The JOBS ACT: A New IPO Playing Field for Emerging Growth Companies

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS Act”). The JOBS Act included a number of provisions intended to reduce the costs and risks associated with initial public offerings for “emerging growth companies,” which are generally defined as companies with gross annual revenue of less than $1 billion during their most recently completed fiscal year whose first public offering of common equity securities occurred on or after December 9, 2011.  These provisions make significant changes to the IPO process, IPO registration statement disclosure requirements and post-IPO reporting and other requirements for emerging growth companies by, among other things, permitting:

• emerging growth companies to confidentially submit draft IPO registration statements and subsequent amendments to the SEC for confidential nonpublic review, provided the initial confidential submission and all amendments are publicly filed at least 21 days prior to the IPO “road show”;

• oral and written communications between the emerging growth companies and certain institutional investors before and after filing a registration statement to “test the waters” to determine whether such investors might have an interest in a contemplated securities offering;

• investment banks that are participating or will participate in an offering to publish or distribute a research report about or have analysts make public appearances regarding an emerging growth company that proposes to file a registration statement or is in registration, without having such research report deemed to be a prospectus or an “offer” under the Securities Act;

• investment banks to publish or distribute research reports about or have analysts make public appearances regarding an emerging growth company following the IPO or within any period prior to the expiration of a lock-up agreement between the investment bank and the stockholders of an emerging growth company;

• emerging growth companies to comply with reduced disclosure requirements in IPO registration statements, including two years of required audited financial statements instead of three years, reduced “smaller reporting company” executive compensation disclosures and the ability to delay complying with new or revised accounting standards that do not yet apply to private companies; and

• newly public emerging growth companies to gradually “phase-in” certain post-IPO disclosure and other requirements for as many as five years, including auditor attestations of internal controls under Section 404(b) of the Sarbanes-Oxley Act, say on pay votes, full executive compensation disclosures and compliance with new or revised accounting standards that do not yet apply to private companies. 

All of these changes became effective upon enactment of the JOBS Act without further rule-making by the SEC or other organizations.  The SEC has already published Frequently Asked Questions regarding these provisions of the JOBS Act, which were released on April 16, 2012, and we expect additional clarifying rules and/or guidance from the SEC and FINRA regarding these changes.  We expect companies contemplating an initial public offering, as well as those currently in registration and those that are newly public, to carefully evaluate and discuss with their advisors the alternative process and disclosure requirements now available to emerging growth companies.

This Client Alert discusses the provisions of the JOBS Act and some considerations for emerging growth companies that are planning to file an initial registration statement, are currently in registration or have completed an IPO on or after December 9, 2011.  Additionally, a chart summarizing the changes made by these provisions of the JOBS Act is available here.  Overall, while this new legislation has clearly changed the rules of the game, the real practical impact of these changes remains to be seen.

Emerging Growth Companies

Emerging growth companies are companies with total gross annual revenues of less than $1 billion during their most recently completed fiscal year whose first public offering of common equity securities occurred on or after December 9, 2011.  An issuer will be able to retain its status as an emerging growth company until the earliest of:

• the last day of the fiscal year in which its total gross revenues equaled $1 billion or more;

• the last day of the fiscal year following the fifth anniversary of its first sale of common equity securities pursuant to an effective registration statement;

• the date on which such issuer has, during the previous three-year period, issued more than $1 billion in non-convertible debt; and

• the date on which such issuer is deemed to be a large accelerated filer[1] under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which could occur as early as the end of the company’s first full fiscal year after its IPO.

The IPO Process

Confidential Submission of IPO Registration Statements

Under the JOBS Act, an emerging growth company, prior to its initial public offering date, is now permitted to confidentially submit to the SEC a draft registration statement, as well as subsequent amendments, for confidential nonpublic review by the staff of the SEC, provided the initial confidential submission and all amendments are publicly filed no later than 21 days prior to the date on which the company conducts a road show (as defined in Rule 433(h)(4) under the Securities Act).[2]  Prior to the JOBS Act, confidential submissions were not permitted for companies other than foreign private issuers and, following a change in SEC policy in December 2011, even foreign private issuers were only permitted to make confidential submissions in limited circumstances. This change is significant in that it permits emerging growth companies to begin the IPO registration process without making public their intention to do so and disclosing all of the sensitive business information required to be included in registration statements. 

