 2010, there were just 324 of those offerings. This
decline is troubling as more than 90 percent of company job
growth occurs after an IPO.
The IPO Task Force recommended providing an on-ramp that
would provide emerging-growth companies up to 5 years to scale
up to regulation and disclosure compliance. During this period
emerging-growth companies could follow streamlined financial
statement requirements and minimize compliance costs and be
exempted from certain regulatory requirements imposed by
Sarbanes-Oxley and Dodd-Frank.
On December 8th, SBA Administrator Karen Mills and National
Economic Council Director Gene Sperling posted a joint online
statement about helping job creators get the capital they need
by passing legislation relating to crowdfunding, Regulation A
mini-offerings, and creating an on-ramp for emerging-growth
companies. There is strong bipartisan support for these
proposals, and I look forward to working together with my
colleagues and others to enact necessary changes to promote
investment and American job growth while protecting the
investors.
Again, Mr. Chairman, I appreciate the fact that we are
holding this hearing. I look forward to the input that our
witnesses will provide to us today.
Senator Reed. Thank you very much, Senator Crapo.
Following the early bird rule, let me ask if Senator Tester
has an opening statement or any comments. No? Then, Senator
Schumer, the next Democrat.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. I do. Thank you, Mr. Chairman. And I thank
you for holding this hearing. It is the fourth time in recent
months--and I thank Chairman Johnson as well, as well as
Senator Shelby. It is the fourth time in recent months that
this Committee or one of our Subcommittees has considered the
issue of capital formation and the legislative proposals being
discussed here today.
This week, the House Republican leadership is scheduled to
vote on a package of bills encouraging capital formation for
growing companies. If the House package looks familiar, it is
because it includes several proposals already advancing in the
Senate. Speaking on behalf of some of us here in the Senate, we
are glad to see the House endorsing a few of our ideas.
The House package, for instance, borrows from a bill
proposed by Senator Toomey and myself that would provide a
transition period for emerging-growth companies to make it
easier for these companies to go public. The House package also
includes a measure to raise the offering limit under Regulation
A from $5 million to $50 million, a proposal championed in the
Senate by Senator Tester and supported by Senators Toomey and
Menendez.
In addition, Senators Warner and Toomey have joined Senator
Carper on a bill that recognizes the reality that companies are
taking longer to go public and would, therefore, help fast-
growing companies use stock to pay their employees without
undergoing a cumbersome SEC registration process ordinarily
designed for companies issuing stock to the general public. The
proposal also made it into the House package being voted on
this week. So the House package took a lot of bipartisan Senate
proposals that had bipartisan support in the House and put it
together, which is good.
There is no reason why the Senate should not bundle these
same proposals together, just like the House has, and we will.
Leader Reid has already indicated the Senate will assemble a
bipartisan package. The Senate version will probably go a
little further than the House version, and I would hope that we
would also take up some needed precautions on investor
protection, which Senator Jack Reed and others have reminded us
is important.
Given the level of bipartisan support for many of these
proposals, passage in the Senate appears not to be a question
of if but of when. I expect a comprehensive Senate proposal
could be announced in the coming days, and this is an important
area for the Senate to address. Many recent IPOs and proposed
IPOs--Zynga, Groupon, Facebook--have generated a lot of hype,
but the actual numbers, if you are a small startup, not one of
the ones that gets a lot of focus and glamour, that tells a
different story. There have been ups and downs over the years,
but the number of U.S. IPOs has actually drastically declined
since the mid-1990s, and companies are taking almost twice as
long to go public than they were then.
I agree with some of today's witnesses who argue that there
is not one simple reason for decline in U.S. IPOs, but I do
think Congress has an ongoing obligation to ask whether the
policy framework for public offerings is striking the right
balance between facilitating capital formation on the one hand
and attempting to protect investors on the other. That is
always a needle we have to thread.
If you ask the people running emerging-growth companies and
looking to raise capital to build their businesses, they will
tell you why our bill is important. In a recent survey, 79
percent of those CEOs said the U.S. IPO market is not
accessible for small companies, and 85 percent said going
public is not as attractive today as it was in 1995. The
primary reasons cited were regulatory and compliance burdens.
This matters because a threat to the U.S. IPO market represents
a direct threat to U.S. job creation. Historically, over 90
percent of job creation at U.S. public companies has occurred
post-IPO. And according to testimony we will hear from Mr.
Rowe, ``Data show that companies that go public grow their
headcount approximately 5-fold.''
It is also important to point out that our IPO on-ramp is
designed to be temporary, transitional, and limited. At any
given time, only 11 to 15 percent of companies will qualify as
emerging-growth companies, and those companies will only
account for about 3 percent of market capitalization. Big-name
companies who have gone public recently would not have
qualified as emerging-growth companies. Neither Groupon nor
Zynga would have qualified, and, of course, Facebook is not
even in the ballpark.
Finally, I should note that the IPO on-ramp we are
proposing is not mandatory. If investors feel they require more
protection, they would be free to request it from the issuer.
Indeed, Carlyle recently filed to go public, and its
registration statement included a provision that would have
prevented investors from suing in court for securities fraud
claims. Investors objected; Carlyle and its advisers amended
the terms of the offering to remove the provision.
In conclusion, Mr. Chairman, all of the bills we are
considering today would advance the goal of capital formation
and job creation. They all have bipartisan support from Members
of this Committee. I see Michael Bennet has walked in, and he
has another proposal that we are working on as well. Many have
passed the House with over 400 votes, and I am glad to see our
Committee devoting so much time to the issue of capital
formation.
I look forward to working with Chairman Johnson, Ranking
Member Shelby, and the rest of my colleagues to see that the
Senate passes a significant package of legislative proposals to
help small companies raise capital and grow their businesses,
and I am confident we will be successful.
Thank you for the time, Mr. Chairman.
Senator Reed. Senator Corker?
Senator Corker. As is my custom, I think we benefit so much
more listening to our witnesses than listening to us, so I look
forward to that.
Senator Reed. Senator Moran, do you have a comment?
Senator Moran. While I agree with the Senator from
Tennessee, I do have an opening statement.
[Laughter.]
Senator Schumer. He was not directing it at you, Mr. Moran.
STATEMENT OF SENATOR JERRY MORAN
Senator Moran. It did not seem like a very good segue.
Mr. Chairman, thank you. It is a privilege to be here and
to hear our witnesses, and I look forward to that moment. I
just wanted to highlight legislation that I and Senator Warner,
also a Member of this Committee, have introduced, which is
called the Startup Act, and a significant component of the
Startup Act is capital formation provisions. It also includes
items related to regulatory balance, to employment of
entrepreneurial and highly skilled talent, and promotion of
commercialization for research done using Federal dollars.
We are also working to bring in others with the ideas that
Senator Schumer and others have mentioned in their opening
remarks, provisions of Senator Tester's legislation, provisions
that Senator Bennet supports, Senator Toomey, and Senator
Crapo.
We discovered in reviewing the research done by the
Kauffman Foundation in Kansas City that startup companies that
are less than 5-years old accounted for nearly all net jobs
created in the United States from 1980 to 2005. And as we look
at trying to balance our budget, grow our economy, and put
people to work, the ability to create an environment in this
country that is entrepreneurial is so critical. And so we look
forward to working with the Majority Leader and others as they
craft legislation that is designed to create opportunities for
greater entrepreneurial efforts in the United States and try to
create the opportunity for success.
So we welcome the opportunity to work with the Senators I
mentioned as well as those who are interested in this topic,
and I appreciate the opportunity to be here to hear these
witnesses that Senator Corker so appropriately indicated were
more articulate and more highly educated and informing than the
Senator from Kansas.
Senator Reed. We thank the Senator from Kansas.
Senator Bennet, do you have a comment?
STATEMENT OF SENATOR MICHAEL F. BENNET
Senator Bennet. I am nowhere near as bold as the Senator
from Kansas, so I am going to avoid the derision of the Senator
from Tennessee and not make an opening statement. I do want to
recognize Lynn Turner, who is here from the great State of
Colorado--thank you very much for testifying--and simply say,
Mr. Chairman, how important this discussion is for our economic
future.
A lot of people do not know that our gross domestic product
is actually higher today than it was before we went into this
recession. The reason they do not know that is because we have
become so productive as an economy that we are producing that
economic output with a lot fewer people, and we are seeing
median family income continue to decline in this country. That
is a huge problem. And the only way it is going to be resolved,
I think, is through the kind of initiatives that the Senator
from Kansas has talked about and by educating our people. Those
are the two things that we need to do in order to drive an
economy that is actually creating jobs and lifting income in
the United States.
So I look forward to hearing the witnesses.
Senator Reed. Thank you very much.
Senator Reed. Let me now introduce the panel.
Our first witness is Mr. William Waddill. He is the Senior
Vice President and Chief Financial Officer of OncoMed
Pharmaceuticals, Incorporated. It is a privately held company
based in Redwood City, California. He has decades of experience
in life science and public accounting and has helped startups
grow. Thank you very much, sir.
Our next witness is Professor Jay Ritter. Professor Ritter
is the Cordell Professor of Finance at the University of
Florida. Over the past 25 years, Professor Ritter has authored
many articles and books on IPOs and is one of the most cited
authorities on this subject. Thank you, sir.
Our next witness is Ms. Kathleen Shelton Smith. She is the
founder and principal of Renaissance Capital. Founded in 1991,
her firm, which is headquartered in Greenwich, Connecticut, is
a leader in providing institutional research and investment
management services for newly public companies, and she has
done a tremendous amount of data gathering and analysis related
to IPOs, and we look forward to your testimony. Thank you.
Our next witness is Mr. Tim Rowe. Mr. Rowe is the founder
and Chief Executive Officer of Cambridge Innovation Center
located in Cambridge, Massachusetts. Previously, he has served
as a lecturer at the MIT Sloan School of Management, as a
manager with the Boston Consulting Group, and has over a
decade-long experience with startups and early stage venture
capital. Thank you, Mr. Rowe.
Our final witness is Mr. Lynn Turner, who is no stranger to
this Committee. He is a former Chief Accountant of the
Securities and Exchange Commission and is currently a Managing
Director of LitiNomics, which has offices in Mountain View,
Oakland, and Los Angeles, California. His expertise in issues
related to accounting and investor protection has been helpful
to the Committee in the past, and I look forward to his
testimony. Thank you.
I want to welcome all of you again. Thank you for your
willingness and your insights today. Mr. Waddill, you may
proceed with your testimony.
STATEMENT OF WILLIAM D. WADDILL, SENIOR VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER, OncoMed PHARMACEUTICALS, INC., ON
BEHALF OF THE BIOTECHNOLOGY INDUSTRY ORGANIZATION
Mr. Waddill. Thank you and good morning, Mr. Chairman,
Members of the Committee, ladies and gentlemen. My name is Will
Waddill. I am Senior Vice President of OncoMed Pharmaceuticals
out in Redwood City, California. I want to thank you for the
opportunity to speak with you today about unique hurdles of
innovation companies like OncoMed that are facing and the
opportunity that the Congress faces to try and get us past
those hurdles.
It takes decades and more than $1 billion to bring
therapies to market in my sector of the world. In order to
finance research and development, we must cultivate a wide
range of public and private investors. Startup companies depend
on venture capital in the early stages and later look to public
markets to pay for the more expensive clinical trials as we
develop our compounds.
However, due to the current economic climate and economic
realities that are hitting the venture capital community,
public markets are both slow to recover, as has been noted this
morning, which creates a barrier for us to progress our
therapies.
The issue facing all of us across the board in the
innovation sector really is the ability to access that capital,
so I strongly support Senator Schumer and Senator Toomey in the
effort to create an on-ramping for public market for emerging
companies like mine.
One of the key components of the on-ramp is the 5-year
transition period to comply with Sarbanes-Oxley Section 404.
That could have an immediate impact on capital that I will be
able to divert more toward developing a product instead of
paying for administrative costs in the company.
Currently, these opportunity costs of compliance can be
quite damaging and cause delays while I go out as a chief
financial officer with other members of our management team to
raise capital.
Newly public companies have virtually no product revenue,
so all operating capital must come from investors. Now, this is
a key point to understand that when you are in an innovation
stage, you are shooting for products, you are developing
products, and you want to have all your capital go toward those
products versus building infrastructure to comply with the
regulations.
Because of this facing my company, which is a private
company, we do fit into that 86 percent that looks at this and
says, hey, you know, this is a cost burden for us and will
cause us significant costs in the first few years of being a
public company.
So for companies that are still too small for the public
markets, another portion of this legislation is Regulation A.
And the current regulation, which was set in 1992, $5 million,
the proposal is to raise that to $50 million, and this, again,
will open up barriers in front of us to raise more capital. I
support Senators Tester and Toomey's legislation to increase
this to $50 million. This higher limit would raise Regulation A
to match the realities of the current marketplace.
Specific to my industry, it costs anywhere from $800
million to $1.2 billion to get a product through clinical
trials and onto the marketplace. It is an enormous sum of
money, and it is an investment time that I talked about
earlier, while you are in the innovation stage, that is
critical that you have your focus on not only your people but
also your capital in developing those products.
Our hope would be to do that and get to the point where we
could be a Genentech, where we could be a Gilead out in the
world. And when you look across the bay in various sectors
where we live, we would want to be a Hewlett-Packard. We want
to have job creation that gets up to a 10,000-, 20,000-,
30,000-person company. But we cannot do that unless we have
early stage capital. So by creating this IPO on-ramp, reforming
Regulation A, that is an opportunity for us to do exactly that.
So with that, I would like to thank the Members for being
here, and I am happy to answer questions when we get to them.
Thank you.
Senator Bennet. [Presiding.] Thank you for your testimony.
Professor Ritter.
STATEMENT OF JAY R. RITTER, CORDELL PROFESSOR OF FINANCE,
WARRINGTON COLLEGE OF BUSINESS ADMINISTRATION, UNIVERSITY OF
FLORIDA
Mr. Ritter. Thank you. My name is Jay Ritter. I am a
Professor of Finance at the University of Florida, and I have
studied initial public offerings for more than 30 years.
I will first give some general remarks on the reasons for
the low level of IPO activity this decade and the implications
for job creation and economic growth and then a few suggestions
on specific bills that the Senate is considering.
First of all, there is no disagreement about the huge drop,
prolonged drop in small-company IPOs that we have seen for 11
years now. But there is disagreement about the reason for the
prolonged decline, the implications for the economy, and what
should be done, if anything, to rejuvenate the IPO market and
spur capital formation.
The conventional wisdom is that a combination of factors,
including heavy-handed regulation such as Sarbanes-Oxley and a
drop in analyst coverage of small companies, have discouraged
companies, especially small companies, from going public. I
agree with this conventional wisdom in terms of being causes of
the decline in IPOs, but I think that this is only a minor
cause for the huge and prolonged decline. I think the more
general problem is the lack of profitability of small
companies, and this is not so much a private versus public
company issue as a big company versus small company issue.
I think that there has been a long-term worldwide trend
favoring big companies that can realize economies of scale,
economies of scope, bring products to market more quickly. And
this is one of the reasons for the increased right-skewness in
the income distribution in the world, income distribution and
wealth distribution, and I think the IPO market in the United
States is just a microcosm, one of the trees in the big forest.
And if this is the fundamental reason why very few small
companies are going public, because small is not the optimal
way of organizing a lot of businesses, but instead getting big
fast has become more important than it used to be, then I think
a lot of these proposed changes are going to have minimal
effects on spurring small-company investing and rejuvenating
the IPO market.
Now, consistent with this idea that the problem is being
small in many industries is a lot less advantageous than it
used to be, there is a whole body of facts consistent with
this. For one thing, small companies that are publicly traded
have had a long-term down trend in their profitability. Indeed,
of the small companies that have gone public since 2000, over
the last 11 years, only 27 percent of them have had positive
profits in one of the 3 years after going public.
Investors have earned very low returns, way below investing
in bigger companies, in the last decade, and that was true in
the 1990s and the 1980s as well. And it is true not only in the
United States, but it is true in Europe, that if you look at
European markets for small companies, the returns that
investors have earned have been far below the returns on
bigger-company IPOs and more established companies.
So investors have gotten burned way too many times on
investing in small companies, and it is the lack of small
companies that become successful big companies that is largely
responsible for the lack of investor enthusiasm. They do not
want to get burned time and time again.
Now, that is not to say that Sarbanes-Oxley costs and other
things have not had some effect on the profitability of small
companies, but in work that I have done with co-authors, we
have computed how many of them would have been profitable if
they did not have the extra compliance costs. And we find that
there would be some effect, but still that long-term down trend
in profitability would still be there.
Now, in terms of the implications for job growth, there
have been a lot of numbers put out by Kate Mitchell before this
Committee that have been repeated in the Wall Street Journal.
One number that has been out there is 22 million jobs would
have been created if IPO activity had just continued to be what
it used to be. I have actually been doing some work currently
for the Kauffman Foundation looking at the actual job growth of
all the companies that have gone public since 1996, and the
numbers we are coming up with are dramatically lower. Companies
that have gone public in the late 1990s that have had 10 years
of experience on average increased their post-IPO employment by
60 percent, a compound growth rate of 4.8 percent per year.
Now, the numbers are higher for venture-backed companies
than, for instance, for older, more mature companies that have
gone public. But I do not think increasing the number of IPOs
is automatically going to spur an enormous amount of job
growth. That said, I would like to see a healthy IPO market
where good companies can get financing at terms that reflect
their prospects and create wealth for society, investors, and
spur employment.
Senator Bennet. Thank you, Professor.
Ms. Smith.
STATEMENT OF KATHLEEN SHELTON SMITH, CO-FOUNDER AND CHAIRMAN,
RENAISSANCE CAPITAL, LLC
Ms. Smith. Thank you. Members of the Committee, thank you
for inviting me to testify today. Capital formation, when
accomplished through the IPO market, plays an important role in
funding our best entrepreneurial companies. So it is no
surprise that in looking to spur job growth, all eyes would
turn to the IPO market--America's most admired system for
funding entrepreneurs.
We share the concerns of lawmakers about the IPO market and
are honored to be asked for our thoughts. For over 20 years,
Renaissance Capital has had a singular focus on the IPO market.
We are involved in IPOs in three ways: we are an independent
research firm providing institutional investors with analysis
of IPOs; we are an indexing firm creating IPO indices that
measure the investment returns of newly public companies; and
we are an investor in newly public companies through a mutual
fund and separately managed institutional accounts.
I will start by examining the condition of the U.S. IPO
market, including where we stand globally and the importance of
investor returns in the equation. I will then make suggestions
on the specific bills under consideration.
IPO markets around the world were hurt by the 2008 U.S.
financial crisis and the 2011 European sovereign debt crisis.
And yet the United States accounted for 32 percent of global
IPO proceeds during each of those years, larger than any other
IPO market in the world. So despite what appears to be low IPO
issuance levels in recent years, much of the U.S. IPO market is
functioning quite well under challenging conditions.
The IPO Task Force provided helpful data about large and
small IPO issuance since 1991. This data, which is contained in
my written testimony, shows that while smaller IPOs have
disappeared, larger companies raising over $50 million in IPO
proceeds continue to access the IPO market. We find little
evidence that these larger issuers are deterred from wanting to
tap the IPO market. Today we count over 200 companies in our
U.S. IPO pipeline, 92 percent with deal sizes over $50 million.
They are seeking to raise over $52 billion in total, the
biggest we have seen in a decade. All these companies have
undergone financial audits, implemented Sarbanes-Oxley
policies, and filed full disclosure documents with the SEC.
On the other hand, as the IPO Task Force concluded,
smaller, sub-$50 million IPOs have practically disappeared from
the market. Now, we can ease the path for IPO issuance for
these smaller companies, but it only works if real investors
are interested in buying these IPOs. At present, the trading
market for IPOs is highly volatile with share turnover on the
first day of trading at times exceeding the number of shares
offered. This suggests that IPO shares are being placed with
short-term trading clients of the IPO Underwriters. We urge
policymakers to study ways to encourage IPO Underwriters to
allocate IPOs to a broader base of long-term investors.
But the most powerful way to fix the IPO market is to
improve returns for IPO investors. There is a chart in my
written testimony that shows how positive returns drive IPO
issuance, and how poor returns shut down the market entirely.
Unfortunately, there is very little policymakers can do about
this.
The bursting of the Internet bubble over 10 years ago
devastated IPO investors, far worse than the rest of the equity
markets overall. Over 70 percent of those IPOs during that
period were unprofitable companies whose offerings were
promoted by the IPO Underwriters' research analysts. No wonder
in the years following that disaster investors have avoided
small IPOs.
Our suggestions on the proposed bills include the
following:
First, properly define ``emerging-growth company'' to
target the really smaller issuers seeking to raise up to $50
million who have disappeared from the IPO market.
Second, strike the proposed informational rules in the
bills that permit Underwriters' research analysts to promote
offerings and obtain access to special information during the
IPO process.
And, third, the proposed private company bills should
assist the smaller companies and add a market capitalization
limit to prevent larger IPO-ready companies from enjoying an
active trading market in their shares while avoiding public
disclosure.
To summarize, a well-functioning IPO market is based on the
principle of full, transparent, and honest disclosure of
company information available evenly to all public investors.
The U.S. IPO market has been functioning well under the
stressful conditions of a global financial crisis. While policy
initiatives may help the most vulnerable, sub-$50 million
issuers to enter the market, it is positive returns that will
lead the way to a rising appetite by IPO investors for smaller
IPOs. Waiving certain disclosure and stock promotion rules that
result in misallocating capital to weak or fraudulent companies
will only endanger the recovery of the IPO market.
Thank you for inviting me to appear before you today.
Senator Bennet. Thank you very much for your testimony.
Mr. Rowe.
STATEMENT OF TIMOTHY ROWE, FOUNDER AND CEO, CAMBRIDGE
INNOVATION CENTER
Mr. Rowe. Thank you very much, Chairman.
Senator Bennet. I like the sound of that.
[Laughter.]
Senator Bennet. It is fleeting, though.
Mr. Rowe. Isn't everything?
I want to thank Senator Bennet and Senator Merkley and
Senator Brown, who is not on this Committee, for bringing
forward crowdfunding proposals. I want to talk about that
today. I think they are very exciting.
First let me just briefly introduce myself. I am Tim Rowe.
