Disclosure, Firm Growth, and the JOBS Act

Financing investment in future growth is an important motivation for firms to go public (Brau and Fawcett, 2006; Ritter and Welch, 2002). Newly public firms fund investments mainly through public equity (Choe, Masulis and Nanda, 1993; Lowry, 2003), and facilitate growth by building new capacity through capital expenditure (capex) and innovation (Asker, Farre-Mensa and Ljungqvist, 2015; Brown, Fazzari and Petersen, 2009), as well as by acquiring the assets of other firms (Aslan and Kumar, 2011; Brau, Francis and Kohers, 2003).

There is a longstanding policy debate on whether lowering the disclosure burden on public firms through regulation can facilitate such investments without inducing short-termist pressures on managers. Supporters of lower disclosure claim that the administrative burden of reporting diverts managers from capital investment and innovation, and discourages them from raising public equity (IPO Task Force, 2011) . Opponents, on the other hand, claim that reduced disclosure limits investors’ ability to monitor managers and provides incomplete information about managerial risk-taking and the long-term value of their investment decisions. These arguments raise an important question: does reducing the disclosure burden on public firms increase information asymmetries, meaning reduced accountability and shareholder value, or does it incentivize managers to focus on company-building and growth?

Our recent paper titled ‘Disclosure, Firm Growth, and the JOBS Act’ investigates this question  by studying the effects of regulatory disclosure requirements on the financing, investment, and growth opportunities of a subset of public firms that were previously exempt from such obligations under the Jumpstart Our Business Startups (JOBS) Act. Our main finding is that exempt firms invest more in physical assets, innovation, and acquisitions than firms which have lost their exemptions, but experience steeper declines in growth opportunities over time. Among firms no longer exempt, we find a more positive relation between equity raising and investment, and a shift towards more efficient utilization of existing assets, which lead to a strong sustenance of their growth opportunities. Our findings highlight a previously unrecognized outcome of the JOBS Act, and suggest that, by giving firms the flexibility to select their optimal level of disclosure, the Act is leading them to grow their assets but not to add value.

The JOBS Act was signed into law on April 5, 2012 to ease the regulatory disclosure burden on firms going public by creating a new issuer category named ‘Emerging Growth Company’ (EGC). EGCs are newly public firms that benefit from certain exemptions post-IPO, including reduced disclosure requirements while raising public equity, as well as waivers on auditor attestation and disclosure of executive pay. Under Title I of the Act, these exemptions can last for up to five years as long as the EGC’s float (market value of traded equity) is below $700 million.  

We investigate the effects of financing and investment decisions on the growth opportunities of EGCs before and after they lose disclosure exemptions under the JOBS Act. Our analysis exploits the fact that an EGC will cease to remain exempt during the first five years if its float exceeds $700 million on the last day of the most recent second fiscal quarter. EGCs that remain below this threshold continue to remain exempt whereas those that cross it (and become ExEGCs) become subject to full disclosure under securities laws. This design provides a quasi-natural experiment in which disclosure requirements intensify for a subset of public firms that were previously exempt from them.

We find that EGCs that lose disclosure exemptions tilt their capital raising towards debt rather than equity. The fact that equity raising is less preferred under stricter disclosure is consistent with EGCs preferring the Act’s disclosure exemptions despite the associated loss of transparency for investors and higher cost of capital.

We next explore the real effects of disclosure by investigating how it affects investments by EGCs when they lose exemptions. Capital expenditures fall by 19%, R&D expenditure drops by 14%, while acquisitions drop by 18% once an EGC becomes an ExEGC, suggesting that stricter disclosure requirements constrain these firms from pursuing new investments.

We also find equity raising by EGCs to be associated with fewer investments in capex, innovation and employees. This evidence suggests that freedom from disclosure encourages inefficient equity allocation that is also difficult for stock market investors to monitor. As for external investments, we find no association between equity or debt raised by EGCs and their acquisition activity.

If stricter disclosure allows better monitoring and focuses managerial attention on investing efficiently, it follows that a switch to ExEGC status should also provide substantial valuation benefits. To test this hypothesis, we use the Tobin’s q ratio as an ex-ante measure of firm value and growth opportunities. We find that Tobin’s q declines more rapidly over time for EGCs than for ExEGCs. Moreover, the fraction of ExEGCs with a Tobin’s q exceeding their Tobin’s q at IPO is consistently higher than that of EGCs. These suggest that even though EGCs invest more in physical assets, innovation and acquisitions, they are less capable of generating incremental growth opportunities than their fully disclosing peers.

Lastly, we observe that EGCs become more profitable, earn better returns on investment, and are less financially constrained upon transitioning to full disclosure. This evidence suggests that stricter disclosure causes EGC managers to shift focus from pursuing new investments towards improving profitability through the efficient utilization of existing assets.

Overall, our findings suggest that although the JOBS Act has simplified the IPO process and freed up managers from regulatory compliance (Teach, 2014), the resulting loss of information to investors contributes to a lower growth trajectory for EGC firms. These findings highlight that the real benefits of mandatory disclosure, as measured by growth opportunities, outweigh the managerial freedom and cost savings resulting from deburdening regulations like the JOBS Act. Our study also shows that investing under reduced disclosure does not lead firms to exploit growth opportunities or make investments that are considered value-adding by investors.

Anantha Divakaruni is Postdoctoral Fellow at the Department of Economics, University of Bergen.

Howard Jones is an Associate Professor of Finance at Saïd Business School, University of Oxford and a Fellow of Keble College, Oxford.