The SEC has provided guidance regarding the form of these confidential submissions as well as initial instructions describing how to make a confidential submission and how an issuer should identify itself as an “emerging growth company” in that submission.  The SEC has also confirmed that no registration fee will be due in connection with a confidential submission and the submission is not required to be signed or include the consent of auditors and other experts (although a signed audit opinion must be included).  The SEC also noted that confidential submissions of draft registration statements will not be deemed by the SEC to be a public filing or filed for purposes of Section 5 of the Securities Act. As a result, a company utilizing the confidential submission process will continue to be subject to the general prohibition contained in Section 5 on making offers, oral or written, until it has publicly filed its registration statement, unless an exception (such as the “testing the waters” exception described below) exists, and will not be able to utilize Rule 134 under the Securities Act that exempts certain limited written communications regarding an offering from being considered a prospectus. In its initial guidance, the SEC has not suggested that the timing or nature of its review of confidential submissions will differ from the process for publicly filed registration statements, but any differences that emerge in practice may impact the desirability of utilizing this process.

While the JOBS Act establishes a minimum period during which the registration statement and subsequent amendments need to be publicly available, we expect companies and their advisors to think strategically about when to “go public” with the filing.  The initial filing of a registration statement often serves as a catalyst for lawsuits from third parties who may have an outstanding claim or disagreement with issuers, and while these suits are often unpleasant to deal with, the timing often enables the company to revise the registration statement to address the litigation risks so investors are able to absorb this information in advance of marketing.  It remains to be seen whether the 21-day minimum period for public disclosure of the registration statement and subsequent amendments is sufficient to smoke out these potential claims, which may have an adverse impact on marketing if they are made public during the road show or on the stock price if they are made public shortly after the completion of the IPO.  A confidential filing may also reduce the company’s exposure to potential acquirers, many of whom learn about potential targets through its public filings, and it is an open question whether some companies will opt not to make a confidential submission for that reason. 

Testing the Waters

Prior to the JOBS Act, companies and other offering participants were generally prohibited from making (i) oral or written offers in connection with public offerings of securities before filing a registration statement for the offering and (ii) written offers in connection with public offerings of securities other than pursuant to a statutory prospectus, subject to exceptions for free writing prospectuses in certain circumstances and other limited communications. The JOBS Act provides a significant exception to these gun jumping restrictions for emerging growth companies. Under the JOBS Act, emerging growth companies and persons authorized to act on their behalf are permitted to engage in oral or written communications with potential investors that are “qualified institutional buyers” (as defined in Rule 144A of the Securities Act) and institutions that are “accredited investors” (as defined in Rule 501 of Regulation D of the Securities Act) before or after the initial filing of a registration statement in order to determine whether such investors might have an interest in a contemplated securities offering. This change enables an emerging growth company to openly discuss a potential IPO with institutional investors in order to “test the waters” prior to incurring the expense and/or public exposure involved in filing a registration statement.

While the JOBS Act does lift some of the prohibitions on offers contained in the Securities Act, it does not exempt companies or other offering participants from potential liability associated with these offers.  In addition, written communications used to test the waters may end up being treated as free writing prospectuses that companies may be required to publicly file, similar to written communications made by well-known seasoned issuers pursuant to Rule 163 under the Securities Act. As a result, we expect that the form and content of these communications, to the extent they are utilized, will be carefully reviewed and the use of written communications may be more limited.

At this point, there are more questions than answers as to whether, how and when “testing the waters” communications will be used in the IPO process, including whether the risks associated with potentially premature communications with institutional investors will outweigh potential benefits of testing the waters and whether institutional investors will be receptive to participating in these meetings and providing meaningful feedback without being presented with a live offering opportunity. Until a more consistent practice emerges, we expect offering participants will consider the potential risks and benefits of engaging in these types of communications on a case-by-case basis.