I run Cambridge Innovation Center. Cambridge Innovation Center
is a facility in Kendall Square that sits next to MIT. We have
about 450 startups going in this one office tower. We are told
that we have more startups in one building at CIC than anywhere
else in the world. And it is my background, having worked with
these guys and, you know, about 1,000 startups overall over our
history, that I bring to this discussion.
What is exciting to me about the moment we are in is that
we have the potential to really radically change the system by
which we create new companies in this country. As Senator Moran
raised when he quoted Kauffman Foundation data, we think now
that most new jobs are coming from startups, companies 5-years
old and younger. I was told I could not really show slides
here, but I am going to cheat and turn my laptop around.
[Laughter.]
Mr. Rowe. This is the Kauffman Foundation chart that I
think you are all familiar with. You have probably seen it in
other people's presentations. The blue is the jobs created by
startups. The black is the jobs lost by existing companies, all
companies 6-years old and older. This data has been pretty
broadly vetted. Oh, it went dark. Did you see it before? All
right. So it has been pretty broadly vetted, and what it says
is that we need more startups.
Now, we have got 80 percent of the world's venture capital
in this country. We are awesome at this stuff. We are really
good at innovation. This is where we are leading.
Unfortunately, that venture capital only is good for the small
percentage of companies that are very high growth companies,
perhaps will be worth $1 billion. Most of the new companies in
this country, as we all know, are local businesses. It may be a
restaurant, somebody starting a construction company, somebody
launching a plumbing business. These businesses are not going
to be financed by venture capitalists, and for the large part,
they are not going to be financed by angel investors. And,
generally speaking, we have resorted to Government support
through SBA loans and other programs like that.
What we have in front of us is the possibility, through
Senator Merkley's bill, through your bill, together with you,
Senator Bennet, and Senator Brown's bill, to really change this
and make it legal for people to help each other, for neighbors
to help neighbors, people on your PTA committee, people in your
Facebook friends circle, to help you start your business. This
is a really healthy thing. We have seen this kind of thing
happen in other countries. People talk about microfinance and
so forth. It is just really exciting.
I do not think there is really any disagreement that it is
exciting. I think the disagreement or the concern--and it is
well placed--is: Is there going to be fraud? Are bad people
going to take advantage of good legislation to somehow, you
know, screw us over? We have got to make sure that does not
happen.
So I have been on the phone with people from all over the
country and around the world trying to learn about this. I am
not a legislative guy. I am not an expert in this stuff. But I
have been asking a lot of questions and pulling together data.
It turns out there is a crowdfunding investing company that
exists already. It is up and running; it is working. And the
only reason it is legal is it is in the U.K. where they already
have laws that permit this. And so they have a lot of data.
They have only been up and running for about a year, but the
data show, interestingly, that they have had zero claims of
fraud so far through this system. What they are doing is very
similar to what eBay does. When you go on there and you list
something, they have systems to make sure that what is listed
is true. They do background checks. They do make sure that the
basic offering is OK.
I thought, well, do we know any more? I looked at some U.S.
companies that do crowdfunding lending. There is a company
called Prosper that does. There is AngelList, which does
Regulation D or accredited investor crowdfunding out of
California. And there is a U.K. company that does micro
lending. I went to all of them. They all said, ``We have had
zero fraud.''
So we can get more into the details of this, but the bottom
line is it seems like these intermediaries, kind of like eBay,
do make these things work. There are some specifics in my
written testimony that I would like to refer people to about
exactly how we do it, but I do not think that is the big point.
The big point is let us get this done. Let us get a compromise
that works for everybody and change the way the country works.
Thank you very much for your time.
Senator Bennet. Thank you very much for your testimony.
Lynn welcome. We will hear your testimony now.
STATEMENT OF LYNN E. TURNER, FORMER CHIEF ACCOUNTANT OF THE
SECURITIES AND EXCHANGE COMMISSION, AND MANAGING DIRECTOR,
LITINOMICS, INC.
Mr. Turner. It is good that both of us are from God's
Country.
Mr. Rowe. Aren't we all from God's Country?
Mr. Turner. I will leave that one alone. But it is good to
be here. It is an honor to be here again.
As some of you know, I have been a founder of a venture-
backed startup company that was highly successful, that did
create jobs. I have been at the SEC. I now serve on the Board
of Trustees and Investment Committee of a $40 billion fund that
does invest in this market through investments in venture
capitalists. So certainly important to all of us, and I think
everyone in the room would agree that the more jobs we create,
the better off we are.
Having said that, though, I would like to talk about some
of the things that bring us here, and I think some misnomers
that in general the IPO market is off because of regulation,
and let me quote from Goldman Sachs, which is in the written
testimony. ``Legal and regulatory factors probably do matter,
and policy reform might strengthen New York's competitiveness.
Nonetheless, we do not see them as the critical drivers behind
the shift in financial market intermediation, even in the
aggregate. Quite simply, economic and geographic factors matter
more.''
I think that is borne out if you look at the charts on page
3 and 4 of my written testimony. The IPO market has always
tracked what is going on with the general economy. When the
general economy is doing well, we have a good, vibrant IPO
market. When the general economy is not doing so well, it has
not done well. This includes at times in the 1970s, 1980s, and
1990s, all before Sarbanes-Oxley was ever passed. So it
certainly has nothing to do with the issue of SOX in that
regard.
In fact, if you look at the London AIM market that everyone
mentions or points to, in Charts 5 and 6 and 7, you will see
that in London they have had the same drop--in fact, their drop
has even been more dramatic in London in the lightly regulated
A market than it has been here in the United States. In fact,
as we heard in the testimony from Renaissance Capital, the
bottom line is people invest in IPOs when they think they can
get a decent return. If you cannot get a decent return out of
that company, people simply are not going to invest in them.
Why should they?
In fact, in the London AIM market, if you look at the
statistics on page 7, you will see that since that market was
created in 1995-96, if you put $1,000 in it at that point in
time, you would have $700 to $800 of that left, while the other
components, the more regulated components of the London market
gave you 50 to 250 percent return.
Perhaps more compelling is the chart on page 8, the venture
capital returns. It highlights the great growth that came along
with the IPO market in the 1990s, and keep in mind, the 1990s
was a once-in-a-lifetime economic event. The economy has never
done as well before, and it has certainly never done as well
since the 1990s. And that IPO market during the 1990s is not
necessarily something that in its entirety we want to
replicate. In fact, when I was at the Commission, we had the
leadership at the Business Roundtable come and meet with
Chairman Levitt and myself at the time, and they were very
highly critical of that IPO market because of misallocation of
capital and losses that they thought it would bring and, in
fact, did bring.
What the chart on the venture capitalists shows is, quite
frankly, our bigger problem, as Goldman suggests, is
infrastructure. We have not invested in this country in the
infrastructure that creates the opportunity for these small
businesses to grow, become successful, then get capital, and
then even grow further. Things such as the incubators--and I
myself have served in two incubators--are very critical.
Education, which I know is very near and dear to Senator
Bennet's heart, as McKinsey said a year ago in a study, our
investment in infrastructure which gives these companies the
people they need is a serious shortcoming and has caused a real
problem with these companies being able to get the talent and
the issues we have in this country with the visas and being
able to keep and retain really talented people who have come
here and got their education, really hurts and impacts these
companies as well, far more than the regulatory issues, just as
Goldman Sachs mentioned.
So, with that, let me just make a couple points on the
bill.
One, on page 13 it shows this bill will affect 98-plus
percent of IPOs, so this is a fundamental shift in the
regulation of IPOs. This is not for a portion. This is almost
for all of them. It will be an impact for a long period of
time. Five years is a very, very long period of time.
The stuff on the control stuff, let me just close by saying
good companies have good controls, and the stats, as the
written testimony shows, it is very, very clear we get higher
returns when we can invest in companies with good controls, not
bad controls, and you are taking that transparency away from us
as an investor.
With that, thank you, Mr. Chairman.
Senator Bennet. Thank you, Mr. Turner, and thank you to all
the witnesses.
I would ask the clerk to put 5 minutes on the clock, and
with that, I will turn it over to Senator Reed.
Senator Reed. [Presiding.] Thank you very much, Mr.
Chairman, Mr. Chairman, Mr. Chairman.
[Laughter.]
Senator Reed. Mr. Ranking Member, Mr. Ranking Member, Mr.
Ranking Member.
Senator Bennet. Your Excellency, Your Excellency.
Senator Reed. Yes, yes.
I apologize. I had to go down to the Armed Services
Committee. General Mattis and Admiral McRaven are down there on
another topic equally as challenging as crowdfunding and
Regulation A.
Professor Ritter, you have done a lot of work on IPOs, and
the sense I had from reviewing your testimony is that there
are, as you say, numerous factors to support the idea that
small companies are not going public, being small is not best,
whether private or public, particularly in this international
marketplace. And it goes, I think, to some of the themes that
my colleagues have spoken about with respect to even if we do
make these changes--and many of them are very thoughtful--is
that going to have the impact we desire because of these market
structure issues? And you might elaborate on what these issues
are.
Mr. Ritter. In terms of the market structure issues, are
you including analyst coverage and smaller bid-ask spreads?
Senator Reed. Analyst coverage, smaller bid-ask spreads,
not having markets, secondary markets in some cases for the
stock, employee stock. There are a whole bunch of issues, but
you might be best to define what you think the most important
ones are in commenting.
Mr. Ritter. Yes. I think that there are a lot of tradeoffs,
as the Committee is fully aware, between lowering the
transaction costs, the compliance costs for companies, but
still providing protection for investors. And as has been
pointed out in the testimony of others here, having
intermediaries who can do some vetting and potentially protect
investors, protect investors from themselves, might be a good
way of allowing some small companies to get access to capital
without needing to go through formal angel investors, formal
venture capital firms. When there are no protections for
investors, it seems there are just too many con men and too
many unsophisticated investors.
But as the example of eBay has shown and crowdsourcing in
the United Kingdom, sometimes intermediaries that do some of
the vetting that have some things at stake can protect
investors. So one possibility might be to put restrictions in
some of the laws that require the use of certain intermediaries
as a way of keeping out the fraudsters and possibly allowing a
couple of years of experimenting to see does this work, and
kind of go from there. Maybe it will not work, and hardly any
capital will be raised. But maybe it will turn out to be a lot
more successful than some people might expect.
Senator Reed. I think your response raises three issues,
and I will sort of put them on the table, and I might ask
anyone else who wants to respond.
One is that it presumes that the issuer is going to provide
adequate disclosure to either the retail buyer or the
intermediary.
Second, if you have an intermediary structure, somehow it
is going to have to police the intermediaries to ensure that
they are really working on behalf of the investor and not on
their own behalf.
And then a lot of the issues we will talk about in the
context of this legislation is, well, so what liabilities are
on each of these different actors? Is it a very loose negligent
standard, we tried our best, did not quite get it? Or is it
much more significant? And those are some--and I have just
seconds left, so, Mr. Rowe, could you respond? And then perhaps
Lynn, but very quickly.
Mr. Rowe. Just very quickly, I think Professor Ritter said
it well. I think intermediaries should be required as I believe
the Bennet, Merkley, and Brown bills do require, and I think
that that has shown that it does block fraud.
Senator Reed. Mr. Turner?
Mr. Turner. Senator Reed, I would probably put a strict
liability on that, and probably to establish accountability, I
would put a fiduciary standard on that intermediary, a
reasonable fiduciary standard. We do not want to go overboard
here in that regard. In some of the information I provided the
Committee, though, there is a paper by Professor Jay Brown from
the University of Denver that gets into the issue of provisions
for bad actors in the intermediary or one of the other roles. I
would certainly turn around and take a look at that because I
think that is one piece--there is some good stuff in these
bills, but I think the lack of accountability is what is
driving a lot of investors and consumers batty about these
bills. They do not see it. So I think you have got to get the
bad-actor provisions and you have got to get the liability and
the fiduciary standard in there, or it will take us back to the
bucket shops and penny stock frauds.
Senator Reed. Thank you.
Thank you, Mr. Chairman.
Senator Warner. [Presiding.] Senator Corker.
Senator Corker. Thank you, Mr. Chairman.
Senator Warner. I know. I am not even going to get a couple
comments in. Senator Corker.
Senator Corker. If you would like to make comments----
Senator Warner. No, no.
Senator Corker.----in advance of a lowly minority Member,
that would be fine.
Listen, we thank all of you for your testimony today, and I
think all of us care greatly about access to capital and
ensuring that our economy flourishes, and I find this testimony
today very interesting. I was most interested in the beginning
on the scale issue that was brought up regarding larger
companies having greater returns than smaller companies. Mr.
Waddill, since you sort of represent the smaller-company issue
now, and Professor Ritter was referring to that, do you have
any comments regarding why that is the case?
Mr. Waddill. It is probably tied to the fact that we all
want to be bigger companies, right? I think what is really
important to point out is access to capital. Without that
access to capital you cannot be a big company. You cannot get
through--and I certainly hope that the 1990s were not a once-
in-a-lifetime thing. I look back at the companies in my
industry that were successful going through the 1990s, the
biggest one being Genentech, a venture-backed company that got
early access to capital, became one of the biggest biotech
companies in the world.
Senator Corker. And conditions have changed since that time
so that Genentech could not have done that in 2012?
Mr. Waddill. Certainly in the past 10 years, conditions
have changed. Part of that, you know, you have to pay attention
to--and I agree with what Lynn was saying--what happened in the
economy. But what is another portion of this--and I can state
as a CFO, an informed investor is a good investor. I want them
to be informed because then they can get in lockstep with me
and what I am trying to do. But I think there needs to be an
appropriate balance in that.
If we look at the past 10 years of the ups and downs in the
economy, certainly IPOs have tracked along with that. But with
this legislation, what is really being proposed is to unleash
the access to capital. And as the economy comes back in an
upswing right now in what clearly in my lifetime is the biggest
financial crisis that I have seen, unless these burdens of
compliances and these costs of compliances are loosened, you
know, over, say, that 5-year period, this is going to be an
anchor. It is going to be a negative factor, a negative
multiplier that is going to prevent us from really growing jobs
going forward in an appropriate way.
Senator Corker. Mr. Ritter, U.S. PIRG, I guess, has
mentioned that reducing compliance costs, meaning people not
exactly knowing what they may be purchasing, will actually
increase the cost of capital. I wonder if you might have any
comments regarding that.
Mr. Ritter. It is certainly possible that investors are
going to demand higher promised returns if they have got
greater concerns about having lack of transparency, having more
bad apples in the barrel, that the good apples wind up
subsidizing the bad apples. There are costs of compliance, and
getting that balance exactly right in terms of imposing costs
on all of the apples to reduce the number of bad apples does
involve difficult balancing issues.
Senator Corker. Mr. Turner, you mentioned the need right
now for greater infrastructure. That is more important:
incubators, education, visa issues, which I think many of us up
here agree, especially on the visa issues.
What was it about the 1990s that--I guess we were doing far
less of that at the time. What was it about the 1990s, in your
opinion, that caused IPOs and just the economy in general to
flourish, whereas now we are looking at a lot of micro issues
here to make that happen?
Mr. Turner. Thank you, Senator. There were things going on.
There was an increase in debt that was occurring over that
period of time that was funding increases, if you go back and
look at the issuances of debt and the debt that individuals,
households, and companies were taking on, were financing a fair
amount of that growth, even at a national level, as everyone
knows these days, through an acquisition of debt; whereas, now
we are in a more austere environment, if you will.
There was probably also an environment, as you saw, the
high-tech industry, which really only came about at about the
end of the 1960s, early 1970s. You really saw the tech industry
as an industry as a whole take hold and grow. We had a
phenomenal amount of manufacturing still going on at that point
in time, but as we reached toward the end of the 1990s, we
started outsourcing. I was an executive in a large high-tech
company at the time. Quite frankly, we started out first with
much more manufacturing. We started to take a lot of our
technology offshore as we came to the end of that decade. And
as we did that and we stopped building the debt--or, you know,
people started maxing out on debts, it has put us into the
current economic situation we have now.
So two vastly different economies, not only here, if we
look around the rest of the globe, as the charts on London
show, you had the same effect going on in other countries. And,
of course, this decade has seen the growth of emerging markets
like India and China. And some of that and the success of the
markets is due to the fact that at the Commission we spent a
lot of time, at the urging of this Committee and others, to go
educate everyone else on how to build really good capital
markets. And everyone else went and really built good capital
markets. And if you have ever sold stock in a market, you know
that it is best if you sell the stock in your home market with
your home investors because that is where you get ultimately
the greatest turnover in your stock and the greatest ownership.
If you were doing a sale of stock in a U.S. company today and
you went to the Japanese Mother market, 6 months later all
those shares would be back trading in the United States, so why
do it anyway? Well, it is the same thing for Chinese and Indian
companies. When they list, they tend to list on their own
markets. They have got good markets now that they did not have
before. So there is a reason they go to those markets, and we
have to be very particularly sure in that case, because of
that, that we keep our market the most competitive, and that
means it has to give the highest return to investors. In our
$40 billion fund, we will put that money wherever we have got
to go in the world to get the highest return for the half
million people in Colorado because they depend on that money
when it comes to retirement.
And so if someone else is able to have more transparency
and higher returns, we will go there, and we have gone there.
Senator Corker. Mr. Chairman, thank you. I think you
performed in an exemplary manner as Chairman, and I just want
to say that I appreciate the efforts of so many on this
Committee to create additional access to capital. But it seems
to me the big issue that so many people, again, at this dais
have worked on is getting the macro issues right, and if we
could deal with some pro-growth tax reform and entitlement
reform and deficit reduction, many of these issues that are
being dealt with in a very micro-targeted way would go away,
and that the market would function very, very well. And I
appreciate your leadership in that regard, too.
Senator Warner. Thank you, Senator Corker, and I am anxious
to get to my time. I will call on Senator Tester next, but I
would just make the comment that the appropriate role for
intermediaries, but the intermediaries as trusted
intermediaries in the late 1990s, I am not sure that that track
record in terms of the ultimate result of a lot of those
companies ended up being a great value-add for the investors.
Senator Tester?
Senator Tester. Yes, thank you, Mr. Chairman, and I
appreciate that perspective. I also want to thank Senator
Corker for his comments about the work that the Members of this
Committee have done--I very much appreciate that, too--to craft
proposals that really will, I think, help small businesses grow
through access to capital.
Let me say at the outset I am very pleased with Senator
Reid's announcement about the consideration of a package of
capital formation bills in the near future. I know you are
working on one, too, Mr. Chairman, and hopefully we can get
something to the floor that is going to work and get it passed
in a bipartisan way.
It is really an indication of the good work that is being
done here on the Banking Committee, important legislation to
open up markets for small businesses under the leadership of
Senator Johnson and Senator Shelby.
This Committee has seen some partisan battles in the recent
past. We have been able to set those differences aside on
several bipartisan bills that have the potential to become law,
I think create jobs, and can happen this year, and I hope we
will move forward and focus really on results instead of
politics.
Members of this Committee and Senators Reid and McConnell I
looked forward to working with to put together a bill, passing
it on the floor, and I am confident that with some strong
leadership we can get a package of legislation signed by the
President.
It is good to see Senator Toomey here. We have been working
on legislation since July when I had an access-to-capital
hearing in my Economic Policy Subcommittee. The key takeaway
from that hearing was we need to ensure the capital markets
within the reach of startups at various stages of their
development, particularly in the stages before they are ready
to go public.
As a result of that hearing, we had a chance to take a
closer look at updating Regulation A and better enable small
businesses, including many of the innovative biotech firms in
Montana and Pennsylvania and around the country, to raise
capital through these public offerings. These capital-intensive
firms face unique challenges in raising the significant amounts
of money necessary to complete clinical trials and complete
development of cutting-edge drugs. Mr. Waddill talked about
that in his testimony, and I appreciate the partnership we have
had working on this bill, a bill that passed the House 420-1.
It makes a number of updates to Regulation A, increasing the
amount of capital that can be raised through these offerings to
$50 million, while providing a host of new additional investor
protections that include a requirement of annual audited
financial statements, and the bill provides the SEC with the
ability to require issuers to provide additional information
regarding the financial condition of businesses to prohibit bad
actors from participating in such offerings.
The bill maintains the most attractive elements of
Regulation A, including the ability of issuers to test the
waters before registering with the SEC, and preserves the
nonrestrictive status of securities sold through Regulation A
offerings, a bill that, along with many others, I hope we can
get passed here in the U.S. Senate.
My first question is for Mr. Waddill. In your testimony you
talk about the opportunity that modifications to Regulation A
present to startup biotech firms. Can you talk a little bit
about how and at what stage of development a firm like yours
might use Regulation A and what an adjustment of that cap from
$5 million to $50 million might mean for your company?
Mr. Waddill. Certainly. So OncoMed is a biotechnology
company. We are doing discovery and development work on cancer
therapies. We are currently in clinical trials. Clinical trials
are extraordinary expensive. For every patient that is in a
Phase I--and there are three phases of the clinical trial
process. For every patient that is in Phase I is approximately
$50,000. Get to Phase II, it gets to be about $75,000. So to
access $50 million when I look at my company's plans, that
would get me from discovery for a therapy to the end of Phase
II.
Now, the end of Phase II is a very important marker,
milestone, because that is when you reach what we call ``proof
of concept,'' where you have shown that your drug has potential
to move forward into Phase III, but the science that you have
been working on for a number of years has gotten to that point.
Now, in terms of would my company try to access $50 million
time and time again, the answer is no because what I have to be
cognizant of is when I raise $50 million, my previous
shareholders are getting diluted a little bit. They own a
little bit less of the company when I raise that money. So we
try to be very strategic when trying to go for those sums of
money and direct them specifically to what we think are the
promising therapies within our pipeline.
Senator Tester. I think your testimony also said it was
1991 it was set at $5 million, and I do not know how long you
have been in the business, pharmaceutical business, but----
Mr. Waddill. Twenty years.
Senator Tester. Well, we are there, then, 1992.
Mr. Waddill. Yes.
Senator Tester. How have the costs increased since then? In
other words, $5 million I would imagine in 1992, as in
agriculture, bought you a hell of a lot more than it is going
to buy you today.
Mr. Waddill. Yes, absolutely, the difference being--and
this gets a little complex--that the recognition in the
marketplace of what is valuable has changed.
Senator Tester. Yes.
Mr. Waddill. So back in the 1990s, when I first got into
biotechnology, you could have $5 million, go for a couple of
years, and shareholders would respond to the value you created
with $5 million. That has changed dramatically in that you have
to not go from just discovery but all the way to the end of
Phase II before they will look at you.
