The JOBS Act and Information Uncertainty in IPO Firms

The following post comes to us from Mary Barth, Professor of Accounting at Stanford University; Wayne Landsman, Professor of Accounting at the University of North Carolina; and Daniel Taylor, Assistant Professor of Accounting at the University of Pennsylvania.

In our paper, The JOBS Act and Information Uncertainty in IPO Firms, which was recently made publicly available on SSRN, we examine whether the Jumpstart Our Business Startups Act (JOBS Act) increases information uncertainty in firms with initial public offerings (IPOs). The JOBS Act, which was signed into law in April 2012, creates a new category of issuer, the Emerging Growth Company (EGC), and eases regulations for EGCs to encourage initial public offerings of their shares. Specifically, the Act includes provisions that allow firms with EGC status to reduce the scope of mandatory disclosure of financial statement and executive compensation information, to file draft registration statements confidentially with the Securities and Exchange Commission (SEC), to delay application of new or revised accounting standards, and to delay compliance with Section 404(b) of the Sarbanes-Oxley Act (SOX), which relates to auditor attestation on internal controls. We find evidence consistent with the easing of these regulations increasing information uncertainty in the IPO market.

A key purpose of the JOBS Act is to reduce the cost of accessing capital markets by eliminating unnecessary or overly burdensome regulations, thereby reducing the cost of an IPO. In reference to the JOBS Act, the SEC’s website states that “…a cost-effective access to capital for companies of all sizes plays a critical role in our national economy.” The JOBS Act reflects the belief that enabling more companies to gain less costly access to capital would enable more companies to create jobs (hence the acronym) throughout the economy. A March 23, 2012 editorial in the Washington Post expresses this logic succinctly: “The case for the JOBS Act goes like this: Small companies create jobs. The easier it is to fund a small company, the more jobs there will be. Federal rules make it harder for start-ups to raise capital. Ergo, relax the rules.”

However, critics of the JOBS Act warned that easing regulatory requirements could undermine investor protections, thereby exposing investors to greater information uncertainty in IPO firms. This claim is consistent with extant theory suggesting that if mandatory disclosure provides investors with decision-relevant information, reducing the disclosure will increase information uncertainty for investors. One consequence of an increase in uncertainty is an increase in the risk premium that investors demand to compensate them for holding the firms’ shares. Thus, even though the JOBS Act may decrease compliance costs associated with an IPO, the Act could increase the costs of an IPO by increasing the risk premium, and therefore the IPO firm’s cost of capital. Examining whether the JOBS Act is associated with an increase in information uncertainty for IPO firms with EGC status provides insight as to whether the critics’ claims have merit.

To qualify for EGC status, an IPO firm must have less than $1 billion in annual revenue in the year prior to its IPO. This revenue threshold is sufficiently high that there are few firms without EGC status after the JOBS Act. Therefore, to address our research question, we compare information uncertainty in IPO firms with EGC status to that in IPO firms that would have qualified for EGC status had their IPO occurred after the JOBS Act, i.e., firms that meet the $1 billion revenue threshold but had IPOs before the JOBS Act. Because all firms in our tests meet the JOBS Act’s $1 billion revenue threshold, selection based on that threshold cannot account for any differences in information uncertainty we observe between the two groups of firms.

We test for differences in information uncertainty using linear regression and propensity score matching. Following prior research, we measure information uncertainty using IPO underpricing and post-IPO equity return volatility. We employ three measures of underpricing: market-adjusted stock returns from the offer price to the closing price on the day of the IPO, from the offer price to the closing price on the day after the IPO, and from the offer price to the closing price thirty days after the IPO. We find that all three measures of underpricing are larger for IPO firms with EGC status. We employ three measures of post-IPO volatility: total volatility, idiosyncratic volatility, and beta, all of which are estimated over the thirty days after the IPO. We find that total volatility and idiosyncratic volatility are significantly higher for IPO firms with EGC status, but no evidence of a difference in beta. These findings are consistent with IPO firms with EGC status having greater information uncertainty at the time of their IPOs and that the greater information uncertainty pertains primarily to idiosyncratic information.

We use two approaches to test for whether variation in the extent to which IPO firms with EGC status apply provisions of the JOBS Act explains the larger IPO underpricing and higher post-IPO volatility. There is substantial variation in the number of IPO firms with EGC status that elect to apply each provision. For example, whereas 87% omit a compensation discussion and analysis, only 43% present fewer than three years of audited financial statements. Finding that specific provisions of the Act are associated with differences in IPO underpricing and post-IPO volatility between the two groups of firms increases our confidence that the differences are attributable to the JOBS Act.

In our first approach, we construct an index based on the number of provisions that each IPO firm with EGC status applies. We find that the index explains the larger underpricing and higher total and idiosyncratic volatility for IPO firms with EGC status, and that simply having an IPO after the JOBS Act does not. In our second approach, we examine the relation between application of specific provisions of the Act and underpricing and volatility. We find that several individual provisions, most notably confidentially filing draft registration statements, presenting compensation information for fewer than five top executives, and presenting fewer than three years of audited financial statements incrementally explains the larger IPO underpricing and higher volatility for IPO firms with EGC status. Collectively, these findings increase our confidence that the greater information uncertainty in IPO firms with EGC status is attributable to the JOBS Act.

The full paper is available for download here.

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