Research Reports and Public Appearances by Research Analysts

The JOBS Act eliminated some of the limitations on offering participants issuing a research report or making a public appearance regarding an emerging growth company in connection with its IPO. In particular, the JOBS Act provides that the publication or distribution of a research report by a broker or dealer about an emerging growth company that is the subject of a proposed public offering of its common equity securities will not constitute a prospectus or an offer for purposes of the gun jumping restrictions under Section 5 of the Securities Act or the liability provisions of Section 12 of the Securities Act, even if the broker or dealer is participating in the offering.  This provision of the JOBS Act effectively extends the safe harbor set forth in Rule 139 of the Securities Act, which only applies to public offerings by companies eligible to use Form S-3 for unlimited primary offerings and in certain other limited circumstances, to public offerings of common equity securities by emerging growth companies.

In addition, the JOBS Act provides that neither the SEC nor any national securities association registered under Section 15A of the Exchange Act, which includes FINRA, could adopt or maintain any rule or regulation prohibiting any broker, dealer or member from publishing or distributing any research report or making a public appearance with respect to the securities of an emerging growth company either (i) within any prescribed period of time following the initial public offering date of the emerging growth company or (ii) within any prescribed period of time prior to the expiration of any lock-up agreement after the initial public offering date. This provision of the JOBS Act appears to be targeted at eliminating the applicability of NASD Rule 2711(f) in the context of IPOs of emerging growth companies. NASD Rule 2711(f), among other things, generally prohibits the managers and co-managers of a company’s IPO from publishing or distributing research reports or making a public appearance regarding the company for 40 days after the completion of the offering and for 15 days prior to and after the expiration, waiver or termination of a lock-up agreement. However, whether intentionally or not, the JOBS Act would not explicitly prohibit the SEC or FINRA from adopting or maintaining a rule prohibiting research reports and public appearances prior to the initial public offering date of an emerging growth company or within any period of time after the expiration of a lock-up agreement.  The JOBS Act also does not specifically address NASD Rule 2711(c), which prohibits an underwriter’s research analysts from participating in a road show for an offering in which the underwriter is participating.

It remains to be seen how much these changes will impact practice with respect to the publication of research reports and making of public appearances in connection with IPOs of emerging growth companies, and we expect any change in underwriters’ policies to be undertaken only after careful consideration. 

Separation of Research Analysts and Investment Bankers

The JOBS Act provides that in connection with the initial public offering of the common equity of an emerging growth company (i) SEC and FINRA regulations may not restrict investment bankers from arranging for communications between research analysts and potential investors evaluating an investment banking transaction and (ii) SEC and FINRA regulations may not restrict research analysts from participating in communications with the management team of an emerging growth company that is also attended by investment banking personnel. Other than this relatively modest change, the JOBS Act did not modify the extensive regulations designed to prevent conflicts of interest between research analysts and investment banking personnel. In addition, these provisions of the JOBS Act did not alter the specific obligations of the firms subject to the Global Research Analyst Settlement of 2003 regarding the separation of research analysts and investment banking personnel.

IPO Registration Statement Disclosure Requirements

Required Financial Information

Prior to the passage of the JOBS Act, companies seeking to go public were generally required to include in their registration statements three years of audited financial statements, five years of selected financial information, unaudited interim financial statements, if applicable, and an MD&A section discussing, among other things, the company’s financial condition and results during the periods covered by the audited and unaudited interim financial statements that were included.  The JOBS Act permits emerging growth companies to file IPO registration statements that only include two years of audited financial statements and selected financial data in addition to any required unaudited interim financial statements, with a correspondingly reduced MD&A section.[3]

While some companies will likely take advantage of the ability to only provide two years of financial information, particularly newly formed companies and companies in the early stages of development for whom prior periods are not particularly relevant to an investment decision (as is often the case for life sciences or clean tech companies), other companies may voluntarily disclose more than the required two years of financial information, particularly if the prior periods are material to an understanding of the company’s financial condition or help to illustrate trends that bolster the marketing story of the company.  We expect, at least initially, practice on this issue to vary based on the company’s particular situation.

Executive Compensation Disclosures

Under the JOBS Act, emerging growth companies will now be eligible to take advantage of the scaled executive compensation disclosure that previously was available only to smaller reporting companies.  As a result, emerging growth companies will now be able to, among other things:

• generally provide executive compensation disclosure for only three named executive officers (the principal executive officer and two other most highly paid executive officers), as opposed to five named executive officers;

• omit the Compensation Discussion & Analysis section;

• provide only two of the six required tables (the summary compensation table and the outstanding equity awards at fiscal year end table); and

• omit the quantification of potential termination and change of control benefits disclosure for the named executive officers.