Senator Tester. Got you.
Mr. Waddill. And that is a key understanding in all of
this, that the data that flows through my financial statements
talk about what is going on financially in the company. We
disclose everything appropriately, but the science underlying
it is really as important, if not more important.
Senator Tester. Just a little liberty, Mr. Chairman.
You can make this answer very, very concise, if you would.
There is some anticipation that people would use this offering
multiple times. Could you talk about that very briefly, if you
see that as something that your company would do, or if it is
something we need to be concerned about?
Mr. Waddill. No, that would be dilutive to my current
shareholders, and I would not have a job.
Senator Tester. Got you. Thank you very much.
Thank you, Mr. Chairman.
Senator Warner. Thank you, Senator Tester, and thank you
for your leadership on this issue. It seems to me--now when I
get to my turn, I will speak a little bit about the fact that
there is a lot of commonality amongst a number of these bills.
I know Senator Toomey has been very active on a series of them,
and this sure ought to be one where we could find some common
ground and a broad bipartisan bill as opposed to a Democrat and
Republican alternative.
Senator Toomey?
Senator Toomey. Thanks, Mr. Chairman, and I do appreciate
your interest and leadership in this, as well as that of
Senator Tester. You know, when we go back home to our
respective States, I am sure we all hear the vocal complaints,
legitimate complaints, from our constituents about how little
is getting done, how little we work together, how this place
has devolved into this partisan battling that has been
downright counterproductive for our economy and for our
country.
I really believe that we are on a topic here today that is
a complete exception to this entire idea. And since I got to
the Senate a year ago, I have been delighted to work with
colleagues on the other side of the aisle to advance bills that
are very broadly, almost universally supported, and I think it
is time we move on this. I am, frankly, delighted that we have
got a strong interest in the House to move a series of bills. I
am delighted that there is interest here.
If ever there was an opportunity to do something that is
unambiguously constructive for the economy, pro-growth, good
for job creation, this is it. And an awful lot of the heavy
lifting has already been done.
So, really, I am glad we are having this hearing. I hope
this is to drive home this message that now is the time to
move.
Senator Tester referred to a bill that he and I have
together that passed the House 421-1. We have many cosponsors
on both sides of the aisle. I have a bill with Carper--it is
known as the ``shareholder bill''--that would limit the
permissible cap on the number of shareholders. It passed the
House Financial Services Committee, which is a big committee,
by a voice vote in October of last year. It is my understanding
some version of that will be included in the House package.
Then there is the bill S. 1933 that I have done with
Senator Schumer, which the nickname for this is the ``on-ramp
bill.'' This one, of course, would facilitate an IPO by
diminishing some of the burdens of registration that currently
attends to an IPO. This bill passed the House Financial
Services 54-1. These bills, if not every one of them certainly
the first and the last, are supported by the President in part
of the Startup America Plan. So I hope we will move on this
very soon.
My quick question for Mr. Waddill: One of the things that
has been stressed to me by some of the folks in the life
sciences in Pennsylvania is how critical the multiple stages of
capital raising is, from infancy right through IPO, and there
are a lot of pieces, a lot of steps along the way.
It seems to me that if you facilitate access to capital at
any step along the way, let us say even the IPO, you increase
the opportunity and the chances and the ability to raise money
at the earlier stages because one stage in many ways depends on
subsequent stages.
So could you comment on whether you agree with that,
whether that is, in fact--and, in other words, if you
facilitate raising capital at one stage, are you really helping
that company out throughout its entire life cycle?
Mr. Waddill. Oh, there is no doubt about it. I can tell you
10 of my 20 years in the industry was spent consulting and help
start 34 different companies, some of those in Massachusetts,
some of them in California. And predominantly they were the
early stage companies, predominantly venture capital-backed.
And those early stages, to raise $5, $10, or $15 million to
establish a lab in biotechnology was just absolutely key. You
cannot progress the science forward unless you set up that
infrastructure.
So it is remarkably important, and you can connect the dots
between the later-stage raise and the earlier-stage raise. And
if you get a high-quality investor in that process, they will
stay with the company for a period of time because they will
believe and understand what you are doing.
Senator Toomey. So would it be your judgment that if we
passed some package of these bills, that could actually
facilitate angel investment, early venture capital, even in
respects that are not directly addressed by the bills?
Mr. Waddill. Yes. So when you look at venture capital
investing, part of their collective problem right now is they
have no exit for their investment. They cannot cash out. And
that is due to economic climate and the barrier to go and be a
public company. Part of that barrier is the cost of compliance.
I am a numbers guy, so I can share some numbers with you. For
my company to try and prepare for it Sarbanes-Oxley compliance
would be somewhere between $3 to $3.5 million. On an ongoing
basis, if we use the SEC study that came out, the medium cost
to comply with 404 is in the $400,000 to $450,000 per year
range. So an easy way to think about that, for every $1 million
of compliance, I am prohibited, because I do not have the
funds, to hire 15 to 20 scientists--those 15 to 20 scientists
will be key in developing the science further--and, more
importantly, another 15 or 20 patients that I cannot treat in
the clinic. For us to be successful in our sector, we have to
be treating patients to progress forward.
Senator Toomey. Mr. Chairman, if you would just indulge me
for 1 second, I notice Mr. Rowe seemed to have something to
indicate. If you want to respond to this question, I would
appreciate it.
Mr. Rowe. Yes, I do. I spent part of my time with New
Atlantic Ventures, which is an early stage venture capital
firm. One of the things that we're seeing is that the exits
that are prevalent today are primarily acquisition as opposed
to IPOs. There is much less upside for a venture capitalist if
you go down the actual path. And, incidentally, unlike in IPOs
where it is somewhere between a 60-percent increase and a 5-
fold increase, depending on whose data you look at in jobs,
typically after acquisition you let go people because there are
redundancies. So this is very important to the venture capital
industry.
Senator Toomey. Thank you very much, Mr. Chairman. Thanks
to the witnesses.
Senator Warner. And thank you for your leadership on these
issues.
Senator Menendez?
Senator Menendez. Thank you, Mr. Chairman, and thank you
all for your testimony. I had two lines of questioning I wanted
to ask.
One, how should we address the counting of beneficial
owners of stock rather than owners of record? In my own view, I
think it makes sense that we should be counting beneficial
owners and raising the threshold to a higher number, and not
necessarily be counting a broker of record that has stock from
many shareholders as a shareholder. But I would be interested
in hearing some of your views.
Mr. Waddill. It is a cumulative number. I agree with you
that the number needs to be raised. I am not sure what that
number is. I can tell you that one of the predominant issues in
my industry is that we compensate employees with stock options.
We do that from the president of the company down to the glass
washer in the lab. And over the course of time, a lot of shares
will be issued to a number of people. So that is another
cumulative set that needs to be added to what you are
addressing.
Mr. Ritter. Senator Menendez, I am in complete agreement
with you that the regulations do need to be changed given that
the concept of shareholders of record is dramatically different
now than it used to be because individuals for public companies
are holding stock in street name. Now if you have got a company
that before going public might have had 1,000 beneficial
shareholders and after going public has 2,000 beneficial
shareholders, the shareholders of record might have only
increased by 10 people. So the regulations do need to be
changed to reflect stock being held in street name.
Senator Menendez. Anyone else? Ms. Smith.
Ms. Smith. Yes, I would add to that that I think that the
ability to do online activities has helped us so much, for
example, with disclosure. EDGAR enables information to reach
the hands of investors so elegantly and has made such a big
impact on transparency.
However, when it comes to the private placement market, the
issues that we have, even with the 500-shareholder rule,
actually developed because of the ability to connect online
with investors of all kinds, and hopefully they are all
qualified. We have had a situation where Facebook, for example,
even under the 500-shareholder rule, has benefited from a
lively trading market in its stock at prices that have valued
the company before they filed for the IPO, something over $80
to $100 billion, the size of McDonald's. A major company that
can then have the benefit of this lively trading market beyond
any of their existing employees but involving outside
shareholders and yet not take on the responsibility of full
disclosure.
So with these rules on the numbers, it appears to us that
it is not the number that--with technology, 500 may even look
like a big number because we can move information around very
quickly among a lot of people. That the real issue is to target
the smaller companies and to put some kind of a market cap
limit. For example, if the company's market valuation is below
$300 million, and below $300 million in total valuation, and it
gets to 500 shareholders, fine, we can have this market. But if
it goes beyond that, we then do not want to establish what I
would call a shadow IPO market of major companies that should
be disclosing and yet accepting the ability to have a lively
trading market in their stock. A shadow IPO market is probably
not in the best interest of promoting a strong IPO market here
in the United States.
Senator Menendez. And a final question, Mr. Waddill. You
mentioned in your testimony a number of avenues where financing
could be potentially raised by small private and public
companies, and in 2010, Congress passed my therapeutic
discovery project tax credit. My understanding is your firm was
awarded credits through the program.
From your experience, can you talk about whether you found
this program beneficial, for example, small biotech capital
formation? And do you believe that an extension of the credit
would help other small innovative biotech firms as they compete
against competitors around the world?
Mr. Waddill. Absolutely. So we applied for five, we got
five. That equated to $1.2 million into my company. And I can
specifically tell you that we had--we did not have funds to
progress one of our therapeutic areas, and that $1.2 million
provided that. So as I sit here today, that for us is a major
initiative in the company which just would not have happened.
And it was one of several areas. So if you equate that to a
smaller company than mine, certainly it would have been
beneficial to advance the technology, so it was a tremendous
help.
Senator Menendez. Thank you, Mr. Chairman.
Senator Warner. Senator Bennet.
Senator Bennet. Thank you, Mr. Chairman. Thank you so much
for holding this hearing. I wanted to associate myself with
Senator Toomey's remarks. This is a place, I think, where there
is very broad bipartisan support and that we ought to figure
out how to advance these bills in a bipartisan way. So much of
the debate that we have around this place is this left-right
discussion that no one at home really understands and, frankly,
find meaningless. And we are at a position now, I think, where
as a Congress we can actually support what is the most
innovative economy in the world still and drive this innovation
in a way that actually is promoting job growth here in this
country and promoting wage growth in the country, the two
biggest issues that the people that I represent face, frankly.
And as the testimony pointed out, we are at a moment in the
economy where the productivity increases, the productivity
gains that legacy firms have achieved, which is great, are not
driving the job growth that we need, and it is going to be the
company that is founded tomorrow and next week and the week
after that that is actually going to drive job growth.
The other point I want to make before asking one question
is the critical importance that education plays in all of this.
You know, the worse the unemployment rate ever got for people
with a college degree in the worst recession since the Great
Depression, the recession we just went through, was 4.5
percent, and there is a reason for that. And if we are not
educating the people in this country to be able to do these
jobs, the capital formation that we are all talking about here
is going to go someplace else to find human capital that
actually can drive these new businesses. So that is not within
the jurisdiction of this Committee, but it is a very important
part of what we are dealing with.
Mr. Rowe, I appreciated very much your comments about
crowdfunding, the bill that Senator Merkley and I and Senator
Brown have been working on. I wonder if you could talk a little
bit about what kind of businesses you would expect to take
advantage of crowdfunding if we were able to pass this. Is it
just somebody who has got an initial idea, existing small
businesses, someone who has got the need for additional
capital? And then, finally, as we look to formulate a consensus
bill on crowdfunding, which I believe we can do, you know, what
thoughts do you have about the lessons that we can learn from
existing Web sites like Kickstarter, which you mentioned in
your testimony, which has enabled individuals to donate to film
production and the arts? So run with it.
Mr. Rowe. Thank you, Senator Bennet. I really appreciate
your question and the whole Committee's time again.
Let us put sort of the potential of this in a little bit of
perspective. Apparently, Americans save in long-term savings
about $30 trillion. This is 401(k)s, you know, pension funds,
IRAs and so forth. Author Amy Cortese framed this by saying if
Americans took 1 percent of their saving and put them into--
instead of saving it in a 401(k), invested it with another
business somewhere in their town, just 1 percent of their
money, that would create a pool of money 10 times bigger than
all the venture capital that we invest every year in this
country. It would create a pool of capital that is half as big
as all outstanding small business loans.
So the size of this, just first of all, is simply huge, and
the Kickstarter analogy--this came out I think in Talking
Points Memo recently, and there was some debate about the
accuracy of the figures, but I think they really nailed it now.
They found that Kickstarter, which is one crowdfunding site
that instead of investing, you get a thing, to kind of work
around the laws today you get an item from the person you are
investing in, you do not get equity. Kickstarter raised for the
arts alone half as much as the NEA, the National Endowment for
the Arts, raised for arts last year in 2011. And they are
predicting that in 2012 it will tie the NEA in money raised for
the arts. This is everything from video games to film to
paintings and so forth. So the impact of this, just the scale,
is huge.
I predict that this is going to be your everyday business.
I think that you are going to have somebody in your community
who starts a catering business, and they are going to go on
Facebook, and this is the general solicitation part. This is
why that is important, because if you post on Facebook that is
a solicitation and it would be illegal today. They are going to
go on Facebook, and they are saying, ``I am starting a catering
business.'' They are going to go to their friends from college
and say, ``Would you back me? Would you put 500 bucks or 250
bucks in to help me get this thing going? I need to buy an
oven.'' That is the kind of business that I think this is going
to really--this is where it is really going to hit the ground
running. And where it really is different from what, you know,
for instance, happened in the late 1990s with the IPO boom and
the venture capital, that happened in a very small part of the
country, in a very small type of business. The rest of the
country did not see those benefits. I think we are talking
about something which is timeless and which is growing. So that
is the first part.
If you are interested, I do have some very concrete
suggestions, having talked to dozens of people about your bill
and other bills. I think there is a potential for a compromise
bill here that is 99 percent what is already in all the bills,
and there are a couple little tweaks that people would like to
see, or we can come back to that afterwards.
Senator Bennet. Great. My time is up, but I for one would
love to hear those suggestions, and I am sure that Senator
Merkley would as well.
I just think the last point is so important. These
initiatives will inject capital throughout the country,
throughout the entire geography of the country, in a way that
we have not seen before. This really is about Main Street, and
we need to do everything we can do to make sure we protect the
investors that will come. But I think the potential here is
just enormous, so thank you, Mr. Chairman.
Senator Warner. Thank you, Senator Bennet.
Senator Merkley?
Senator Merkley. Well, thank you very much, Mr. Chair, and
I will follow up by saying I had highlighted in your testimony,
Mr. Rowe, the comment about the $30 trillion. So I think it is
a reminder of the potential, and that is just retirement
savings.
As we wrestle with the crowdfunding platform, the goal that
I brought to this, and my colleagues who have joined me in the
bill, is to establish a successful system, because if it gains
a taint of fraud on the front end, it will be very hard to
improve on that in the future. And one philosophy we brought to
that was portal neutrality, so the portal itself is not
involved in any sort of pump scheme that might discredit its
legitimacy.
A second was accountability for accuracy among the officers
and directors, and I know you have made the point in your
testimony that maybe that is going too far. I think that is an
important conversation for us to have, at least at the startup
of this, and as we search for a way to try to give folks
confidence that what they are reading is accurate.
And the third was having statements reviewed under 500K and
audited over 500K as three of these approaches.
But I thought I would just invite you to share your concern
that the accountability for accuracy might be going too far.
And, Mr. Turner, I think if you would like to follow up on
that, I would appreciate it.
Mr. Rowe. Thank you. So on the accountability, I think we
are very close. I think the definition you used in your bill is
almost identical to the--and I am not an expert in this, but
the SEC Rule 10b-5, which Lynn probably authored, which defines
the accountability for fraud in private exempt offerings of
securities today under the SEC. It is identical to yours with
one exception. They do not hold the officers liable if there
was no intent of malfeasance or negligence. So in the basic
standard in the bill today, it just says if you misstate
something, then you are liable. And we are concerned that if
you have got 100 investors and one of them gets made at you
because of, you know, maybe a personal dispute or something,
they sue you ad you are liable because you accidentally
misstated something, we are hoping that would not be included.
The standard SEC fraud clause works fine. It just says you are
liable as long as you did not--as long as there was
malfeasance, or I think they call it--you are probably going to
be able to do a better job with this.
On the other bits, I think that reporting is great. There
was some suggestion that maybe reporting should be quarterly.
Again, for these small businesses it would be really great if
that could be annual. I mean, this is a catering business. They
do not do quarterly accounting typically, and it is an extra
cost. It is that kind of level of tweak that we are really
talking about. I do not think we are in disagreement at the
overall level.
Senator Merkley. Thank you very much. I think it is very
helpful to chew on these things.
Mr. Turner, do you want to make a comment on that?
Mr. Turner. Thank you, Senator Merkley. In general, I like
the notion in your legislation that there is a degree of
accountability. I think it needs to be more than just an
intent-based thing. If, in fact, you go out and mislead people,
you ought to be held accountable. And on the flip side of that,
if you are the intermediary representing someone trying to
raise the money, then I think you ought to have a fiduciary
standard to that investor that you are held to. And I think it
goes beyond just being something with scienter or fraud. I
think that if people recklessly go out there and exhibit gross
negligence in doing this and misrepresent things, certainly
those people should be held accountable. If it is merely an
oversight, you know, I do not think an oversight, but,
nonetheless, there is a danger to the system here. We have a
very good history with these types of situations in the past,
as recent as Congress did the penny stock fraud reform act in
this building.
So we have a history that when people are out attracting
this type of money, unless you have a fair degree of
accountability so that investor can go recover, you turn around
and create a situation where there will be damage done and
people withdraw from doing these. Rather than increasing them,
you are going to decrease them if we go back to the whole penny
stock frauds or bucket shop days that we have had a couple
times. We have tried this a couple times, and it never worked.
So if we are going to try it a third time, you have got to
build in transparency, you have got to build in full disclosure
of conflicts, and you have got to put in a decent level of
liability if you take people's money and misappropriate it or
mislead them on it.
Senator Merkley. So, Mr. Turner, I am running out of time,
but I will look forward to following up with you on this issue
of platform fiduciary responsibility, because I think we had
really worked to frame this as a facilitator rather than a
vetter, and I think a couple alternative perspectives are being
presented here to chew on.
Mr. Chair, can I extend for a moment here? Yes, Mr. Rowe?
Mr. Rowe. Yes, I think that probably the word ``vet'' is
the problem because it could mean different things to different
people. What seems to be working well is where the facilitator
does background checks, makes sure that the offering
descriptions are very complete, does a bunch of other stuff to
make sure that these are not fraudsters; but does not try to
say this is a good catering business or a bad catering
business. That is the line that I think they should not cross.
And I think that is also what you are saying as a facilitator.
If you look at AngelList, which is working very successful
now under Regulation D for just accredited investors, they
describe the offerings. They also do clever things. They
describe well-known people who are investing in these things,
well-known people in the community that have already privately
vetted them, and they say, you know, if Mitch Kapor wants to
invest in this--they do not say this overtly. They say, ``Here
are the people who are investing. You draw your own
conclusions.''
So there are very clever ways that they can get the
intermediary without actually directly vetting can facilitate
and prevent fraud.
Senator Merkley. Mr. Chair, I have two more questions, if
we have time.
I want to throw both of these out there at once. One is
that another challenge for small investors--because they are
looking at the front end, and they figuring in a couple years
this company is going to sell out or be purchased or is going
to merge. How do you ensure that there is some protection for
the small investor who is so key in the success on the front
end, but the deals struck by management when they sell the
company might basically undermine any return to that small
investor. So that is one question.
A second is: Should there be the possibility for
intermediary funds? For example, let us say I think it would be
quite interesting to put 1 percent of my retirement funds into
small companies, but I have no time or desire to vet those
companies. Should I be able to put 1 percent of my money into
basically an intermediary fund that would then invest in
crowdfunding?
So I will throw those two questions out for any thoughts or
insights you might have. And, Mr. Ritter, I think that you
might want to start, or if you would like to start, related to
this issue of protecting the small investor when M&As come up.
Mr. Ritter. Right. In regard to your first issue, with a
lot of startup businesses, they fail, and investors, I think,
will certainly be aware that there is a possibility of failure.
But there is also an issue, what if the company is very
successful?
One possible thing that could go on is the small investors
wind up ex post being diluted out. For instance, the first-
round financing might be Class A shares, and then later on some
venture capitalist or brother-in-law of the entrepreneur comes
in and is issued Class B shares that have conversion rights of
100:1 into Class A shares. So the company is very successful,
but the original Class A investors wind up owning 0.1 percent
of the company and they do not get to share much in that upside
potential.
I think that, you know, angels, venture capitalists, are
aware of these possibilities. They insist on fine-print anti-
dilution rights. A lot of individual investors are not going to
be thinking about all of these concerns, and if they are
talking about investing $1,000 in a company, it is certainly
not worth their while to go out and hire a securities lawyer
before they decide to invest this $1,000, to put the $1,000 in.
So one possibility might be to craft the legislation to
have certain defaults, anti-dilution provisions or something as
the base case that these Class A shareholders would have to
vote to override if they are overridden.
Mr. Rowe. If I may, I do think it is a very valid concern,
and I would say there are other concerns, similar concerns,
such as if it does very well, what if it just does not sell the
stock for a long time, does not make dividends. You know, when
does this investor get out, for instance?
So this is why I believe that you should require
intermediaries, and I know you do in your bill. The
intermediaries will compete to be attractive to these small
investors. What is already happening in England is that they
are looking at--the intermediaries are looking at putting in
just such these provisions themselves in order to be more
competitive to draw small investors. I think this actually is
an area where we can leave the intermediaries to figure out
what is the best deal. How can we structure this with standard
docs and standard provisions that will be attractive to these
small investors? The intermediary who loses all the investments
or whose investors hate it because they lost all their money
will go out of business very quickly and I do not think
realistically will set up in the first place.
Senator Merkley. Thank you. And I am way over my time, so I
am going to return it to the Chair.
Senator Warner. Thank you, Senator Merkley. And I want to
also thank all the witnesses and all the good work of the folks
on the Committee. This was my business for 20 years in the
venture business, and I believe there is enormous opportunity
here to jump-start capital access, because, frankly, our recent
efforts in terms of the small business bill and some of the
other capital access bills have not been very successful.
