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E-MailJames J. Park is Professor of Law at UCLA School of Law. This post is based on his recent paper, forthcoming in the Harvard Business Law Review.
In this age of entrepreneurship, emerging companies have created trillions of dollars in new market value. Remarkably, many of the most promising ventures have gone public without an extensive history of profitability. Indeed, many are losing significant amounts as they command valuations once reserved for blue chip corporate giants with decades of substantial profits. The undeniable success of companies like Amazon, Google and Facebook has created a template for new ventures that are able to sell shares at prices that anticipate the possibility of future wealth. Investors, mostly institutions, have reaped billions of dollars in gains as emerging companies have gone public.
The investor protection policy of federal securities regulation faces new challenges in this climate. The longstanding model where companies are only permitted to sell stock to the public after generating several years of profits and surviving scrutiny from an independent underwriter is under pressure. Rather than protecting investors, securities law seems like a barrier that delays access to promising investments. The SEC has defined investor protection so vaguely that its goals are unclear. It has no theory that explains why investors are permitted to take on some risks but not others.
This paper sets forth a conception of investor protection that better articulates the role of the securities laws in this new period of entrepreneurship. It argues that an important function of securities regulation is to distinguish between risk and uncertainty. As famously defined by the University of Chicago economist Frank Knight, a risk can be estimated and quantified while an uncertainty is not subject to meaningful estimation. Put another way, a “risk” is a “measurable uncertainty” that should be distinguished from “uncertainty” that is “immeasurable.”
Knight’s distinction between established corporations and entrepreneurial ventures maps onto the traditional securities regulation framework. By mandating that companies issue disclosure before selling securities to the public, the securities laws essentially limit public investment to those companies that are able to publish meaningful risk profiles that investors can adequately assess in valuing their stock. In contrast, only sophisticated investors are permitted to evaluate the securities of private companies that are shrouded in Knightian Uncertainty.
The underwriter plays an important role in the transition from the uncertainty of the entrepreneurial stage to public company status. Its most important function is to verify that a company’s future prospects can be evaluated with some certainty. The underwriter evaluates the company’s projections of future profitability and assesses their reasonableness based on its own knowledge, due diligence, and discussion with investors. Based on its own projections, it generates an initial public offering (IPO) price for the stock. The underwriter’s clients will purchase stock at that price, creating an incentive for the underwriter to calculate a more conservative valuation than would the issuer. Ideally, the IPO price reflects the Knightian Risk of investing in the IPO. While investors may be willing to take on uncertainty by paying more than that price, the IPO price serves as an important reference point that distinguishes investing from speculation.
Traditionally, emerging companies have been viewed as difficult to value because their prospects are uncertain. Because they have little or no record of profitability, entrepreneurial valuation is based largely on speculation about a company’s future performance. But the success of emerging companies over the last two decades, particularly in the internet and social network sectors, has provided a basis for investors to view their investments in private companies as involving Knightian Risk. The past precedent of successful companies serves as a basis for projecting the future performance of similar companies. Valuations in private markets, which have become increasingly sophisticated, can serve as a starting point for generating credible valuations in public markets.
The success of entrepreneurial companies has complicated the distinction between risk and uncertainty. This new age of entrepreneurship is particularly challenging because it has spurred high valuations that are speculative but not entirely irrational. Past successes may convince investors they are taking on risk when investing in companies that have not yet generated profits. If a significant percentage of entrepreneurial companies have succeeded, investors may believe that they can assess the probability that new entrepreneurial companies will create value. There is thus a stronger case that a wider range of investors should take on the risk of buying stock in emerging companies.
There has thus been a persistent push to alternatives to the highly regulated initial public offering. Emerging companies now routinely go public with an abbreviated financial history and receive initial leniency from some of the federal obligations expected of public companies. The SEC has made it easier for private companies to raise funds from investors without registration. Regulators have also permitted companies to go public through vehicles such as Special Purpose Acquisition Companies (SPACs) and direct listings, which do not use a traditional underwriter with an incentive to generate a conservative valuation. Initial Coin Offerings for a time raised billions of dollars in funds through the sale of digital tokens to fund new ventures.
The SEC has been left flat footed in addressing the modern blurring of risk and uncertainty. It stood by while market participants innovated around the protections of the securities laws. For example, in permitting the wider use of SPACs and direct listings, it has failed to appreciate the essential role of the underwriter in establishing a valuation based on risk rather than uncertainty. It has thus permitted wide public investment in ventures without sufficient investor protection.
The paper concludes by suggesting ways in which the SEC can address the Knightian Uncertainty of investments in emerging companies. The Knightian framework highlights that the key issue in protecting investors is the reliability of a company’s future performance. As the underwriter’s role has declined, public investors are increasingly accessing investments without an independent evaluation of the company’s projections. The SEC should thus mandate disclosure of financial projections along with the basis for those projections when they access public capital without an underwriter. By providing investors with additional disclosure about the projections of companies that access funds from a wide range of investors, securities regulation can better protect investors from Knightian Uncertainty.
The complete paper is available for download here.