In addition, under the JOBS Act, emerging growth companies will be excluded from the rules that the SEC is required to adopt under the Dodd-Frank Act requiring public companies to disclose (i) the ratio comparing the median of total annual compensation for employees to the total annual compensation of the CEO  and (ii) the relationship between executive compensation the company paid to named executive officers and the company’s financial performance. The SEC has not yet proposed these rules under the Dodd-Frank Act, but is currently scheduled to do so by June 2012 according to its most recently published implementation timetable.

We suspect that many companies will take advantage of most of these reduced executive compensation disclosure requirements because of the burdensome nature of many of the previously required disclosures and the inherent sensitivities to public disclosure of executive compensation generally.

Compliance with New or Revised Financial Accounting Standards

The JOBS Act provides that emerging growth companies will not be required to comply with any new or revised financial accounting standards until those standards are also broadly applicable to private non-reporting companies, if they apply to such companies.  However, emerging growth companies will be prohibited from choosing to apply some new or revised accounting standards and not others, but instead must opt in or out on a consistent basis (although presumably if one or more private company standards permitted early adoption of the public company standard, it would still be permissible for an emerging growth company following private company standards generally to elect early adoption of such standards).  In addition, emerging growth companies will have their audits exempt from any PCAOB rules requiring mandatory audit firm rotation or an auditor discussion and analysis, as well as all other future PCAOB rules unless the SEC determines the application of such other rules is necessary or appropriate in the public interest after considering the protection of investors and whether the action will promote efficiency, competition and capital formation.

Whether emerging growth companies will choose in practice to delay implementation of accounting standards that are applicable to their public peers remains to be seen. We expect that some companies in the early stages of development that are not yet generating appreciable revenues (as can be the case for life sciences or clean tech companies) may more seriously consider delaying implementation of new or revised financial accounting standards. Conversely, we expect there will be greater pressure on IPO companies with more meaningful historical and ongoing results of operations to present their financial statements in a manner that is consistent with their public peers. 

Phase-In of Post-IPO Reporting and Other Requirements

In addition to making the IPO process and registration statement less burdensome for emerging growth companies, the JOBS Act also provides continuing relief for these companies once they have completed their IPOs. The JOBS Act delays the applicability of certain disclosure and other requirements for emerging growth companies for as long as they continue to be emerging growth companies. This phase-in for emerging growth companies affects four principal areas:[4]

• say on pay votes enacted under the Dodd-Frank Act;

• executive compensation disclosures;

• financial reporting and auditing requirements; and

• the independent auditor attestation of management’s assessment of the effectiveness of internal control over financial reporting required by 404(b) of the Sarbanes-Oxley Act.

In addition, emerging growth companies remain eligible to take advantage of certain of the offering-related provisions of the JOBS Act in connection with follow-on public offerings after their IPOs.

Say on Pay Votes

Prior to the JOBS Act, all public companies completing their IPOs were required to (i) provide their shareholders with the opportunity to vote on the company’s executive compensation at its first annual meeting post-IPO and at least once every three calendar years thereafter (commonly referred to as a “say-on-pay” vote); (ii) provide a separate shareholder vote at its first annual meeting post-IPO and at least once every six calendar years thereafter to determine the frequency of say-on-pay votes (commonly referred to as a “say-on-pay frequency” vote); and (iii) provide a separate shareholder vote on certain golden parachute arrangements in proxy statements for meetings at which shareholders are being asked to approve a merger or similar transaction (commonly referred to as a “say-on-golden-parachute-pay” vote).  Each of the foregoing votes is advisory in nature and therefore non-binding on the company. 

The JOBS Act provides that for as long as a company qualifies as an emerging growth company, that company will be exempt from “say-on-pay” votes, “say-on-pay frequency” votes and “say-on-golden-parachute-pay” votes.  Once a company no longer qualifies as an emerging growth company, it must (i) include a “say-on-pay” vote within one year of ceasing to be an emerging growth company, unless the company was an emerging growth company for less than two years after its first sale of common equity securities pursuant to an effective registration statement, in which case, it must include a “say-on-pay” vote within three years after the date of such sale and (ii) include a “say-on-pay frequency” vote at its first annual meeting thereafter.  Notwithstanding this exemption, emerging growth companies may choose to voluntarily provide shareholders with a “say-on-pay” vote sooner than is required to address investor desires.