I am very intrigued with the crowdfunding notions. I do
think these questions around--having been that, you know, bad
venture capitalist coming in at times, you know, there are real
concerns about dilution interests, trying to protect those
early stage investors. But the flip side is if the company is
not doing well, the market drives some of this. So the question
of how you get the intermediary right is, I think, an important
one. I know Senator Merkley has been working on this.
Clearly, the intermediary in and of itself, though, we had
very ``trusted'' intermediaries in the late 1990s, I am not
sure all the products that were put out in the marketplace, you
know, their performance record was obviously not that good. I
still recall a number of companies I had that had, you know,
momentary billion-dollar caps that went to zero as the tech
bubble burst.
One of the things that I am--and I have great respect for
Lynn Turner, but I do believe that the regulatory burdens of
Sarbanes-Oxley, 404 and others, are stopping companies from
choosing to pursue that route. And I think some of the bills
that I've been working with Senator Toomey and Senator Schumer
on, on the on-ramp approach, make some sense.
I would argue that one of the things that is different than
the bucket shop era is that the power of the Internet bringing
more and more transparency and being able to more quickly
identify bad actors through this tool I think is something that
might preclude some of this bad behavior, and I would just be
curious to hear folks' comments on that. And, Lynn, I would
love to have your rebuttal as well to that presumption.
Mr. Waddill. Well, I can tell you from our company's point
of view, when we look at the use of capital, it clearly comes
into the equation. Do we want to spend $3 million ramping up
into Sarbanes-Oxley compliance? Do we want to spend $2 million
over the next 5 years, $1 million plus? Do I need to hire a
couple more staff to support this internally? It comes up,
because every dollar is precious.
One thing that is just fundamentally different than the
crowdfunding--crowdfunding, they have a product. I am in an
innovation stage where I am shooting for a product, and this is
something that is interesting to cut across industries that
when you are in that zone, when you are spending your capital
to get to the point where you can make hopefully millions and
tens of millions of dollars and build a company, that is when
the funds are really critical.
Ms. Smith. Just to comment on the power of the Internet and
having a IPO market perspective, we can do much more. It may be
outside of these bills, but we are not using the power of the
Internet enough to help the IPO market, which is ultimately the
end game for so many of these companies.
For example, in early IPO trading, we know very little
about who owns the shares as soon as they are allocated and
during the first days they trade. The transparency of our
trading markets is extremely poor, which hurts and scares a lot
of investors in the market. They do not understand the trading
volatility. And I think we can use more transparency.
The ease of information when a stock ownership gets to be
over 5 percent is poor. We should not have to wait for days to
find out who owns that stock. So there is a whole lot we can do
to make our IPO market better. And that is regarding the
trading.
When it comes to information, I mentioned how important
EDGAR Online has been to the market. There is so much more that
we can do. We file registration statements that are lengthy,
and when they are updated, we do not know--we are not given a
red line as to what the update is online. Companies' talk at
road shows, why aren't they transcribed? Information is there,
and it does not cost much to get it out to investors. And I
believe that if we could add that kind of attention, it would
help. The market is what it is--we are not going to be able to
change too much. It is about returns. But the more information
that we can give investors would help the IPO market that these
smaller companies are trying to address.
Senator Warner. Lynn?
Mr. Turner. Senator Warner, we do totally agree that the
Internet is bringing out more of the bad actors. The problem
is, as we have seen it with the Chinese companies--and keep in
mind, all these bills are applicable to the Chinese companies--
is that the Internet is getting it out after the fact. So while
it is good it is getting out earlier before losses can get as
big as perhaps they might have been in the past, it is still
water over the dam, and the money is gone. And so while it gets
out sooner, it ultimately does not prevent the losses. So from
that, it is not a workable thing. And as we have seen with the
Chinese companies, that IPO market has totally dried up, and
people went away from it because they do not trust it. No one
is going to play at a Vegas casino, which is what that IPO
market was.
As far as the SOX 404 stuff, yes, we would probably
respectfully disagree on that point. SOX 404, I went through
two companies, including a fairly new software company that had
done it. I actually found that in the long run--one was Sun
Microsystems. We found that we actually had tremendous savings
from getting the company run the way it should be and the way
it controls when we put that in. As the data in the testimony
shows, companies that do not have those controls way
underperformed the market, way underperformed their peers. And
yet this year--I got an email just yesterday from a service
that tracks this. They said something like 22 percent of the
2011 filers so far have reported problems with their controls,
and there are a number of studies now underway to look at these
IPO companies and see how long it is between the IPO and when
we are all of a sudden seeing this, because you actually trade
in the market. What we have found is you can make money, good
money, as a trader in the market by trading against the
companies that have the poor controls because they underperform
versus the companies with good controls. So when I was at Glass
Lewis, when we put out this type of research, we actually found
funds trading on the data and making good money just by
identifying the companies with poor controls. They do
underperform.
So if a company goes public with poor controls, sooner or
later it is going to impact on the stock. There has also been
research that shows that that has a contagion effect now. It
not only impacts that company, but it impacts the stock price
of other companies in the trading, especially with all the
trading and all that is going on today. And so especially given
the fact--you cannot say SOX 404 cost you that much at IPO
because it is not until the second annual report 2 years later
that you are doing your first SOX 404.
We also know that a high percentage of these companies in
terms relative, you know, are still not getting that fixed, so
it is having an impact on them, and it is having an impact on
the investors in those companies. And why is it that you are
going to take that away? Why are you all of a sudden going to
say in a situation where before you would have told me they had
bad controls, now you are going to let them hide it for 5
years?
Senator Warner. I would take issue. I do not think that the
on-ramp proposals that we are laying out allow you to hide it.
I think there are appropriate balance controls for these
companies to ramp up. I do think having been on boards and
investors in many of these entities, it is a burden and hurdle
that slows the IPO market.
That brings me to my next question, which is, you know--and
I would like anybody's comments on this. One of the challenges
with a much more limited IPO market is not only the fact that
less companies get access to that capital, but I think there is
a competitive price our overall economy pays when companies are
forced through their only virtual exit to be a merger and
application. I can tell you in the telcom business, you know,
the ability of the big guys to take over the innovative guys
and a way to stifle innovation, to continue to control the
market, to not have as competitive of a landscape, I think does
damage to our economy. And I would just be curious--we have
talked a lot about the capital part, but more on the macro
standpoint here of, you know, having companies only having kind
of an M&A exit strategy, whether any of you agree that that
also has a negative effect on overall innovation growth in our
economy. Mr. Rowe?
Mr. Rowe. Yes, just very briefly, and in my experience
sitting on boards in the venture capital context, we see--and I
will not name names, but over and over again the companies that
are acquired very frequently end up dying. The buying company
may pay a high price, but they do not really have the spirit or
the passion that the entrepreneur had. The entrepreneur cashes
out and leaves. And I do not know. Maybe there is some research
on this. I would love to see it. But I see this in practice all
the time. And if these companies can instead go public and that
entrepreneur becomes the next Bill Gates running that company
for another decade or two, that is where you see real impact on
this country.
You know, Harvard Business School's Bill Sahlman said this
nicely yesterday at a forum on crowdfunding. He said, you know,
we should distinguish between fraud, which is illegal and we
should clamp down on that and make sure it does not happen and
enforce it, and failure. He said failure has been the thing
that has made this country great. The fact that we are willing
to take risks, the fact that we are willing to start companies
and try to be Apple, try to be Microsoft, try to be Zynga or
Facebook, that is what is great about this country, and if we
try to legislate out failure, we are making a great mistake.
Mr. Waddill. I can tell you that my last company, we did
sell the company. It was a great transaction. It was great for
investors. The company got sold to Amgen, another U.S.-based
company, and the result of that was people were rewarded, but
the employees that were there that were incented to get to the
point where they could sell the company are starting another
company and continue on in the same vein.
So certainly out in the Bay Area, once you get the bug, you
just keep on doing it. It is an avenue for exit, and there is
some chance that the technology is going to go away. But the
incentives are in place in the capitalist society to perpetuate
this.
Senator Warner. Although one of the things by having a
broader-based IPO market, you know, my hope would be we would
have this innovation not just taking place in the valley or
Northern Virginia, but around----
Mr. Waddill. Sure.
Senator Warner. And I think, again, some of the
opportunities. We have got to get this balance right on
crowdfunding and crowdsourcing. You know, that does open up
enormous, enormous opportunities elsewhere.
I will just simply close, and I want to again thank the
panel for their good work and good comments. This is an area
where a group of us on this Committee and others are looking at
combining a series of these bills and launching a bipartisan
effort. It would be, I think, great for startup companies, but
it would also be great in terms of sending a message that there
are actually issues that Democrats and Republicans can work
together on, get done, and end up jump-starting greater job
growth in our economy.
Again, my thanks to the panel, and with that the hearing is
adjourned.
[Whereupon, at 11:53 a.m., the Committee was adjourned.]
[Prepared statements, responses to written questions and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON
Today we will have our second full Committee hearing on ``Spurring
Job Growth through Capital Formation While Protecting Investors.'' It
is our fourth hearing overall on capital formation, following Senators
Reed and Crapo's Securities Subcommittee hearing on ``Examining
Investor Risks in Capital Raising'' and Senators Tester and Vitter's
Economic Policy Subcommittee hearing on, ``Access to Capital: Fostering
Job Creation and Innovation Through High Growth Startups.''
Growing small businesses is critical to building a stronger
American economy, and today we meet to consider how to help small
business and entrepreneurs access the capital they need through stock
markets. The intent is to help them grow and create new jobs, while
having suitable protections so investors are assured they will not be
taken advantage of if they put their money at risk.
Businesses may attempt to raise more capital if the process of
selling stock is made easier and less costly. At the same time,
investors are more likely to buy stock when they have adequate reliable
information and fair trading markets. Last week in the Committee, in
response to my question, Fed Chairman Bernanke said, ``Startup
companies--companies under 5-years old--create a very substantial part
of jobs added to the economy'' and he encouraged assisting startups.
SEC Chairman Schapiro has said, ``companies seeking access to capital
should not be overburdened by unnecessary or superfluous regulations At
the same time, . . . we must balance that responsibility with our
obligation to protect investors and our markets.''
In previous hearings, witnesses have discussed how public markets
allocate capital and help create jobs, SEC requirements for a company
to go public, why some firms prefer to remain private, how investors
may be solicited to buy stock, how institutional investors decide
whether to buy a company's IPO shares, the importance of liquidity in
the secondary markets, the importance of investor protections, measures
to reduce the cost of selling stock and their potential impact on the
cost of capital and other considerations.
Today, we will hear testimony from experts analyzing the history
and state of the IPO market, the needs of startup and small businesses,
why investors buy IPOs, the role of accounting and other disclosures,
analyst conflicts of interest and other matters.
Members of this Committee on both sides of the aisle including
Senators Schumer, Crapo, Tester, Reed, Vitter, Merkley, Toomey, Bennet
and Johanns have been working hard on bipartisan proposals and I
welcome our witness to provide their insights on these measures and
others on the topic.
I look forward to working with the entire Committee and with Senate
Leadership to quickly move bipartisan legislation forward.
______
PREPARED STATEMENT OF WILLIAM D. WADDILL
Senior Vice President and Chief Financial Officer,
OncoMed Pharmaceuticals, Inc., on behalf of
the Biotechnology Industry Organization
March 6, 2012
Executive Summary
The Biotechnology Industry Organization (BIO) represents
more than 1,100 innovative biotechnology companies, along with
academic institutions, State biotechnology centers, and related
organizations in all 50 States.
It can take over a decade and more than $1 billion to
develop a single biotechnology therapy. Venture capital
fundraising is stagnant and the IPO market is largely closed,
forcing innovative companies to delay research on promising
scientific breakthroughs.
BIO supports S. 1933, the Reopening American Capital
Markets to Emerging Growth Companies Act, which would create an
``on-ramp'' to the public market for ``emerging growth
companies.'' Most newly public biotech companies have no
product revenue, so the 5-year transition period into
compliance with Sarbanes-Oxley (SOX) Section 404(b) and certain
accounting and disclosure requirements would allow growing
biotechs to focus on the search for cures and treatments rather
than costly regulations.
BIO supports S. 1544, the Small Company Capital Formation
Act, which would reform SEC Regulation A by expanding its
eligibility requirements to include companies conducting direct
public offerings of up to $50 million, an increase from the
current threshold of $5 million. This increase would provide a
valuable funding alternative for small biotech startups, giving
them access to the market at an earlier stage in their growth
cycle and allowing them to raise valuable innovation capital.
BIO supports S. 1824, the Private Company Flexibility and
Growth Act, which would increase the limit that requires
private companies to register with the SEC from 500 to 2,000
shareholders, giving growing biotech companies more investor
options to finance their early stage research. The bill would
also exempt employees from the shareholder count, allowing
biotech companies to attract and hire the most qualified
researchers and scientists.
BIO supports S. 1831, the Access to Capital for Job
Creators Act, which would require the SEC to revise Rule 506 of
Regulation D to permit general solicitation in direct public
offerings, broadening the investor base.
* * * * *
Good morning Chairman Johnson, Ranking Member Shelby, Members of
the Committee, ladies, and gentlemen. My name is William Waddill, and I
am the Senior Vice President and Chief Financial Officer of OncoMed
Pharmaceuticals in Redwood City, California. I am also the Co-chairman
of the Finance and Tax Committee at the Biotechnology Industry
Organization (BIO). I want to thank you for the opportunity to speak
with you today about the unique hurdles that innovative biotechnology
companies face as they work toward developing cures and breakthrough
medicines to treat crippling illnesses that affect families across the
Nation.
Biotechnology has incredible potential to unlock the secrets to
curing devastating disease and helping people to live longer,
healthier, and more productive lives. My company, OncoMed
Pharmaceuticals, is working at the cutting edge of oncology research,
focusing on a specific set of cells within tumors that drives the
growth of the tumor and can morph into various cell types within the
tumor. We have developed the ability to isolate and monitor these tumor
initiating cells, and our studies have shown that they are more
resistant to standard chemotherapy agents. Some current treatments may
succeed at initially decreasing the size of a cancer, but leave behind
an increased proportion of these most malignant cells. We have
developed a portfolio of antibodies that target biologic pathways
critical for survival of tumor initiating cells, with the goal being to
stop those cells from replicating. We believe these models are more
representative of the effects of these treatments in cancer patients
than traditional models using cancer cell lines, which may no longer
accurately reflect the properties of the original tumor. Currently we
have three antibodies that target tumor initiating cells in Phase I and
are developing other promising therapeutic candidates.
BIO represents more than 1,100 innovative companies like mine,
along with academic institutions, State biotechnology centers, and
related organizations in all 50 States. Entrepreneurs across the
biotech industry are conducting groundbreaking science like ours, and
are deeply invested in treating the severe illnesses that families
around the Nation and world face. At the same time, biotech leaders
must deal with the day-to-day challenges of running a small business.
Of great import in the biotechnology industry is the constant struggle
to find working capital. It takes 8 to 12 years for a breakthrough
company to bring a new medicine from discovery through Phase I, Phase
II, and Phase III clinical trials and on to FDA approval of a product.
The entire endeavor costs between $800 million and $1.2 billion. For
the majority of biotechnology companies that are without any product
revenue, the significant capital requirements necessitate fundraising
through any source available, particularly venture capital firms.
Later, we must turn to the public markets in the final stages of
research to fund large-scale and expensive clinical trials.
Startup companies depend on venture capital fundraising to finance
the early stages of research and development. In fact, many companies,
including mine, rely on venture financing to fund even middle- and
late-stage clinical trials. However, the current venture landscape has
made this type of funding difficult. In 2011, we saw only 98 first
round venture deals with biotechnology companies, a significant drop
from the industry's peak of 141 in 2007. Last year was only the third
time since 2000 that the number of deals dropped below 100. Small,
startup companies are the innovative heart of our industry, but
depressed financing means that potential cures and treatments are often
left on the laboratory shelf.
Further, venture capitalists expect this downward trend to
continue. A recent survey conducted by the National Venture Capital
Association (NVCA) found that 41 percent of venture capital firms have
decreased their investments in the biopharmaceutical sector in the past
3 years. Additionally, 40 percent of venture capitalists reported that
they expect to further decrease biopharmaceutical investments over the
next 3 years. Therapeutic areas that affect millions of Americans will
be hit by this change in investment strategy, including cardiovascular
disease, diabetes, and cancer.
A significant reason for reluctance in venture investing has been
the inaccessibility of the public markets. Venture capital investors
need to know that they will have an exit through which they can get a
return on their investment; often, they look for this exit when a
company enters the public market. Unfortunately, due to the current
economic climate, it is becoming harder for biotech companies to go
public. As a result, venture capital firms are turning elsewhere to
make their investments, leading to a dearth of innovation capital for
biotechnology.
Despite the desire on the part of companies and private investors
for a clear path to a public offering, public markets remain
essentially closed to growing biotech companies. There was only $1
billion in public financing for biotechnology last year, just a third
of the total from 2007. Though funding totals are slowly climbing back
toward pre-recession levels, this progress has been made almost
entirely by larger, more mature companies. These more established
companies are getting better deals and emerging companies making their
first forays onto the public market are getting squeezed out. The weak
demand for public offerings for smaller companies is restricting access
to capital. This then hampers critical research, forces companies to
stay private for longer, and depresses valuations of later-stage
venture rounds. Although the industry is slowly recovering from its
recession-induced nadir (in 2008 there was only one biotechnology IPO),
this progress is not fast enough for struggling biotechs that need
funding to innovate or patients waiting for breakthrough medicines.
These disturbing investment trends could be ameliorated by allowing
emerging growth companies increased access to the public markets. In a
recent survey conducted by NASDAQ and the NVCA, 86 percent of chief
executive officers cited ``accounting and compliance costs'' and 80
percent cited ``regulatory risks'' as key concerns about going public.
If burdens on public financing were removed, private investors would
have greater certainty that they would have an avenue to exit, leading
to augmented venture capital investment, the lifeblood of the
biotechnology industry. Additionally, companies on the cusp of a public
offering would have the confidence that a successful IPO could fund
their late-stage trials and push therapies to patients who desperately
need them.
Public Market On-Ramp
Senators Schumer and Toomey have introduced S. 1933, the Reopening
American Capital Markets to Emerging Growth Companies Act. This bill
would create a new category of issuers, called ``emerging growth
companies,'' and ease their transition onto the public market. The
legislation would give newly public companies much-needed relief by
allowing them to transition into full regulatory compliance over time
as they grow. This transitional ``on-ramp'' will encourage
biotechnology companies and other small businesses on the cusp of going
public to venture onto the public market.
One of the key components of the on-ramp is the 5-year transition
period before emerging growth companies are subject to full Sarbanes-
Oxley (SOX) Section 404(b) compliance. While we can all agree that
investors benefit from greater transparency, the unintended consequence
of the regulations found in Section 404(b) is the diversion of precious
invested capital away from innovative product development and job
growth to onerous, costly compliance with little to no benefit to
investors or the general public. The opportunity cost of this
compliance can prove damaging, resulting in delays to developing cures
and treatments during a necessary and often prolonged search for
investment capital.
SEC studies have shown that SOX compliance can cost companies more
than $2 million per year. The biotechnology sector is especially
disadvantaged by this burden due to the unique nature of our industry.
Newly public biotech companies have little to no product revenue, so
they are essentially asking investors to pay for SOX reporting rather
than research and development. The compliance costs are fixed and
ongoing, and have a severe impact on the long-term investing of
microcap and small cap companies at the forefront of developing new
treatments for severe diseases. Companies are the most vulnerable
during their first few years on the public market, yet they are forced
to shift funds from core research functions to compliance costs. This
can lead to research programs being shelved or slowed as compliance
takes precedence.
Further, the true value of biotech companies is found in scientific
milestones and clinical trial advancement toward FDA approvals rather
than financial disclosures of losses incurred during protracted
development terms. Investors often make decisions based on these
development milestones rather than the financial statements mandated by
Section 404(b). Thus, the financial statements required do not provide
much insight for potential investors, meaning that the high costs of
compliance far outweigh its benefits.
In 2010, Congress made the important acknowledgement that SOX
Section 404(b) is not an appropriate requirement for many small
reporting companies. The Dodd-Frank Wall Street Reform and Consumer
Protection Act sets a permanent exemption from Section 404(b) for
companies with a public float below $75 million. Additionally, the SEC
Small Business Advisory Board in 2006 recommended that the permanent
exemption be extended to companies with public floats of less than $700
million.
Similarly, the Reopening American Capital Markets to Emerging
Growth Companies Act would allow emerging growth companies time to find
their footing on the public market without diverting precious funds to
onerous SOX reporting. I support giving these companies 5 years to
transition onto the public market, providing them with time to create
jobs and continue research before entering full regulatory compliance.
Additionally, an on-ramp transition period would allow emerging
growth companies to provide only 2 years of previous audited financial
statements prior to going public rather than the 3 years currently
required. Similar to the transition into SOX compliance, this change
would save emerging biotech companies valuable innovation capital that
could be used for important research and development. I fully
appreciate and agree that strong auditing standards can enhance
investor protection and confidence and I support this goal. However,
overly burdensome auditing standards impose a significant cost burden
on emerging growth companies without providing much pertinent
information to their investors. By allowing for limits on the look-back
requirements for audited financial statements, a public market on-ramp
would balance the goals of cost-efficient auditing standards and
investor protection. Two years of audited financials is sufficient for
investors to gather information about companies going public. Further,
most biotech investors look to scientific and development information
when making investment decisions, so the extra year of audited
financials imposes costs without providing benefit. Requiring just 2
years of audited financial statements would continue to protect
investors but would allow emerging growth companies to expend more of
their capital on the search for breakthrough medicines.
An on-ramp approach would also exempt emerging growth companies
from certain rules issued by the Public Company Accounting Oversight
Board (PCAOB), particularly a proposal being considered regarding
mandatory audit firm rotation.
Audit fees would most certainly increase with the implementation of
audit firm rotation. There would be a steep learning curve for any new
audit firm, and the additional resources necessary to educate the audit
firm about business and operations would raise audit fees. Companies
might even need to hire more compliance personnel to avoid disruption
of day-to-day operations, further increasing the cost burden. Audit
firms have also suggested that audit firm rotation could increase the
challenges and costs to maintain high-quality personnel. The cost
associated with these scenarios would be transferred to the company
while making relationships between the audit firm and the company more
difficult to establish. Each new cost burden would require funds to be
diverted from research and development to the transition between audit
firms, slowing the progress of cures and treatments for which patients
are waiting.
I support the ongoing efforts to incentivize emerging growth
companies to go public and make their transition smoother while
continuing to protect investors. Easier access to the public market
will improve the health and stability of the biotechnology industry,
both for companies considering an IPO and for those which are still
seeking private investment.
Financial Services Capital Formation Proposals
While easing entry onto the public market is a key component of
capital formation for growing companies, there are several proposals
being considered that would benefit companies that are not yet suited
to enter the public markets but face their own unique burdens as they
grow. These proposals would strengthen the fundraising potential for
small, innovative biotech companies developing solutions to the health
problems that our Nation faces.
SEC Regulation A (Direct Public Offerings)
Regulation A, adopted by the SEC pursuant to Section 3(b) of the
Securities Act of 1933, was created to provide smaller companies with a
mechanism for capital formation with streamlined offering and
disclosure requirements. Updating it to match today's market conditions
could provide an important funding source for small private
biotechnology companies.
Regulation A allows companies to conduct a direct public offering
valued at less than $5 million while not burdening them with the
disclosure requirements traditionally associated with public offerings.
The intent of Regulation A was to give companies which would benefit
from a $5 million influx (i.e., small companies in need of capital
formation) an opportunity to access the public markets without weighing
them down through onerous reporting requirements.
However, the $5 million offering amount has not been adjusted to
fit the realities of the costs of development and Regulation A is not
used by small companies today. The current threshold was set in 1992
and is not indexed to inflation, pushing Regulation A into virtual
obsolescence. As it stands, a direct public offering of just $5 million
does not allow for a large enough capital influx for companies to
justify the time and expense necessary to satisfy even the relaxed
offering and disclosure requirements.
Senators Tester and Toomey have introduced a Regulation A reform
bill, the Small Company Capital Formation Act (S. 1544), which I
believe would have a positive impact for small biotechnology companies.
The legislation increases the Regulation A eligibility threshold from
$5 million to $50 million while maintaining the same disclosure
requirements. This increase would allow companies to raise more capital
from their direct public offering while still restricting the relaxed
disclosure requirements to small, emerging companies. The Small Company
Capital Formation Act could provide a valuable funding alternative for
small biotech startups, giving them access to the public markets at an
earlier stage in their growth cycle and allowing them to raise valuable
innovation capital. I support this legislation.
SEC Reporting Standard (Shareholder Limit)
Although the SEC generally monitors public companies, the agency
also keeps tabs on private companies when they reach a certain size.
Modifying the SEC's public reporting standard would prevent small
private biotechnology companies from being unnecessarily burdened by
shareholder regulations.
Once a private company has 500 shareholders, it must begin to
disclose its financial statements publicly. Biotechnology companies are
particularly affected by this 500 shareholder rule due to our
industry's growth cycle trends and compensation practices. As I have
mentioned, the IPO market is essentially closed to biotechnology,
leading many companies to choose to remain private for at least 10
years before going onto the public market. This long timeframe can
easily result in a company having more than 500 current and former
employees, most of whom have received stock options as part of their
compensation package. Under the SEC's shareholder limit, a company with
over 500 former employees holding stock, even if it had relatively few
current employees, would trigger the public reporting requirements.
Exempting employees from any shareholder limit is a minimum necessary
measure to ensure growing biotech companies are able to hire the best
available employees and compensate them with equity interests, allowing
them to realize the financial upside of a company's success.
Senators Carper and Toomey have introduced legislation, the Private
Company Flexibility and Growth Act (S. 1824), which would address these
barriers to private company growth. Their bill would increase the
shareholder limit from 500 to 2000, relieving small biotech companies
from unnecessary costs and burdens as they continue to grow. As it
stands, the 500-person limit encumbers capital formation by forcing
companies to focus their investor base on large institutional investors
at the expense of smaller ones that have been the backbone of our
industry. The legislation would also exempt employees from the
shareholder count, allowing growing biotech companies to attract and
hire the most qualified researchers and scientists. I support the
Private Company Flexibility and Growth Act, as it would remove
significant financing burdens from small, growing companies.
SEC Regulation D (Ban on General Solicitation)
Another potential avenue for capital formation in the biotech
industry is SEC Regulation D. Under Rule 506 of Regulation D, companies
can conduct offerings to accredited investors without complying with
stringent SEC registration standards. This exemption allows companies
to access sophisticated investors (who do not need as much SEC
protection) without burdensome disclosure requirements. However, the
upside of this fundraising avenue is hindered by the ban on general
solicitation in Rule 506. Companies are limited in their investor base
by this rule, meaning that a vast pool of investors remains untapped.
If the ban on general solicitation were lifted, growing biotech
companies would be able to access funds from the entire range of
wealthy SEC accredited investors without undergoing the full SEC
registration process.
I support Senator Thune's Access to Capital for Job Creators Act
(S. 1831), which would require the SEC to revise Rule 506 and permit
general solicitation in offerings under Regulation D. If enacted, this
legislation would enhance fundraising options for growing biotech
companies searching for innovative cures and treatments.
Closing Remarks
The U.S. biotechnology industry remains committed to developing a
healthier American economy, creating high-quality jobs in every State,
and improving the lives of all Americans. Additionally, the medical
breakthroughs happening in labs across the country could unlock the
secrets to curing the devastating diseases that affect all of our
families. There are many pitfalls and obstacles endemic to this effort,
including scientific uncertainty and the high costs of conducting
research. However, the regulatory burdens I have discussed continue to
stand in our way without providing any real benefit to the investors
the laws purports to protect. By making targeted changes that support
emerging growth companies in the biotechnology industry and elsewhere,
Congress can unburden these innovators and job creators while
maintaining important investor protections. Congress has the
opportunity inspire biotechnology breakthroughs and allow innovators
and entrepreneurs to continue working toward delivering the next
generation of medical breakthroughs--and, one day, cures--to patients
who need them.
______
PREPARED STATEMENT OF JAY R. RITTER
Cordell Professor of Finance
Warrington College of Business Administration, University of Florida
March 6, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, I want to thank you for inviting me to testify. My name is
Jay R. Ritter, and I am the Cordell Professor of Finance at the
University of Florida's Warrington College of Business Administration.
I have been studying the initial public offering (IPO) market for over
three decades, and I have published dozens of peer-reviewed articles on
the topic. I have consulted with private companies, Government
organizations, and law firms on IPO-related matters.
I will first give some general remarks on the reasons for the low
level of U.S. IPO volume this decade and the implications for job
creation and economic growth, and then make some suggestions on the
specific bills that the Senate is considering.
First, there is no doubt that fewer American companies have been
going public since the tech stock bubble burst in 2000, and the drop is
particularly pronounced for small companies. During 1980-2000, an
average of 165 companies with less than $50 million in inflation-
adjusted annual sales went public each year, but in 2001-2011, the
average has fallen by more than 80 percent, to only 29 small firm IPOs
per year. The patterns are illustrated in Figure 1.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Although there is no disagreement about the existence of this
prolonged drought in small company IPOs, there is disagreement about a)
the causes of the decline in IPOs, b) the implications for the economy,
and c) what should be done, if anything, to rejuvenate the IPO market
and spur capital formation. My opinions about the causes of the decline
are at odds with the conventional wisdom. My opinions about the
implications for the economy are not too different from those of some,
such as Prof. John Coates of Harvard Law School, who testified before
this Committee on December 14, 2011. These opinions are different,
however, from those of the IPO Task Force, whose chair, Kate Mitchell,
also testified on December 14, and those of the Wall Street Journal's
editorial writers. My opinions about what should be done are similar to
those of several witnesses, but in disagreement with those of several
others who have a much different opinion about the causes and
implications than I do.
The Causes of the Decline in IPO Volume
The conventional wisdom is that a combination of factors, including
a drop in public market valuations of tech companies, heavy-handed
regulation such as Sarbanes-Oxley (SOX), and a drop in analyst coverage
of small companies, have discouraged companies, especially small
companies, from going public in the United States in the past decade. I
agree with the conventional wisdom that these factors have discouraged
small companies from going public, but I believe that only a small part
of the drop in small company IPO volume can be explained by these
factors. Instead, I think that the more fundamental problem is the
declining profitability of small firms. In many industries, over time
it has become more important for a firm to be big if it is to be
profitable. Emerging growth companies (EGCs) are responding to this
change in the merits of being a small, stand-alone firm by merging in
order to grow big fast, rather than remaining as an independent firm
and depending on organic (internal) growth.
Numerous facts support the idea that small companies are not going
public because being small is not best, whether private or public.
These facts are documented in ``Where Have All the IPOs Gone?'',
coauthored with Xiaohui Gao and Zhongyan Zhu.\1\ My co-authors and I
document that U.S. public market investors have earned low returns in
the 3 years after the IPO on the IPOs of small companies, defined as
firms with less than $50 million in pre-IPO annual sales (2009
purchasing power), in every decade for at least 30 years. Furthermore,
we show that for both recent IPOs and for public companies that have
been traded for at least 3 years, the fraction of small companies with
positive earnings has been on a long-term downtrend, starting far
before the tech stock bubble burst in 2000. Other studies have
documented that a larger and larger fraction of aggregate corporate
earnings are being earned by the largest firms, and that the fraction
of public firms that earn positive profits in a year has been on a
long-term decline.\2\
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\1\ See ``Where Have All the IPOs Gone?'' Xiaohui Gao, Jay R.
Ritter, and Zhongyan Zhu, March 2012, unpublished University of Florida
working paper. Many additional tables can be found on the ``IPO Data''
page of my Web site (just Google ``Jay Ritter'').
\2\ See DeAngelo, Harry, Linda DeAngelo, and Douglas Skinner, 2004,
``Are Dividends Disappearing? Dividend Concentration and the
Consolidation of Earnings,'' Journal of Financial Economics, 72, 425-
456; and Fama, Eugene F., and Kenneth French R., 2004, ``New Lists:
Fundamentals and Survival Rates,'' Journal of Financial Economics, 73,
229-269.
---------------------------------------------------------------------------
In the last decade, a larger fraction of venture capital-backed
firms have sold out in trade sales rather than go public, as documented
by Kate Mitchell in her December 14, 2011 testimony to this Committee.
The IPO Task Force interprets this evidence as suggesting that the IPO
market is broken. My coauthors and I show that, of the small companies
that do go public, there has been an increase over time in the fraction
that is subsequently acquired, and as well as the fraction that
subsequently make acquisitions. This ``eat or be eaten'' evidence is
consistent with the notion that getting big fast has become more
important over time, and does not imply that the IPO market is broken.
My co-authors and I also show that in the last decade there has
been no deterioration in analyst coverage for companies that do go
public, inconsistent with the assertion that a lack of analyst coverage
is deterring IPOs.
My co-authors and I address whether the low profitability of small
publicly traded firms in the last decade can be attributed to the costs
of compliance with SOX's Section 404. To ascertain whether this is
important or not, we add back to earnings an estimate, provided by the
U.S. SEC, of the SOX costs incurred by small firms. We report that the
downtrend in profitability would be present even if these costs did not
exist. Furthermore, as Prof. John Coates mentioned in his December 14th
testimony, there has been no resurgence of small company IPOs after the
SEC altered the regulations to lessen these costs.
If the U.S. IPO market is broken for small companies, but being a
small independent firm is still attractive, we might expect to see many
small U.S. firms going public abroad. In fact, as documented by several
studies, only a few U.S. firms per year have gone public abroad in
recent years.\3\ In ``Europe's Second Markets for Small Companies,'' my
co-authors and I document that European public market investors have
earned low returns on European IPOs from 1995-2009 that listed on
Europe's markets that cater to emerging growth companies.\4\
Furthermore, we document that 95 percent of the listings on London's
Alternative Investment Market (AIM) have been ``placings,'' restricted
to qualified institutional buyers (QIBs). Most of these IPOs have been
for very small amounts, and no liquid market ever developed. The
reality is that very few of the AIM IPOs would have qualified for
Nasdaq listing.
---------------------------------------------------------------------------
\3\Doidge, Craig, G. Andrew Karolyi, and Rene M. Stulz, 2009, ``Has
New York Become Less Competitive than London in Global Markets?
Evaluating Foreign Listing Choices over Time,'' Journal of Financial
Economics 91, 253-277.
\4\See ``Europe's Second Markets for Small Companies,'' by Silvio
Vismara, Stefano Paleari, and Jay R. Ritter, European Financial
Management, forthcoming.
---------------------------------------------------------------------------
In addition, if being small but public was unattractive relative to
being small but private, we might see many U.S. publicly traded small
companies going private. Instead, the vast majority of small companies
that have voluntarily delisted have done so by selling out to a larger
company, rather than by staying independent and going private.\5\
---------------------------------------------------------------------------
\5\See Table 8 of Gao, Ritter, and Zhu (2012).
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To summarize, there is a large body of facts supporting the view
that the drop in small company IPO activity is due to the lack of
profitability of small stand-alone businesses relative to their value
as part of a larger organization. In my opinion, this is the major
reason why venture capital-backed firms are selling out (merging)
rather than going public. This is a large firm vs small firm choice,
not a private firm vs. public firm choice. Although the IPO market may
need reforms, private firms are not avoiding IPOs because the IPO
market is broken, but because being part of a larger organization
creates more value.
Implications for the Economy of the Decline in IPO Volume
In ``Post-IPO Employment and Revenue Growth for U.S. IPOs, June
1996-December 2010,'' my co-authors and I document the employment and
revenue growth for U.S. companies that went public from June 1996-
December 2010.\6\ For the 2,766 domestic operating company IPOs from
this period, we find that the average company added 822 employees since
their IPO. In the 10 years after going public, the average company
increased employment by 60 percent, amounting to a 4.8 percent compound
annual growth rate (CAGR).\7\
---------------------------------------------------------------------------
\6\ Martin Kenney, Donald Patton, and Jay R. Ritter, work in
progress for the Kauffman Foundation on ``Post-IPO Employment and
Revenue Growth for U.S. IPOs, June 1996-December 2010.''
\7\ The 60 percent cumulative average growth in employment and 4.8
percent CAGR numbers are based on the 1,857 IPOs from June 1996-
December 2000.
---------------------------------------------------------------------------
One can use these numbers to calculate the number of jobs that
would have been created if the average annual volume of domestic
operating company IPOs from 1980-2000 had continued during 2001-2011,
rather than collapsing. In 1980-2000, an average of 298 domestic
operating companies per year went public, whereas an average of only 90
domestic operating companies per year have gone public since then, a
difference of 208 IPOs per year. Over the eleven year period 2001-2011,
this amounts to a shortfall of 2,288 IPOs, with 822 jobs per IPO lost.
Multiplying these two numbers together results in a figure of 1.88
million jobs that were not ``created'' due to the IPO shortfall. This
calculation assumes that these employees would have been sitting at
home watching TV if they weren't hired by the recent IPO firm, and that
the roughly $100 million raised per IPO would not have been invested in
anything else. But, in a mechanical sense, 1.88 million jobs have been
``lost.''
This 1.88 million figure is dramatically lower than the 10 million
jobs figure that Delaware Governor Jack Markell used in his March 1,
2011 WSJ opinion piece ``Restarting the U.S. Capital Machine,'' or the
22.7 million figure used in the IPO Task Force report presented to the
U.S. Treasury and this Committee in late 2011 by task force chairwomen
Kate Mitchell. The 22.7 million number comes from a 2009 Grant Thornton
white paper, ``A Wake-up Call for America,'' written by David Weild and
Edward Kim. Weild and Kim make four different assumptions than my
coauthors and I do in order to generate their 22.7 million jobs lost
figure.
First, Weild and Kim make the reasonable assumption that IPO volume
should be proportional to real GDP, and since the U.S. economy has
grown over the last 30 years, one would expect IPO activity to rise
rather than be flat. Thus, our number, which assumes that IPO activity
would be constant over time, is biased downwards.
Second, on page 26 Weild and Kim make the assumption that the
normal level of IPO activity is that of 1996, the peak of the IPO
market, and that the volume should grow from this level. This
assumption, that the 1996 number of 803 IPOs is normal, biases their
number upwards. Third, they assume that each IPO that didn't occur
would have had 1,372 employees before going public, and post-IPO
employment grows at a CAGR of 17.8 percent, a number that implies
employment growing by 415 percent in the 10 years after an IPO. The
17.8 percent per year number is justified based on a ``select'' group
of prior IPOs. In other words, they assume that thousands of companies
that didn't go public would have grown as fast as companies such as
Google if they had! This assumption, which I would tend to categorize
as completely ridiculous, has a huge impact on their calculations.
Fourth, they assume that there was an IPO shortfall starting in 1997,
rather than 2001, and that more than 1,500 additional firms would have
gone public in 1997-2000 and then grown their employment by 17.8
percent per year for more than a decade. This 1997-2000 shortfall
assumption, combined with the 17.8 percent CAGR assumption, adds at
least 9 million lost jobs to their 22.7 million total.
What Should Be Done
If the reason that many small companies are not going public is
because they will be more profitable as part of a larger organization,
then policies designed to encourage companies to remain small and
independent have the potential to harm the economy, rather than boost
it. Not all EGCs should stay private or merge, however, and to the
degree that excessive burdens associated with going public, and being
public, result in less capital being raised and wisely invested,
standards of living are lowered. I do not think that the bills being
considered will result in a flood of companies going public. I do not
think that these bills will result in noticeably higher economic growth
and job creation.
In thinking about the bills, one should keep in mind that the law
of unintended consequences will never be repealed. It is possible that,
by making it easier to raise money privately, creating some liquidity
without being public, restricting the information that stockholders
have access to, restricting the ability of public market shareholders
to constrain managers after investors contribute capital, and driving
out independent research, the net effects of these bills might be to
reduce capital formation and/or the number of small EGC IPOs.
I think that Prof. John Coates zeroed in on the tradeoffs in his
December 14, 2011 testimony. He stated ``While the various proposals
being considered have been characterized as promoting jobs and economic
growth by reducing regulatory burdens and costs, it is better to
understand them as changing, in similar ways, the balance that existing
securities laws and regulations have struck between the transaction
costs of raising capital, on the one hand, and the combined costs of
fraud risk . . . ``As he notes, fewer investor protections can
potentially result in more fraud, with rational investors responding by
demanding higher promised returns from all companies, resulting in good
companies receiving a lower price for the securities that they sell.
Good investor protection laws, and their timely and effective
enforcement, can lower the cost of capital for good companies, but
investor protection does impose compliance costs on all companies.
I will now comment on some of the specific bills under
consideration by the Senate:
S. 1791 ``Democratizing Access to Capital Act of 2011'' and S. 1970
``Capital Raising Online While Deterring Fraud and Unethical
Non-Disclosure Act of 2011''
These bills deal with Regulation D and its requirements on
solicitations, and crowdfunding. In general, they reduce constraints on
the ability of parties seeking capital to reach out to unsophisticated
investors, potentially increasing the amount of fraud. Fraudsters are
happy to relieve unsophisticated investors of their cash.
An increase in fraud if these bills are passed is not, however, an
automatic result. When eBay and Craigslist were created, a concern was
raised about whether fraud by sellers, and bounced checks from buyers,
would be so prevalent that an electronic exchange that matched buyers
and sellers of nonfinancial goods and services would fail. In practice,
both organizations have been successful at matching buyers and sellers,
even if there are some unsatisfactory outcomes.
In financial markets, as with eBay and Craigslist, it is possible
that organizations will evolve that provide sufficient voluntary
policing and certification to minimize the amount of fraud and create
value by bringing buyers and sellers (investors and entrepreneurs)
together.
I am not certain what problem crowdfunding is solving. Many
startups are able to get funding from angel investors, and, once a
certain threshold of size has been reached, venture capital (VC) firms
have billions to invest. If VC firms were demanding excessively onerous
terms, one might expect to see extremely high returns for the limited
partners (LPs) of VC funds. Over the last decade, however, the bigger
problem has been low returns. The market is not failing when firms with
poor investment prospects are unable to get funding. The market is
working when firms with good prospects are able to get funded at
reasonable cost and grow, and firms with poor prospects are deprived of
capital that would be wasted.
S. 1970 appears to offer some protections to investors that are not
present in S. 1791. I am modestly supportive of S. 1970, but not
enthusiastic about S. 1791.
S. 1824 ``The Private Company Flexibility and Growth Act''
This bill increases the 12(g)(1) of the 1934 Act threshold at which
public reporting of financial statements is required from 500 to 2,000
shareholders of record, and Section 3 removes current and past
employees from the count. The number of beneficial shareholders, of
course, may be far in excess of the number of shareholders of record
since individuals normally hold shares in street name.
On December 1, 2011, Prof. John Coffee of Columbia Law School
testified that the shareholders of record requirement should be
supplemented with a public float requirement: if either the 2,000
shareholders of record threshold is passed, or if the public float is
above $500 million, public reporting should be required.
My suggestion would be to keep the 500 shareholders of record
threshold, but exclude current and former employees from the count, and
to add a public float requirement. Alternatively, the ``shareholders of
record'' requirement should be changed to reflect the fact that for
publicly traded firms, individuals keep their shares in street name.
S. 1933 ``Reopening American Capital Markets to Emerging Growth
Companies Act of 2011''
This bill establishes a new category of issuers, called emerging
growth companies (EGCs) that have less than $1 billion in annual
revenue at the time of SEC registration, and exempts them from certain
disclosure requirements, such as executive compensation. The exemptions
would end either 5 years after the IPO or when the annual revenue
exceeds $1 billion.
From 1980-2011, 7,612 operating companies went public in the United
States, excluding banks and S&Ls and IPOs involving units, an offer
price below $5.00, or partnerships. Ninety-four (94) percent of these
companies had annual sales of below $1 billion when they went public,
including Carnival Cruise Lines and AMF Bowling.
Section 3 deals with disclosure obligations. I cannot think of any
reason for why public market investors should not need to know how much
executives are paying themselves, nor have a say on this cost through
shareholder voting.
Section 6 deals with coverage from sell-side research analysts. As
I interpret it, this legislation would abolish quiet period
restrictions on the ability of sell-side analysts that work for an
underwriter to provide research to institutional investors for EGCs,
which historically have comprised 94 percent of all IPOs. Because the
sell-side analysts are potentially privy to inside information, they
will be at an informational advantage relative to other analysts. This
proposed legislation is completely at odds with the logic of Reg FD,
which seeks to create a level playing field. The proposal may have the
effect of crowding out unbiased independent research.
As I mentioned earlier in this testimony, my research shows that
there has been no lack of analyst coverage of companies conducting IPOs
in the last decade.\8\ If the purpose of Section 6 is to create
incentives for analyst coverage because none exists, this legislation
is based on a faulty premise.
---------------------------------------------------------------------------
\8\ Table 6 of Gao, Ritter, and Zhu (2012) shows that essentially
all IPOs with a midpoint of the file price range of above $8 receive
coverage. This $8 cutoff is a good proxy for IPOs that are large enough
to attract institutional investors.
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______
PREPARED STATEMENT OF KATHLEEN SHELTON SMITH
Co-Founder and Chairman, Renaissance Capital, LLC
March 6, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee:
I want to thank you for inviting me to testify today. Capital
formation, when accomplished through a transparent IPO market open to
all investors, plays an important role in allocating capital to our
best entrepreneurial companies, spurring significant and sustainable
job growth. We are all concerned about economic growth and job
creation, so it is no surprise that our eyes would turn to the IPO
market--America's most admired system for funding entrepreneurs.
The issue we address today is access to capital by entrepreneurial
companies. When America's job-creating smaller companies are unable to
access the IPO market, we need to understand why and what we can do
about it. Measures to ease costly regulatory burdens that weigh most
heavily on small firms may be helpful. At the same time, care must be
taken in waiving certain disclosure and stock promotion rules that
could result in misallocating capital to weak or fraudulent companies.
Weak companies that ultimately fail cause job losses, not job creation,
and result in serious stock market losses to investors who abandon the
IPO market, as was the case after the Internet bubble burst.
Renaissance Capital's IPO Expertise
We share the concerns of lawmakers about the IPO market and are
honored to be asked for our thoughts on this important policymaking
process. For over 20 years, Renaissance Capital has had a singular
focus on the IPO market. We are involved in IPOs in three ways:
1. We are an independent research firm. We provide institutional
investors with research on IPOs. We analyze every IPO in the
United States and we cover the international IPO market.
2. We are an indexing firm. We create and license IPO indexes that
measure the investment returns of newly public companies. These
indices are used by IPO investors as a benchmark of
performance.
3. We are an IPO investor. We invest in newly public companies
through a mutual fund and separately managed institutional
accounts.
Regulators around the world often reach out to us about our views
on IPO issuance, valuation and research. These regulators are studying
the best practices of the U.S. IPO market. They know that a well-
functioning IPO market can be the most efficient way for them to
allocate capital to their growing enterprises. A well-functioning IPO
market is based upon full and honest disclosure of company information
made available evenly to all public investors.
I will start by examining the condition of our IPO market,
including where we stand in global IPO market share, what is working
and what is not, and the importance of investor returns in the
equation. I will then make suggestions on the specific bills under
consideration.
The U.S. IPO Market is Doing Well Relative to IPO Markets Around the
World
While there is legitimate concern that recent issuance in the U.S.
IPO market has been below long-term trends, the U.S. market is not
alone. IPO markets globally have been hurt by the 2008 U.S. financial
crisis and the 2011 European Sovereign debt crisis. However, in the
context of weak global IPO markets, the United States has actually
gained market share, accounting for 32 percent of global IPO proceeds
in 2008 and again in 2011. In 2011, when international IPO issuance
fell 50 percent, U.S. IPO issuance fell only 6 percent. This tells us
that when put to the test of a financial crisis, investors trust the
disclosure, transparency and depth of the U.S. IPO market more than any
other IPO market in the world. So, despite the low IPO issuance levels,
much of the U.S. IPO market is functioning as well as can be expected
under challenging conditions.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Larger Issuers Continue to Access the IPO Market
The IPO Task Force provided helpful data about IPO issuance since
1991. This data shows that while smaller IPOs have effectively
disappeared, larger companies raising over $50 million in IPO proceeds
continue to access the IPO market. From 2000 to date, investors have
experienced the weakest period of stock market returns in decades. As
the chart shows, during this period, the larger issuers have dominated
the IPO market. In weak markets, investors gravitate to the perceived
safety of larger, more liquid IPOs.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Furthermore, despite our current regulatory regime, we find little
evidence that these larger issuers have been deterred from tapping the
IPO market. Today, we count over 200 companies in the U.S. IPO pipeline
seeking to raise over $52 billion in aggregate proceeds who have
undergone financial audits, implemented Sarbanes-Oxley policies and
filed full disclosure documents with the SEC. This is the largest
backlog of companies lined up to go public that we have seen in over a
decade. Over 92 percent of these companies are larger issuers seeking
to raise over $50 million in IPO proceeds.
The U.S. IPO Market is Closed to Small Issuers
On the other hand, as the IPO Task Force concluded, smaller IPOs of
$50 million proceeds or less have become a reduced presence in the IPO
market. Prior to 1999, smaller IPOs represented 50 percent or more of
the IPO market, currently they represent less than 15 percent. Helping
these smaller job-creating companies lower the cost of accessing the
IPO market, while protecting investors, may help somewhat in boosting
the presence of smaller IPOs in the market.
However, opening the path for easier issuance by smaller companies
only works if investors are interested in buying these IPOs. Thus, it
is even more critical to address the investor side of the equation. At
present, the trading market for IPOs is highly volatile with average
IPO trading turnover on the first day often equal to the number of
shares offered. This suggests that IPO shares are being placed with
short-term trading clients of the IPO Underwriters. IPO shares placed
with a broader base of fundamentally oriented investors would go a long
way to help open the IPO market to smaller issuers. We urge
policymakers to study ways to encourage IPO Underwriters to allocate
IPOs to a broader base of long-term investors.
Ultimately the IPO Market Opens Up When IPO Investors Earn Positive
Returns
While policy to ease the way for more small issuers to accomplish
an IPO may be helpful, the most powerful fix for the IPO market would
be to improve returns for IPO investors. Unfortunately, there is little
policymakers can do on this front, short of creating a Government fund
that purchases shares in every small IPO--which we would not recommend.
Returns to IPO investors matter because good returns for IPO investors
drive future IPO activity. IPO issuance grows when returns are
positive. The IPO market closes when returns are negative.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
After a long run through the 1990s of positive equity returns for
all investors, the bursting of the Internet bubble devastated IPO
investors, causing losses of -49 percent and -61 percent in 1999 and
2000, respectively, far worse than the rest of the equity market. No
wonder in the years following that disaster, investors were cautious
about smaller IPOs, shutting off IPO issuance for these important job-
creating small companies. Over 70 percent of the IPOs during that
period were unprofitable companies whose offerings were promoted by the
IPO Underwriters' research analysts. We caution lawmakers to avoid new
policies that would pave the way for IPO Underwriters to engage in
these types of promotional activities again.
We are encouraged that following the poor returns of 2008 and 2011,
returns for IPO investors have turned strongly positive so far in 2012.
These positive returns will startup the IPO issuance engine again. We
believe that an extended period of positive returns for IPO investors
is the most powerful solution to increasing IPO market activity leading
to a greater presence of smaller sub-$50 million issuers. In the
meantime, policies that assist these smaller IPOs to lower the cost of
accessing the IPO market and improve IPO allocation to attract a
broader base of long-term investors could provide some helpful relief.
* * * * *
Renaissance Capital's Recommended Improvements to the Proposed
Legislation
1. Focus on the companies seeking to raise under $50 million that
are currently shut out of the IPO market by properly defining
Emerging Growth Company as smaller issuers seeking to raise up
to $50 million.
2. Strike the proposed informational rules in S. 1933 Section 6 that
permit IPO Underwriters and issuing companies to promote
offerings and provide special information to selected clients
during the IPO process to avoid re-creating the Internet
bubble.
3. Encourage larger private companies (e.g., Facebook) to file
public disclosure (i.e., go public) when active trading markets
develop in its shares, by adding a public float requirement to
the proposed private company legislation.
Recommendation #1: Refine the definition of ``Emerging Growth Company''
to focus on the small companies seeking to raise up to $50
million, replacing the proposed $1 billion revenue rule
The S. 1933 legislation defines Emerging Growth Company as a firm
with $1 billion in revenue. By this definition, we would be giving
relief to over 90 percent of the companies going public, effectively
the entire IPO market, and would include companies with very large
market capitalizations. The real Emerging Growth Companies that need to
be targeted are smaller issuers seeking to raise under $50 million in
capital. Based upon our analysis, an Emerging Growth Company should be
redefined as one seeking to raise up to $50 million with an implied
market capitalization under $200 million. This would target the part of
the market that needs attention.
Recommendation #2: Strike the proposed rules that permit IPO
Underwriters and issuing companies to promote offerings and
provide special information to select clients during the IPO
process
We agree that more research on companies would be favorable for
stock trading, but Section 6 in the S. 1933 legislation, as written,
would allow IPO Underwriters to engage in promotional activities. After
the Internet bubble burst, investors suffered devastating losses of -49
percent and -61 percent in 1999 and 2000, respectively, from purchasing
overvalued IPOs pumped up by underwriter research. Over 70 percent of
the IPOs during that period were unprofitable companies, many of which
went out of business. As we know from bitter experience, research by
broker dealers and their affiliates that underwrite the IPO is
inherently biased, used as a marketing tool to sell shares in the IPO
and, without some restrictions, provides an informational advantage to
the IPO Underwriters' research analysts and proprietary clients,
contrary to Regulation FD.
Recommendation #3: Improve legislation expanding the size and dollar
thresholds of the private placement market by adding another
threshold that would encourage private companies, whose shares
are actively trading, to go public
The various bills seeking to expand the size of the unregistered
(``no-doc'') private market from $5 million to $50 million and the
number of accredited investors from 500 to 1,000, may help to open up
more capital raising opportunities for smaller issuers. However, these
changes may have the unintended consequence of creating a shadow IPO
market of larger private companies. These private IPO-ready companies
would reap the benefit of being public without taking on disclosure
responsibilities. For example, even under the existing 500-shareholder
limit, active private transactions in Facebook shares have occurred
prior to its IPO filing at large cap valuations of $100 billion, the
size of McDonald's. We recommend adding a provision to these new rules
that encourage private companies (e.g., Facebook), who meet certain
thresholds of transactional activity, to go public, providing full
disclosure to all investors. We support the market capitalization limit
proposed by Columbia University Professor John Coffee of $500 million
or less. This would help the IPO market.
Summary
A well-functioning IPO market is based upon the principal of full
and honest disclosure of company information made available evenly to
all public investors. The U.S. IPO market is functioning amazingly well
under the stressful conditions of a global financial crisis. While
there may be initiatives that can help improve the functioning of the
IPO market, especially as it pertains to the most vulnerable smaller
companies, the IPO market will heal itself starting with the larger,
more established private companies. Waiving certain disclosure and
stock promotion rules that could result in misallocating capital to
weak or fraudulent companies will only endanger the recovery of the IPO
market. It is the positive returns that investors earn from these
larger issuers that will lead to more issuance for smaller IPOs.
______
PREPARED STATEMENT OF TIMOTHY ROWE
Founder and CEO, Cambridge Innovation Center
March 6, 2012
Thank you for inviting me to speak today. As you know, I am the CEO
and Founder of Cambridge Innovation Center (CIC). CIC houses
approximately 450 startup companies in a large office tower in Kendall
Square, Cambridge, Massachusetts. We are told that CIC has more
startups under one roof than any other building anywhere. More than
$1.5B dollars have been invested in these companies. We have been a
launch-pad for several well-known companies, including Google Android
and Great Point Energy.
I also serve as the President of the Kendall Square Association.
Kendall Square is home to the Massachusetts Institute of Technology
(MIT) and more tech and biotech companies per square mile than anywhere
else in the world, and includes such global leaders such as Amgen,
Biogen, the Broad Institute, Google, MIT, Microsoft, Novartis, Genzyme,
VMWare, and the Whitehead Institute. Our goal is to ensure that Kendall
Square remains a place where the world gathers to develop breakthrough
discoveries that positively impact our society.
In other responsibilities, I serve on the investment committee for
New Atlantic Ventures, a $120M early stage venture capital firm.
Together with my partners, we have helped make dozens of investments in
small companies.
This past December, Massachusetts was asked to send a delegation to
the Startup America Summit at the White House to share what we believe
to be the national priorities for helping grow jobs through
entrepreneurship. Many Massachusetts leaders got involved, and together
we settled on five key measures: 1) Crowdfunding, 2) IPO on-ramp
legislation, 3) easier Visas for overseas entrepreneurs who want to
come create jobs in the United States, 4) better mid-skills job
training, and 5) limitations on noncompete agreements in employment
contracts (some States already ban them). I was selected by the group
to present our conclusions, and I will do my best to do so again today.
Given the topic of today's hearing, I plan to talk about the first two
measures.
We believe startups are at the root of restoring the United States
to full economic health. As is now well known, a Kauffman Foundation
study using U.S. Census data recently found that, over the last quarter
century, all net new jobs in the United States have come from companies
5-years old and younger. Existing firms (those 6 years old and older)
collectively lost jobs during that same quarter-century period analyzed
(1980 to 2005). For every job lost by existing firms, new firms
generated three. It seems clear that supporting startups and
entrepreneurship is the key to job creation in the United States.
Enabling better access to capital will be the single most impactful
step Government can take. I will speak in particular to two proposals:
1) Crowdfunding (S. 1791 and S. 1970)
Risk capital is distributed unevenly in our country. Startups do
not today have adequate places to go to find the money to start a new
business. Everyday businesses that are the bread and butter of our
communities--businesses like restaurants, small construction companies
and the like--are starved for capital. There are, for instance, nearly
8 million women-owned businesses in the United States, yet only a few
hundred a year are able to raise venture capital.\1\
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\1\ Estimated to be between 140 and 280 deals per year based on
data from the Kauffman Foundation at http://www.kauffman.org/research-
and-policy/gatekeepers-of-venture-growth.aspx and http://
www.pwcmoneytree.com.
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I believe that crowdfunding legislation can change this. As we have
all heard, the Internet changes everything. One of the things that the
Internet has changed is the ease with which an organization can
broadcast its needs and attract supporters online. Another thing that
has changed is that it is much harder for bad actors to hide from the
scrutiny of the masses. Many companies have sprung up to help
individuals and small businesses find loans, donations, and first
customers this way. Politicians have found the Internet effective to
raise campaign donations.
In an example that shows the power of crowdfunding, popular Web
site Kickstarter, which collects money from fans to support principally
film, arts and design-oriented projects, raised almost half as much
money for the arts in 2011 as the National Endowment for the Arts
(NEA). Due to its rapid growth, it appears likely to roughly tie the
NEA in 2012.\2\ The NEA acknowledged this, stating ``Kickstarter and
the other platforms that crowdsource donations for arts organizations
and projects are becoming increasingly important in helping the arts.''
---------------------------------------------------------------------------
\2\ Analysis from Talking Points Memo at http://
idealab.talkingpointsmemo.com/2012/02/the-nea-responds-to-kickstarter-
fundingdebate.php?m=1.
---------------------------------------------------------------------------
Crowdfunding proposes to harness this same power to help people
start new businesses, and create new jobs. It will enable individuals
to make small equity investments in others' businesses without the
usual regulatory burdens associated with a public offering.
Many of us in the startup community believe that such a mechanism
will allow far more startups to get going in the United States, thereby
creating much-needed new jobs. This is evidenced by a petition started
by some entrepreneurs in my center, which can be found at Wefunder.com.
They obtained commitments from more than 2,500 individuals to invest
over $6M through crowdfunding.
How big could the impact of crowdfunding be? Americans have about
$30 trillion dollars in savings plans (401Ks, IRAs, and the like). Amy
Cortese, author of the book Locavesting, points out that if Americans
diverted just 1 percent of this amount into crowdfunding type
investments, the amount raised would equally half of all small-business
loans in the country, and would be about 10 times the total amount of
venture capital invested each year in the United States. The potential
benefit to the country from this is very large.
The chief concern with crowdfunding is the threat of fraud. Some
have voiced a concern that unscrupulous individuals might take
advantage of unsophisticated investors, misrepresenting risks, and
effectively stealing investors' money.
While this concern is understandable, the data show that Internet
intermediaries have been successful at blocking such fraud. United
Kingdom-based crowdfunding startup Crowdcube, for instance, reports
zero fraud claims after a year in business (see attached letter from
its CEO). They achieve this in part by thoroughly vetting the
opportunities they present for investment. Similarly, Prosper.com, a
crowd-lending business operating under SEC regulation claims to have
raised $124M in loans and to have no reports of fraud or
misrepresentation. Funding Circle, out of the U.K., another crowd-
lending platform, claims to have raised 26M in 569
transactions and reports no fraud (and only 5 defaults so far).
AngelList is a crowdfunding platform in the United States that works
only with accredited investors. It operates under the SEC's Regulation
D, and has raised ``more than $100M'' in equity investments using its
online platform. AngelList claims zero reports of fraud. Net-net, I
conclude that if crowdfunding legislation requires that any investments
be made through an SEC-licensed intermediary, the fraud problem can be
resolved.
To draw a broader analogy from a different industry, as we all
know, eBay is a Web site that permits one to buy items from people they
have never met, and never will meet, based solely on an online
description. On the face of it, this would similarly seem to be a
hotbed for fraud. Yet any eBay user will tell you that the
incorporation of a system that tracks the reputation of buyers and
sellers significantly mitigates fraud. We believe that the analogous
mechanisms will be developed by competing crowdfunding intermediaries,
leading to an enviable investment environment that is safe and free
from undue regulation.
To the extent that there are continued concerns about fraud, one
additional attractive market-based solution could be fraud insurance.
Given the low actual incidence of fraud, crowdfunding proponents have
attracted the interest of insurers who have voiced an openness to issue
policies protecting crowdfunding investors against fraud.
I understand that there are efforts underway to create a
``consensus'' crowdfunding bill that would incorporate the best of the
various bills under consideration. Having studied the topic closely, I
would urge the drafters to do so, and to incorporate the following
provisions:
a) Require the use of SEC-licensed intermediaries. Intermediaries,
playing the ``eBay'' role, are the key to eliminating fraud.
Intermediaries will compete to be attractive to investors, offering
such incentives as anti-fraud insurance. Intermediaries would
creatively develop competing mechanisms to reduced fraud, be that by
manually vetting the deals, or using some other mechanism such as crowd
input. I don't think we should legislate how the do it, since this is
an area where we want creative innovation. Instead, any intermediaries
deemed ineffective at eliminating fraud would simply be subject to
losing their license. It is important that the regulations that
intermediaries should be subject to enable them to flexibly, and at
low-cost handle these small transactions (e.g., not subject to the full
brunt of onerous broker-dealer regulations, but only the specific
intermediary requirements spelled out in the bills, which all look
fine). To the extent that a workable definition of such an intermediary
can be agreed upon, ideally it would also be extended to the
aforementioned Reg-D-based crowdfunding intermediaries as well, since
they face the same issues.
b) Enable investments larger than $1,000 for those who can afford
it. Some of the proposed bills provide formulas for determining limits.
Data show that 90 percent+ of the dollars raised in crowdfunding
initiatives are from people investing more than $1,000, so it is highly
desirable to enable larger investments. See attached chart. One way to
address this concern would be to set a higher limit, say $100,000, or
no limit, on the amount accredited investors can invest under
crowdfunding legislation, effectively extending this same concept of
crowdfunding through intermediaries to cover both crowdfunded &
accredited investments.
c) Don't burden the process with unnecessary restrictions that
would render crowdfunding legislation meaningless. For instance, it is
essential that the degree of interaction required with individual
States be limited. Fifty States and 50 different sets of rules, and
these small companies can't handle that amount of complexity. Limited
State filings for the issuer's State and a State in which the majority
of the issuer's investors live are reasonable, but, in general, it is
imperative that State securities laws be preempted by the crowdfunding
exemption (with the exception of State anti-fraud laws). Additionally,
it is important that overly burdensome disclosure obligations are not
placed on issuers. These rules were created with large issuers in mind,
and would stifle crowdfunding. Instead, follow the example of
Crowdcube-they have a strong incentive to eliminate fraud and do not
list opportunities they believe to be inadequately described, or where
stories don't check out.
d) Don't burden crowdfunding issuers with excessive liability.
Issuers should be subject to collective action by investors if they
commit wrongs, but some provisions would appear to create the
possibility for individual rights of action, and that would create an
untenable risk for issuers.
e) Do require a periodic ongoing review of how this is going, as
called for in S. 1970.
2) IPO on-ramp legislation (S. 1933)
While most jobs are created by companies 5-years old and younger,
an exception is larger companies that go public and raise substantial
amounts of capital. Data show that companies that go public grow their
headcount approximately 5-fold, often creating thousands of jobs.
Unfortunately, the current regulatory frameworks impacting public
companies have had the unintended consequence of substantially reducing
the number of companies that are able to go public. It costs an
estimated $2.5M for a company to go public today, and $1.5M per year to
stay public. These are heavy burdens for young companies to bear.
Proposed legislation would reduce this regulatory and paperwork
burden for so-called ``Emerging Growth Companies'': smaller, younger
companies that are less likely to go public otherwise. This category,
by virtue of being comprised of young companies, today represents only
a small 3 percent of the total value of publicly traded companies. At
the same time, it represents our future. It is important that we
nurture it.
Under this proposal, regulation would ``scale'', growing with a
company's compliance abilities. I believe it is important to note that
I personally applaud the intent of many of the regulations that are
scaled under this bill. I believe each regulation was created with good
intentions, and under the proposed legislation, each will, in time, be
applied to every company that goes public. This bill simply delays the
day that these companies must face the economic burden of compliance.
I am hopeful that the Senate will find these proposals have merit
and that Congressional enactment is necessary to jumpstart our economy.
This is a time when we must be creative and work together to find
solutions to help America get back to work.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
PREPARED STATEMENT OF LYNN E. TURNER
Former Chief Accountant of the Securities and Exchange Commission, and
Managing Director, Litinomics, Inc.
March 6, 2012
Thank you Chairman Johnson and Ranking Member Shelby for holding
this hearing and it is an honor to be invited to testify before you. I
am sure everyone here at the hearing today can agree that increasing
employment in the United States, and bringing back jobs that have left
the country, is vitally important to our economy and the well being of
America, and Americans. The destructive effect of the most recent
financial crisis on American jobs, the United States (U.S.) capital
markets, retirement and savings accounts, and families provides us
stark lessons in this regard, if we choose to learn from them, rather
than repeat them.
Background
Let me begin by noting my comments today are framed by my
past experiences including:
Having been involved as an executive in starting up a
successful venture backed company that created jobs.
Having served on a Commission formed in my State in the
1980s to explore what could be done to improve the success
rates of startup businesses and smaller companies.
Serving as a trustee for two institutional investors,
including on the investment committees. One of those
institutions does invest in startup and/or growing companies
via investments in venture capital and private equity.
Serving as the U.S. Securities and Exchange Commission
(SEC) Chief Accountant, responsible for advising the SEC
Chairman and Commission on matters of disclosure, transparency
and auditing affecting all public companies.
Serving as a Vice President and Chief Financial Officer at
a semiconductor and storage systems company. Attracting capital
and financing was critical to the company's success as we made
major investments and purchases in manufacturing plants and the
jobs in them. We spent 2 years preparing for an Initial Public
Offering (IPO), including preparation of filing documents,
selection of underwriters, and working with sell side analysts
as they wrote research reports in anticipation of the offering.
Ultimately, due to the downturn brought on by the Asian Crisis
and its contagion effect on the capital markets, the IPO was
not completed.
Spending 20 years of my career with a Big 4 accounting and
consulting firm, including spending considerable time in the
Emerging Business Services Group that advised and audited
emerging and growing businesses. This included working with
companies inside two business incubators in Boulder and Denver
Colorado for which the Boulder Incubator Board presented me
with the Board Partnership Award.
Initial Public Offerings
Public offerings of stock by companies to investors are an
important factor in the success of our capital markets. The number of
offerings completed, as well as the amount of money raised, tracks the
economy in general. This was noted in the Goldman Sachs Global
Economics Weekly report February 7, 2007 which stated:
Several recent reports have fuelled anxiety that Wall Street is
losing out . . . most keenly to London and is doomed to lose
its perch as the world's pre-eminent capital market. Studies
have pointed to strict legal and regulatory practices in the
United States as reasons why issuers are increasingly looking
elsewhere for IPOs. These issues are typically contrasted with
London's light touch regulation, more hospitable legal regime
and ease of migration.
The regulatory climate does matter, and policy reform might
strengthen New York's competitiveness. Nonetheless, we do not
think this is the main problem nor indeed that Wall Street is
losing out in a regrettable way. Instead we see the growth of
capital markets outside the United States as a natural
consequence of economic growth and market maturation elsewhere.
The United States has in fact been losing market share for
several decades, and it trails Europe in trading of FX and many
derivatives.''
Legal and regulatory factors probably do matter, and policy
reform might strengthen New York's competitiveness.
Nonetheless, we do not see them as the critical drivers behind
the shift in financial market intermediation, even in the
aggregate. Quite simply, economic and geographic factors matter
more.
The reason IPO's track the economy is that investors invest to earn
a return. When the economy is growing, companies can grow. That growth
in revenues, profits, cash and investments such as employees fuels the
growth in companies' stock and the returns investors seek. However,
when the economy has stalled or is declining, and companies are not
growing, investors simply cannot achieve the types of returns they need
to justify making an investment. The following chart highlights that.
As a result of the downturns in the economy that occurred during much
of the 1970's brought on in part by withdrawal from Vietnam, the
recession brought on by inflation at the beginning of the 1980s, the
dot com bubble and corporate scandals, and the most recent great
recession, investors became concerned about returns that could be
earned in the markets and IPO's declined. As the economy and employment
have recovered after each of these downturns, so has the IPO market.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
During the 1990s, the U.S. economy experienced high growth rates,
which has not since been matched. Charts 1 and 2 illustrate how the IPO
market reached an unprecedented level during the 1990s not achieved
before or after. Some argue that is because the U.S. regulations
protecting investors are overly onerous. Often they cite Sarbanes-Oxley
and its Section 404(b) requirement for companies, mandating an audit of
their internal controls as an unjustified cost. But the facts simply
don't bear this out, and those arguments have a lot in common with the
too common refrain--``the sky is falling.'' Those making this argument
also cite the London AIM market as an example of a ``lightly''
regulated market the United States should attempt to emulate.
However, a close examination of the issue does not support these
individuals. First of all, the U.S. IPO market had very significant
declines in the 1970s, 1980s, and as the last century came to a close.
Some of those declines occurred before current regulator financial
reporting requirements were adopted, and certainly before Sarbanes-
Oxley was adopted in 2220. In addition, if one looks at the following
charts for the AIM market, one can see that market also experienced
deep declines in its IPO market.
And its recovery has significantly trailed those in the United
States as the U.S. economy has outperformed that in Britain. One can
only ask, why would a reasoned and thoughtful person want to copy that?
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
A number of years ago, a former SEC Commissioner caused a ruckus
when he made reference to the AIM market as being somewhat akin to a
Las Vegas Casino. He had a point. As noted in the following chart, this
lightly regulated market was started in the 1995/96 timeframe. If one
had invested in the AIM market index at the time with a $1,000, one
would no longer have the $1,000, as the market has generated a negative
return for investors. It is no surprise then that The Daily Telegraph
in the U.K. recently stated that: ``Recent research for The Daily
Telegraph has also shown that at least 80 leading money managers do not
have confidence in the current regulation of natural resource companies
on AIM.'' (See Exhibit 1).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Despite a market that has risen from the despair of 2009, investors
remain cautious about giving their money to companies. The aggregate
returns they have earned since 1999 have been somewhat meager when
compared to the 1980s and 1990s. Baby boomers have seen their 401-K's
turned into 201-K's by the scandals and dot com bubble at the beginning
of the last decade with the most recent financial crisis burning them
badly. Both the Nasdaq and Dow Jones Indexes remain well below their
highs. And just a couple of weeks ago, an article in the Wall Street
Journal noted that in 37 of the past 40 weeks, investors had pulled
cash out of investments in small cap companies.
Again, investors invest to make a reasonable return. But just as
such returns have been fleeting for them, they have also been lower for
Venture Capitalists (VC's). My experience has shown that VC's are
astute at picking the companies and management teams to invest in, that
will yield them and the investors in their funds, the highest possible
returns. And they bring great insights and expertise to these
companies, greatly aiding them in their efforts to grow and become
highly successful. Yet despite all this experience, knowledge and
expertise, as noted in the following chart, VC's and the investors in
their funds have experienced the same impact from the downturns in the
economy everyone else has. And that should be no surprise to anyone who
understands fundamental, basic economics. It takes a growing economy
such as existed in the United States in the 1990s, and exists now in
China, India and certain other emerging countries in the world, to
generate returns for investors.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Critical Success Factors for an IPO
I have often counseled that not all companies should do an IPO. If
you take someone's money, you should do so ONLY if you think it is
likely, you will be able to yield them a reasonable return on their
money. After all, they are owners of the business once they have bought
stock and should be treated accordingly. Those who go public thinking
that ``possession is 9/10ths of the law'' when it comes to cash, are in
for a very rude awakening.
When I served on a Colorado Commission that explored why so many
small companies were failing in Colorado at the time, and how their
success rate could be improved, we found that access to capital was not
the primary cause of failure. Rather it was a lack of sufficient
expertise and management within the company including in such areas as
marketing and operations. While access to sufficient capital for any
company is important, I have found that those emerging companies with
better management teams and proven products, or products with great
growth potential, are able to obtain it. Those are the types of
companies VC's and private equity seek out.
My experience has also taught me that many IPO's are not a success.
We are all very mindful of the Googles, Apples, HP's, and Microsofts
that have become great successes. In fact, the vast majority of the
jobs they created have been created after an IPO, not before.
In an American Enterprise Institute Paper titled ``Are Small
Businesses The Engine of Growth'' Veronique de Rugy, the author states:
It is a common belief among entrepreneurs and policymakers that
small businesses are the fountainhead of job creation and the
engine of economic growth. However, it has become increasingly
apparent that the conventional wisdom obscures many important
issues. It is an important consideration because many
Government spending programs, tax incentives, and regulatory
policies that favor the small business sector are justified by
the role of small businesses in creating jobs and is the raison
d'etre of an entire Government agency: the Small Business
Administration (SBA). This paper concludes that there is no
reason to base our policies on the idea that small businesses
are more deserving of Government favor than big companies. And
absent other inefficiencies that would hinder small businesses
performances, there is no legitimate argument for their
preferential treatment.
And in the paper titled ``What Do Small Businesses Do?'' professors
Erik Hurst and Benjamin Wild Pugsley state:
In Section 3 of the paper, we study job creation and innovation
at small and/or new firms. First, using a variety of data sets,
we show that most surviving small businesses do not grow by any
significant margin. Most firms start small and stay small
throughout their entire lifecycle. Also, most surviving small
firms do not innovate along any observable margin. We show that
very few small firms report spending resources on research and
development, getting a patent, or even copywriting or trade
marking something related to the business (including the
company's name). Furthermore, we show that nearly half of all
new businesses report providing an existing good or service to
an existing market. This is not surprising in light of the most
common small businesses. A new plumber or a new lawyer who
opens up a practice often does so in an area where existing
plumbers and existing lawyers already operate.
They go on to conclude:
Recognizing these characteristics common to many small
businesses has immediate policy implications. Often subsidies
targeted at increasing innovative risk taking and overcoming
financing constraints are focused on small businesses. Our
analysis cautions that this treatment may be misguided. We
believe that these targets are better reached through lowering
the costs of expansion, so they are taken up by the much
smaller share of small businesses aspiring to grow and
innovate. In fact, the U.S. Small Business Administration
already partners with venture capitalists whose high powered
incentives are aligned with finding these small businesses with
a desire to be in the tail of the firm size distribution.
In fact, during the heydays of the IPO market of the 1990s, many
companies went public and took money from investors that never should
have. Yet shortly after going public, as Exhibit 2 notes, many failed,
causing investors great losses in their retirement and college
education savings accounts, and destroyed over a hundred thousand jobs.
Many large pension funds have never been able to recover to their pre
dot com bust funding levels, leaving Americans wondering where the
money will come for their retirement.
At the height of the bubble, leadership of the Business Roundtable
invited then SEC Chairman Arthur Levitt and me to dinner. At the
dinner, they urged us to prohibit many of these companies from taking
investors money. (The SEC did not have that regulatory power as the
United States appropriately has a disclosure rather than merit based
system.) They argued that rather than the investments going to
companies who could put it to good use, investing in plants, jobs and
research, the money was flowing into young, unproven companies that
lacked adequate management, let alone revenues, profits and a
substantive business plan. They turned out to be right. The capital was
poorly allocated, and many American investors, businesses and workers
paid a stiff price.
Not too long after that, I had lunch with a managing director of
one of the ``Bulge Bracket'' investment banks who had done many public
offerings. By that time the market had cratered taking trillions of
dollars of wealth with it. He said that in fact, Wall Street, the
venture capitalists, attorneys and other gatekeepers, had facilitated
the IPO of many companies that never should have gone public. He went
on to say that whereas before the IPO market bubble got way out of
hand, companies had to have attained at least certain levels of
revenues for an established period of time, to demonstrate they were
viable companies who could earn a reasonable return for their
investors. But in the bubble, he said all that was thrown out the
window, and any company they could take public they did. When I asked
him why, he responded ``Because if we didn't do it, the next guy
would!''
Conclusion on Legislation
For any capital market to work effectively, it must provide
investors with high quality, timely and complete financial information
that is accurate. Conflicts inherent in the markets must preferably be
prohibited and at a minimum must be clearly and completely disclosed to
all participants. And there must be an enforcement mechanism that
ensures a fair and orderly market.
In the past, the U.S. capital markets have had a reputation for
appropriate regulatory and enforcement mechanisms, and continues to
attract capital, including from foreign investors. But the scandals of
the last decade has damaged our reputation, beginning with the dot com
IPO market bubble, to the Wall Street analysts scandal, to mutual fund
market timing and trading frauds, to Madoff and other ponzi schemes,
along with the once in a lifetime financial crisis brought on by
extremely lax regulation by securities and banking regulators, and by
people who originated bad loans, collected huge fees for doing so and
then sold the worthless paper to investors.
Lax regulation, in some cases the result of acts of Congress, has
hammered the investment accounts of retirees and baby boomers that no
longer have sufficient time to recover from the losses incurred. Laws
that were passed by this Committee, including the Gramm-Leach-Bliley
Act, and the Commodities Modernization Act of 2000, which prohibited
regulation of derivates; were driving factors behind too big to fail
companies; and resulted in a $600 trillion dollar unregulated
derivatives market, both of which AIG and Lehman engaged in. These laws
neither protected investors nor taxpayers, but certainly did allow them
to be taken advantage of. It is not sufficient to say legislation will
protect investors, it must actually do it.
As I review the legislation before the Committee, I find it reduces
the level of transparency and amount of information investors will
receive. It removes critical investor protections put in place to
protect against a repeat of past scandals. It decreases the credibility
of the information one will receive. It not only allows market
participants such as analysts to once again engage in behavior and
activities that were associated with prior market disasters, it treads
on the independence of independent standard setters such as the Public
Company Accounting Oversight Board (PCAOB) established by this
Committee, as well as the Financial Accounting Standards Board (FASB).
If ill-conceived amendments regulating the cost benefit analysis the
SEC would have to perform, that were adopted in the U.S. House of
Representatives, I suspect investors would be well served to understand
that handcuffs had been put on the SEC, rather than bad actors.
The proposed legislation is a dangerous and risky experiment with
the U.S. capital markets, and the savings of over 100 million Americans
who depend on those markets. The evidence does not support the need for
it. In fact, it contradicts it. I do not believe it will add jobs but
may certainly result in investor losses. If jobs are created, as the
evidence above indicates, it will come from growth in the economy, not
this legislation. And finally, there has not been the type of cost
benefit study performed with respect to the proposed legislation that
Congress itself mandates the SEC must do before adopting such
regulations. Senator Shelby has been correct in noting there was
insufficient study performed before enactment of Dodd/Frank. There has
been even less study of the bills that are the subject of this hearing
today.
As a result, I do not support the various bills including the IPO
on ramp and crowd funding legislation. I share many of the concerns
voiced by others including the Council for Institutional Investors,
Consumers Federation, Americans for Financial Reform, AFL-CIO to name a
few. Their concerns are set forth in greater detail in Exhibit 3 which
I include for inclusion in the record.
Comments on Particular Bills
I do offer the following specific comments on the legislation for
your consideration.
Senate Bill 1933.
Section 2 Definitions
The definitions included in this bill would make it applicable to
companies under $1 billion in revenue, and $700 million in market
capitalization, for up to 5 years or until they broke those thresholds.
While these companies are defined as ``emerging', that is serious a
misnomer. As the charts below illustrate, this would scope in over 98
percent of all IPO's. And the vast majority of public companies
currently filing periodic reports are under these thresholds according
to raw data from Audit Analytics.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Given the nature of the experiment being run through this proposed
legislation, I would strongly urge the threshold be reduced to $75
million. Experimenting with such a large segment of public companies
and IPO's, as the proposed thresholds would, is highly risky and
chances putting millions of Americans at risk.
Section 3 Disclosure Obligations
This section would reduce by a third, the amount of credible,
audited financial information investors would receive. That information
is the lifeblood of the capital markets and necessary for making
informed decisions on where capital should be allocated. Yet this vital
information is proposed to be seriously restricted by this legislation.
My experience tells me that successful IPO's, are done by companies
with sufficient track records to demonstrate they are worthy of an
investment. If a company has been established for more than 2 years,
then it should continue, as has been the practice for decades, to
present 3 years of audited financial information to investors. If
companies are unable to do this, I would be seriously concerned if they
are ready for the ``prime time'' of being a public company, and are not
likely to generate sufficient returns to warrant an investment.
This section also impinges on the independence of the FASB as it
exempts emerging companies from having to adopt new accounting
pronouncements. As a result, if the FASB were to adopt a new
pronouncement in response to a significant problem such as the off
balance sheet special purpose entities of Enron or the off balance
sheet reporting at Lehman, emerging companies may well avoid having to
implement such standards for a period of time, leaving investors once
again in the dark.
As noted at Exhibit 4, Senator Shelby has correctly defended the
independence of standard setters such as the FASB. His counsel should
be heeded once more and this provision regarding accounting
pronouncements should be removed from the legislation.
Section 4 Internal Controls Audit
As discussed earlier, Sarbanes-Oxley Section 404(b) has not been
the reason there has been a decline in the number of IPO's. Companies
under $75 million in market capitalization have never had to implement
SOX 404(b) so it cannot be the reason such companies have not gone
public. And for those companies that do go public, they have not had to
implement SOX 404(b) at the time of the IPO or at the subsequent annual
report filed with the SEC. It is only at the time of the second annual
report that a public company must complete an audit of its internal
controls. This is a reasonable exemption from the requirements of SOX
404(b) that should be retained rather than replaced.
Data has clearly demonstrated that prior to the enactment of SOX,
thousands of companies were not complying with the internal control
provisions of the Foreign Corrupt Practices Act of 1977. As SOX was
implemented, the chart below highlights the numbers of companies that
were found not to have complied with the law. SOX 404(b) did bring much
greater transparency to the number of companies that had inadequate
internal controls, and that as a result, had to correct their financial
statements.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
As SOX 404(b) was implemented, erroneous financial statements, that
in most instances had previously been attested to by the executives,
came to light in record numbers. In a February 2007 report by Glass
Lewis, where I was the Vice President in charge of the research, found:
Companies with U.S.-listed securities filed 1,538 financial
restatements in 2006, up 13 percent from what had been a record
number in 2005. About one out of every 10 public companies
filed a restatement last year, compared with one for every 12
in 2005. Of the latest restatement batch, 118 were by foreign
issuers.
If there was any lingering question about whether these figures
matter, consider this: The median stock return of companies
that filed restatements last year was minus 6 percent. That was
20 percentage points lower than the return of for the Russell
3000 stock index in 2006.
The report went on to list key findings:
Key Findings
1,244 U.S. companies and 112 foreign companies--1 of every
10 companies with U.S.-listed securities--filed 1,538 financial
restatements to correct errors
2,931 U.S. companies, about 23 percent, filed at least one
restatement during the last 4 years; 683 companies restated two
or more times
Restatements by companies required to comply with SOX 404
declined 14 percent; restatements by non-SOX 404 companies rose
40 percent
Difference in audit fees between SOX 404 and non-SOX 404
companies pales in comparison to cost of corporate accounting
frauds and executive compensation
One-third of larger companies and two-thirds of microcap
companies that restated still claimed to have effective
internal controls over financial reporting
The median 1-year stock return of companies that restated
last year was 20 percentage points lower than the return of the
Russell 3000 stock index in 2006.
Companies with deficient internal controls tend to be poorly
managed companies that underperform their peers in the markets, and
which yield lower returns to investors. Accordingly, information on the
quality of internal controls is very important to investors. The chart
below highlights this issue, and notes that investors in companies that
have poor internal controls and restatements cost investors dearly.
However, those who question the costs of SOX 404(b) often disregard
such data, caring only about the cost to the company and not the huge
economic benefit to investors.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The General Accountability Office and SEC have also issued studies
and reports on their findings on the benefits of SOX 404(b). One such
report captioned ``United States General Accounting Office Report to
the Chairman, Committee on Banking, Housing, and Urban Affairs, U.S.
Senate (October 2002) FINANCIAL STATEMENT RESTATEMENTS Trends, Market
Impacts, Regulatory Responses, and Remaining Challenges'' GAO-03-138
found:
The 689 publicly traded companies we identified that announced
financial statement restatements between January 1997 and March
2002 lost billions of dollars in market capitalization in the
days around the initial restatement announcement. For example,
from the trading day before through the trading day after an
initial restatement announcement, stock prices of the restating
companies that we analyzed fell almost 10 percent on average
(market adjusted). We estimate that the restating companies
lost about $100 billion in market capitalization, which is
significant for the companies and shareholders involved but
represents less than 0.2 percent of the total market
capitalization of NYSE, Nasdaq, and Amex. However, these losses
had potential ripple effects on overall investor confidence and
market trends. Restatements involving revenue recognition led
to greater market losses than other types of restatements. For
example, although restatements involving revenue recognition
accounted for 39 percent of the 689 restatements analyzed, over
one-half of the total immediate losses were attributable to
revenue recognition-related restatements. Although longer term
losses (60 trading days before and after) are more difficult to
measure, there is some evidence that restatement announcements
appear to have had an even greater negative impact on stock
prices over longer periods. The growing number of restatements
and mounting questions about certain corporate accounting
practices appear to have shaken investors' confidence in our
financial reporting system.
This finding is very consistent with research and findings of the
Staff of the SEC while I was Chief Accountant. As a result, I believe
the data clearly supports that the benefits of SOX 404(b) to investors
significantly outweigh the costs. Congress should conduct a cost
benefit test, consistent with what it mandates of the SEC, if it
exempts any additional companies from SOX 404(b).
Section 5 Auditing Standards
Section 5 is troubling for two reasons. First, Congress established
the PCAOB to regulate auditors of public companies. At the time it did
so, it acknowledged that such an entity would be able to do a better
job of that than Congress itself.
The PCAOB has a project on its agenda, as the direct result of very
troubling findings arising from its inspections of public companies.
This project as instituted because auditors have been found to be
lacking in independence, professional skepticism and reasonable
judgment. The project is in the early stages and a concept release
seeking public comment has been released. Yet, at this very early stage
Congress is proposing to step in and override the PCAOB, preventing it
from adopting rules on mandatory rotation.
Audits are only worth paying for, if they are independent. A dozen
years ago, the SEC rewrote the auditor independence rules. But these
rules were watered down as a result of undue pressure from Congress as
it bowed to the whims of the auditing profession lobby. That turned out
to be a disastrous decision as Enron, WorldCom, Adelphia, Xerox and a
host of other corporate scandals arose in which it appeared the
auditors lacked independence.
Congress is now poised to make the same mistake, yet again.
Instead, it should allow the process to run its normal course, obtain
the comments from the public, conduct the 4 public hearings it has
undertaken, and wait for the outcome of the deliberations.
The second concern with Section 5 is that it requires the SEC to
perform a cost benefit analysis of each new rule the PCAOB promulgates.
The legislation wording as currently crafted, puts a premium on the
cost to the company rather than the benefit to investors and capital
markets.
And I understand it, any cost benefit study would need to be
completed within 60 days of the adoption of a new PCAOB rule. Often
that is simply not possible, and so the legislation in essence would
exempt emerging companies as defined from new PCAOB rules.
At a minimum, the language should be changed to balance any cost
benefit analysis. The SEC should also be given a reasonable period of
time to conduct such studies. In addition, while I was Chief
Accountant, the industry refused to provide data useful to a cost
benefit study. If the industry was once again to refuse to provide
necessary data to the SEC or PCAOB, those agencies should be exempted
from the cost benefit study requirement provided they can demonstrate
any new rule would adequately protect investors and was in investors'
best interests.
It is also worth noting that the restrictions that Congress
proposes to place on the SEC, the PCAOB and the FASB apply to all
companies defined as emerging companies. This would include for
example, the population of Chinese companies that in recent years have
become an emerging scandal in and of themselves. Investors have and
continue to suffer losses in investments of such companies. One must
ask, is it really good public policy to roll back regulations as
proposed for such companies when the problems grow larger by the day.
I would urge the Committee to consider adding to this section of
the legislation, the bi-partisan proposal by Senator Reed and Grassley
that would enhance the transparency of the enforcement activities of
the PCAOB. As the press and public have rightly pointed out, this would
enhance the credibility of the agency and permit investors to
understand whether there are serious questions about the quality of
audits they are receiving from certain auditors.
Section 6 Availability of Information About Emerging Growth Companies
This is an ill-conceived and poorly thought out section of the
bill. As a CFO, I watched as analysts engaged in ``marketing'' the
underwriting of IPO's and public companies to investors. They were
anything but independent and their research was misleading. They were
in essence, an extension of sales and underwriting arms of the
investment banking firms. This led to the Wall Street Analyst Scandal
discussed further at Exhibit 5. It also resulted in investors being
mislead and suffering significant losses on their investments.
Unfortunately this legislation legitimizes this type of behavior.
And it fails to recognize the importance of independent research as
well as meaningful disclosure of conflicts that do exist. Rather it
establishes a process whereby analysts can once again engage in issuing
conflicted reports and avoid accountability for their actions.
Below is a chart that reflects the type of reporting this
legislation is likely to bring about. As noted, even after the dot com
bubble had burst, and just before the largest corporate scandals in
this country erupted, analysts were still touting stocks.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
At a minimum, the legislation should adopt the investor protection
measures encompassed in the well known Wall Street settlement. This
includes provisions that ensure the analyst has to remain independent
of the underwriting and investment banking function, and that any
conflicts are disclosed in a complete and transparent fashion.
With the Wall Street settlement requirements having lapsed,
behavior among Wall Street analysts has quickly returned to what it was
before the settlement. No one should be surprised if the outcome and
history is repeated once again.
Other
The Administration has indicated, and the title of the hearing
today would suggest, that the legislation should include investor
protections. Currently Senate Bill 1933 and the other bills have fallen
way short in this respect. Other commenters and people who have already
testified have eloquently pointed that out. I hope the Committee will
give due consideration to those points. For example, at Exhibit 6, the
ICI has voiced its strong opposition to general solicitations noting
they are not appropriate for the U.S. capital markets. At Exhibit 7,
Professor Jay Brown has noted some reasoned changes that should be
made. And at Exhibit 3, several organizations have made meaningful
suggestions very worthy of consideration and acceptance.
In addition to those improvements to the legislation, I would add:
1. Private offerings, which in all likelihood will reduce rather
than increase the number of IPO's, should be regulated.
Currently, the SEC does not have the resources to engage in
meaningful regulation. Accordingly, the State securities
regulators should be permitted to regulate offerings and
protect investors in their communities when the SEC is unable
to.
2. Recent reports have highlighted the level of recidivism that has
occurred on Wall Street and gone unchecked. I would urge the
Committee to adopt stronger enforcement penalties that ratchet
up as recidivism occurs. Penalties such as those included in
SOX for auditors are much more appropriate today than existing
penalties given changes in the markets.
3. Sanctions should be strengthened for both private and public
offerings, when it is found a seller of securities has failed
to undertake and ensure the suitability of a security for the
investor, or has failed to conduct meaningful and necessary due
diligence. All too often we have seen underwritings in which
the investment bankers failed to ensure adequate disclosure of
key risks and financial data. This is especially true when one
relaxes rules governing solicitation.
4. The definition of an accredited investor should be changed. Tying
this definition to wealth is inappropriate as we saw with many
of the investors in recent Ponzi schemes, such as in the Madoff
matter. The seller should be required to obtain a statement
from the investor that they not only have a specified level of
assets, but also have a reasonable working knowledge to permit
them to appropriately analyze the intended investment. If the
broker has knowledge that contradicts this, then the investor
should not be accredited.
Summary
More jobs and a larger number of qualified IPO's is something we
all strive for. But IPO's have to be successful for not only those
selling stock, but also for those buying shares. This legislation is
currently unbalanced and likely to result in more unsuccessful
investments for investors. In the long run, history has judged clearly
that such incidents serve to reduce IPO's, cost jobs, and cost
investors money sorely needed for retirement and education.
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM WILLIAM
D. WADDILL
Q.1. What do you feel are the primary reasons for the decline
in the number of initial public offerings for smaller
companies? Do you foresee a return to the number of IPOs from
the late 1990s?
A.1. Did not respond by publication deadline.
Q.2. In S. 1933, an ``emerging growth company'' would include
companies with up to $1 billion in revenues. What are your
views on whether this is the appropriate number and whether
revenues is the appropriate metric to identify companies that
should get reduced regulatory requirements?
A.2. Did not respond by publication deadline.
Q.3. What would be the effects of exempting an ``emerging
growth company'' from having its auditor attest to the
effectiveness of its internal financial controls on the company
and on investors?
A.3. Did not respond by publication deadline.
Q.4. What types of companies would you expect to use
crowdfunding to raise capital, instead of going to other
sources of funds such as private equity fund, venture capital
fund or banks? What types of investors do you expect to invest
through crowdfunding?
A.4. Did not respond by publication deadline.
Q.5. Professor Ritter in his testimony identified the
possibility that if a company is very successful, and has
multiple rounds of financing, there is a possibility that ``the
small investors wind up exposed, being diluted out.'' Mr. Rowe
stated that ``it's a valid concern.'' How do you feel that this
issue should be addressed for small investors in crowdfunding
offerings?
A.5. Did not respond by publication deadline.
Q.6. Ms. Smith testified that ``the transparency of our [IPO]
markets are very poor, which hurts and scares a lot of
investors in the markets.'' She suggested greater use of the
SEC's EDGAR Onliner system to post transcripts of road shows or
a red-lined copy of amended registration statements. Do you
feel that the transparency of the IPO market could be enhanced
in ways that would encourage more investors to invest in IPOs?
A.6. Did not respond by publication deadline.
Q.7. You testified that ``For my company to try and prepare for
Sarbanes-Oxley compliance will be somewhere between $3 million
to $3.5 million.'' You later testified ``from our company's
point of view, when we look at the use of capital . . . do we
want to spend $3 million ramping up into Sarbanes-Oxley
compliance?'' Costs are a relevant factor to this discussion.
Please describe the types of costs that you have identified for
your company to comply with Sarbanes-Oxley that would total a
cost of $3-$3.5 million.
A.7. Did not respond by publication deadline.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM JAY R.
RITTER
Q.1. What do you feel are the primary reasons for the decline
in the number of initial public offerings for smaller
companies? Do you foresee a return to the number of IPOs from
the late 1990s?
A.1. I think that the primary reason for the decline in IPOs,
especially small company IPOs, is a lack of investor enthusiasm
due to low stock market returns, which in turn is due to the
lack of profitability of most small companies after going
public. From 1980-2009, 3,761 companies went public in the
United States that had less than $50 million ($2009) in annual
sales in the year before the IPO. From the closing market price
on the first day until their 3-year anniversary, the average
small company IPO had a 3-year buy-and-hold return of only 4.7
percent, and performance relative to the broader stock market
of -35.7 percent. The small company IPOs from 1980-2000 were
unprofitable (negative EPS) in 58 percent of their first three
fiscal years after the IPO. This percentage has increased to 73
percent for the small company IPOs from 2001-2009.
I believe that the deteriorating profitability of small
company IPOs is attributable to a long-term trend in many
sectors of the global economy, especially in the technology
industry, that is favoring big companies. Many sectors are now
``winner takes all'' markets, where getting big fast has become
more important than it used to be. Small companies are
accomplishing this by selling out to a bigger company, rather
than staying independent. Thus, the issue is big vs. small, not
public company vs. private company.
Q.2. In S. 1933, an ``emerging growth company'' would include
companies with up to $1 billion in revenues. What are your
views on whether this is the appropriate number and whether
revenues is the appropriate metric to identify companies that
should get reduced regulatory requirements?
A.2. I believe that revenue is an appropriate measure, although
$1 billion may be too high.
Q.3. What would be the effects of exempting an ``emerging
growth company'' from having its auditor attest to the
effectiveness of its internal financial controls on the company
and on investors?
A.3. I am in favor of dropping the auditor attestation
requirement. A more effective way of deterring securities fraud
is to penalize the people who commit the fraud.
Q.4. What types of companies would you expect to use
crowdfunding to raise capital, instead of going to other
sources of funds such as private equity fund, venture capital
fund or banks? What types of investors do you expect to invest
through crowdfunding?
A.4. I do not expect crowdfunding to be very successful.
Venture capitalists provide both money and advice. I do not
think that there are a lot of great investment opportunities
out there that will be identified and funded through
crowdfunding.
Q.5. Professor Ritter, in your testimony you identified the
possibility that if a company is very successful, and has
multiple rounds of financing, there is a possibility that ``the
small investors wind up exposed, being diluted out.'' Mr. Rowe
stated that ``it's a valid concern.'' How do you feel that this
issue should be addressed for small investors in crowdfunding
offerings?
A.5. One possibility would be to have anti-dilution provisions
as the default. It is very possible that private sector
intermediaries will insist on this without Government
requirements.
Q.6. Ms. Smith testified that ``the transparency of our [IPO]
markets are very poor, which hurts and scares a lot of
investors in the markets.'' She suggested greater use of the
SEC's EDGAR Online system to post transcripts of road shows or
a red-lined copy of amended registration statements. Do you
feel that the transparency of the IPO market could be enhanced
in ways that would encourage more investors to invest in IPOs?
A.6. Her suggestion to flag changes in the S-1 s is a good
idea. One issue that was not discussed is why investment
banking fees (the gross spread) are much higher in the United
States than in Europe. If a company sets an offer price of $10
per share and pays a gross spread of 7 percent, the company
nets $9.30 if the stock trades at $11.00, the company has
received $9.30 for shares worth $11.00, and this $1.70 cost
(direct and indirect) is more than 15 percent of the $11 market
price. If these costs were lowered, more companies would go
public.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM KATHLEEN
SHELTON SMITH
Q.1.a. What do you feel are the primary reasons for the decline
in the number of initial public offerings for smaller
companies?
A.1.a. While the global financial crisis in 2008 and 2011
reduced investor interest in stocks overall, as well as IPOs;
it is the outsized losses that investors suffered from owning
stocks of smaller newly public companies when the Internet
bubble burst in 2000 that is the primary reason for the decline
in the number of offerings for smaller companies. After the
Internet bubble burst, many unprofitable and overvalued smaller
newly public companies went out of business. Investors lost
trust in this segment of the IPO market and in the underwriting
firms that promoted these offerings.
Q.1.b. Do you foresee a return to the number of IPOs from the
late 1990s?
A.1.b. The high IPO activity levels of the 1990s were above
historical norms and the culmination of 20 years of strong
stock market returns following the weak 1970s. However, we
could foresee achieving above average IPO levels again, but
only after investors experience a sustained period of positive
stock market returns. As investor confidence returns, more
capital will be allocated to equities and a rising number of
smaller companies will be able to access the IPO market.
Q.2. In S. 1933, an ``emerging growth company'' would include
companies with up to $1 billion in revenues. What are your
views on whether this is the appropriate number and whether
revenues is the appropriate metric to identify companies that
should get reduced regulatory requirements?
A.2. We believe that revenue is not an appropriate metric to
identify a company as an ``emerging growth company''.
Differences in revenue recognition and profit margins among
companies in different industries make revenue a poor measure
to judge company size. We believe that market capitalization (a
measure of company value) is the most appropriate metric to
measure the size of a company.
We define an emerging growth company as one having a market
capitalization below $250 million, a definition also used by
the SEC (see attached). Our data shows that companies with less
than $250 million in market capitalization typically offer IPOs
of $50 million or less. It is these companies seeking to raise
$50 million or less that have had difficulty accessing the
public markets as shown by the IPO Task Force data.
Q.3. What would be the effects of exempting an ``emerging
growth company'' from having its auditor attest to the
effectiveness of its internal financial controls on the company
and on investors?
A.3. Investors may be more cautious about investing in an
emerging growth company that is exempt from the auditor test.
This could result in a higher cost of capital for the company.
However, for a smaller company (<$250 million in market
capitalization), improved earnings from the savings of audit
costs, may offset this higher cost of capital.
Q.4. What types of companies would you expect to use
crowdfunding to raise capital, instead of going to other
sources of funds such as private equity fund, venture capital
fund or banks? What types of investors do you expect to invest
through crowdfunding?
A.4. Crowdfunding will likely be used by weak businesses unable
to access funding from knowledgeable investors/bankers. We
would expect those who invest through crowd funding would be
unsophisticated consumers.
Q.5. Professor Ritter in his testimony identified the
possibility that if a company is very successful, and has
multiple rounds of financing, there is a possibility that ``the
small investors wind up exposed, being diluted out.'' Mr. Rowe
stated that ``it's a valid concern.'' How do you feel that this
issue should be addressed for small investors in crowdfunding
offerings?
A.5. Anti-dilution provisions, tag along rights, board
representation, convertible preferred structures favorable in
bankruptcy, and many other protections are common in contracts
used by knowledgeable private investors. While it may be
difficult to replicate all these protections in a crowdfunding
scenario, we recommend requiring participants (companies,
intermediaries, platforms) in this market to comply with
securities and consumer protection laws.
Q.6. Ms. Smith, you testified that ``the transparency of our
[IPO] markets are very poor, which hurts and scares a lot of
investors in the markets.'' She suggested greater use of the
SEC's EDGAR Online system to post transcripts of road shows or
a red-lined copy of amended registration statements. Do you
feel that the transparency of the IPO market could be enhanced
in ways that would encourage more investors to invest in IPOs?
A.6. We believe that the transparency of the IPO market could
be enhanced in two ways that would encourage more investors to
invest in IPOs. One is more timely disclosure of the share
ownership of newly public companies and the other is further
modernization of corporate disclosure on EDGAR.
At present, the trading market for IPOs is highly volatile
with average IPO trading turnover on the first day often equal
to the number of shares offered. This suggests that IPO shares
are being placed with short-term trading clients of the IPO
underwriters. We believe that the IPO allocation process should
be subject to SEC supervision. At the time an IPO is priced and
prior to its trading, we recommend that underwriters file
confidentially with the SEC the name of the account receiving
an IPO allocation and the number of shares allotted and to
disclose certain of this information publicly (as is done in
Hong Kong). In aftermarket trading, to the extent an investor's
share ownership exceeds 5 percent of the public float, we
recommend that notice be made to the marketplace immediately
(the standard 10-day notice is too long). IPO shares placed
with a broader base of fundamentally oriented investors would
help open the IPO market to smaller issuers and additional
timely disclosure of share ownership would help calm the
volatile trading market for newly public companies.
We recommend continuing to modernize corporate electronic
disclosure through EDGAR to make it easier for investors to
obtain and analyze information. We suggest showing red-lined
amendments to registration statements and providing transcripts
of company presentations. Efficient and open access to
information about newly public companies is the best way to
encourage an informed public viewpoint about new companies,
which ultimately benefits smaller issuers.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
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RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM TIMOTHY
ROWE
Q.1. What do you feel are the primary reasons for the decline
in the number of initial public offerings for smaller
companies? Do you foresee a return to the number of IPOs from
the late 1990s?
A.1. I am not an academic, but I can say anecdotally that I
regularly hear smaller companies speak of the pain of being a
public company. They focus in particular the time and
distractions from the core business that the requirements of
being public pose.
Q.2. In S. 1933, an ``emerging growth company'' would include
companies with up to $1 billion in revenues. What are your
views on whether this is the appropriate number and whether
revenues is the appropriate metric to identify companies that
should get reduced regulatory requirements?
A.2. I think the threshold should be set such that it
accomplishes two goals: a) high enough that the new scaled
regulations are available to most companies that might
otherwise shy away from going public due to regulation, while
b) not being so high as to include many companies that don't
need this incentive. One billion ($1B) seems reasonable in this
context.
Q.3. What would be the effects of exempting an ``emerging
growth company'' from having its auditor attest to the
effectiveness of its internal financial controls on the company
and on investors?
A.3. In all things, there is a balance. In a costless
environment, it would always be preferable to have more audits
and more reviews. But every review implies a cost. I believe
there is a logic that the smaller the company, the lower costs
of regulation that we ought impose on them. If we do not make
this choice sometimes, the engine of commerce will be impaired.
I believe it is incumbent on regulators to measure the total
cost to society of the regulation and compare it with the total
cost to society of the losses incurred as a result of
malfeasance. I have not seen such an analysis, but I would
welcome it. It would shed light on this debate.
Q.4. What types of companies would you expect to use
crowdfunding to raise capital, instead of going to other
sources of funds such as private equity fund, venture capital
fund or banks? What types of investors do you expect to invest
through crowdfunding?
A.4. I'm as eager as all of us to see how this plays out. I'm
hopeful that it will serve local businesses: a new catering
business here, a plumbing business there, as well as
innovation-driven businesses such as Gotham Bicycle Defense,
that recently raised money for its theft-resistant bike lights
on Kickstarter. If you look at examples from England, companies
include, for example, a natural salad dressing provider, an
organic soap manufacturer and a regional pro soccer team.
Q.5. Professor Ritter in his testimony identified the
possibility that if a company is very successful, and has
multiple rounds of financing, there is a possibility that ``the
small investors wind up exposed, being diluted out.'' Mr. Rowe,
you stated that ``it's a valid concern.'' How do you feel that
this issue should be addressed for small investors in
crowdfunding offerings?
A.5. I'm pleased that the final legislation requires the use of
intermediaries. I believe that in order to stay in business,
crowdfunding intermediaries will naturally be driven to ensure
that both sides of the transaction are taken care of. Investors
must be protected by fair investment terms, and investees must
have the flexibility to run their businesses. Fair terms are
settled on every day in the venture investing world. It is a
straightforward matter for the crowdfunding portal do develop a
menu of ``model'' investing terms that it enforces. I don't
believe at this time that it is necessary for Government to
define these terms, as I believe the market will evolve the
most balanced solutions on its own through the self-regulation
structure embodied in the legislation.
Q.6. Ms. Smith testified that ``the transparency of our [IPO]
markets are very poor, which hurts and scares a lot of
investors in the markets.'' She suggested greater use of the
SEC's EDGAR Online system to post transcripts of road shows or
a red-lined copy of amended registration statements. Do you
feel that the transparency of the IPO market could be enhanced
in ways that would encourage more investors to invest in IPOs?
A.6. Again, there is a balance in all things. Transparency is
good, but it comes at a cost, both in time to prepare,
limitations on what can be shared spontaneously, and in terms
of exposure of private commercial information to competitors. I
don't consider myself the expert that Ms. Smith is in these
matters. I would simply caution that ``more transparency'' is
not universally always useful: we need to strike an appropriate
tradeoff here. One exception is that were information is
already required to be publicly available, I strongly agree
that it should be made available in an easy-to-access manner,
such as providing it to EDGAR.
Q.7. Mr. Rowe, you testified that ``in my experience sitting on
boards in the venture capital context, we see . . . over and
over again the companies that are acquired very frequently end
up dying. The buying company may pay a high price, but they do
not really have the spirit or the passion that the entrepreneur
has.'' Please provide additional information on your
experiences and how these acquired companies died and, to the
extent of your knowledge, the impact on jobs.
A.7. Here is an excellent article in the popular press on the
subject: http://www.xconomy.com/san-francisco/2012/03/05/
googles-rules-ofacquisition-how-to-be-an-android-not-an-
aardvark/
Quoting from the article:
Acquisitions so often go awry that it's a wonder big
corporations keep shelling out to buy smaller ones at all. I
believe this would be a valuable area for academic research.
Anecdotally, most observers of venture capital would agree that
companies that go public are far more likely to succeed than
companies that are acquired.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM LYNN E.
TURNER
Q.1. What do you feel are the primary reasons for the decline
in the number of initial public offerings for smaller
companies? Do you foresee a return to the number of IPOs from
the late 1990s?
A.1. Did not respond by publication deadline.
Q.2. In S. 1933, an ``emerging growth company'' would include
companies with up to $1 billion in revenues. What are your
views on whether this is the appropriate number and whether
revenues is the appropriate metric to identify companies that
should get reduced regulatory requirements?
A.2. Did not respond by publication deadline.
Q.3. What would be the effects of exempting an ``emerging
growth company'' from having its auditor attest to the
effectiveness of its internal financial controls on the company
and on investors?
A.3. Did not respond by publication deadline.
Q.4. What types of companies would you expect to use
crowdfunding to raise capital, instead of going to other
sources of funds such as private equity fund, venture capital
fund or banks? What types of investors do you expect to invest
through crowdfunding?
A.4. Did not respond by publication deadline.
Q.5. Professor Ritter in his testimony identified the
possibility that if a company is very successful, and has
multiple rounds of financing, there is a possibility that ``the
small investors wind up exposed, being diluted out.'' Mr. Rowe
stated that ``it's a valid concern.'' How do you feel that this
issue should be addressed for small investors in crowdfunding
offerings?
A.5. Did not respond by publication deadline.
Q.6. Ms. Smith testified that ``the transparency of our [IPO]
markets are very poor, which hurts and scares a lot of
investors in the markets.'' She suggested greater use of the
SEC's EDGAR Online system to post transcripts of road shows or
a red-lined copy of amended registration statements. Do you
feel that the transparency of the IPO market could be enhanced
in ways that would encourage more investors to invest in IPOs?
A.6. Did not respond by publication deadline.
Additional Material Supplied for the Record
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