Financial Reporting and Auditing Requirements

Under the JOBS Act, emerging growth companies will retain some of the benefits of the reduced financial reporting and auditing requirements applicable to their IPO registration statements, as described above. In particular, emerging growth companies:

• will not be required to provide selected financial data in their annual reports for any period prior to the earliest audited period presented in connection with their first registration statement under the Securities Act or the Exchange Act that became effective;
• will not be required to comply with any new or revised financial accounting standards in periodic and other reports under the Exchange Act until those standards are also broadly applicable to private non-reporting companies, if they apply to such companies; and
• will have their audits exempt from any PCAOB rules requiring mandatory audit firm rotation or an auditor discussion and analysis, as well as all other future PCAOB rules unless the SEC determines the application of such other rules is necessary or appropriate in the public interest after considering the protection of investors and whether the action will promote efficiency, competition and capital formation.

An emerging growth company will be required to provide three years of audited financial statements in its annual reports unless it qualifies as a smaller reporting company.

Executive Compensation Disclosures

Under the JOBS Act, emerging growth companies will continue to be able to take advantage of the scaled disclosure requirements available to smaller reporting companies with respect to executive compensation disclosures, as described above, in future registration statements, proxy statements and annual reports for as long as they continue to be emerging growth companies.

Exemption from Section 404(b) of the Sarbanes-Oxley Act

Under the JOBS Act, emerging growth companies are exempt from Section 404(b) of the Sarbanes-Oxley Act, which generally requires public companies to provide an independent auditor attestation of management’s assessment of the effectiveness of their internal control over financial reporting.  Prior to the JOBS Act, all newly public companies were able to delay compliance with this requirement until their second annual report filed with the SEC, and public companies that qualified as non-accelerated filers (i.e., generally, those companies with less than $75 million of non-affiliate common equity market capitalization) were exempt. Emerging growth companies, like non-accelerated filers, will still be required to maintain internal control over financial reporting and assess the effectiveness of their internal controls on an annual basis. For affected companies, this is likely a welcome change that reduces the cost and time required for an outside audit.

Follow-On Public Offerings

Some, but not all, of the changes made by the JOBS Act that are applicable to IPOs by emerging growth companies will also apply to follow-on public offerings by these companies. In particular, for follow-on public offerings by emerging growth companies:

• confidential submissions of draft registration statements to the SEC for confidential nonpublic review will not be permitted for follow-on public offerings;
• oral and written communications to “test the waters” will be permitted to the same extent as they are in connection with an IPO;
• the provision of the JOBS Act that effectively extends the safe harbor set forth in Rule 139 of the Securities Act will also apply to follow-on public offerings of common equity securities, but will not apply to public offerings of other types of securities;
• the provision of the JOBS Act that appears to be targeted at eliminating the FINRA rule prohibiting public appearances and the distribution of research reports by offering participants after the IPO and prior to expiration of an IPO lock-up agreement does not address rules prohibiting or limiting such activities at or around the time of a follow-on public offering or expiration of a lock-up agreement for a follow-on public offering;
• the provision of the JOBS Act slightly loosening the separation of research analysts and investment banking personnel will not apply in connection with follow-on public offerings; and
• the same reduced disclosure requirements will generally apply to registration statements for follow-on public offerings, provided that audited financial statements and selected financial data will be required for the same periods as they are for non-emerging growth companies, except that these financial statements and data are not required to be provided by an emerging growth company for any period prior to the earliest audited period presented in the registration statement for its IPO.[5]

Overall, we expect the impact of these provisions on follow-on public offerings to be less significant than the impact on IPOs, but we do expect them to have an impact in some situations.

Review of Regulation S-K

In addition to the changes outlined above, the JOBS Act also requires the SEC to conduct a review of Regulation S-K (which contains disclosure rules applicable to both offerings under the Securities Act and periodic reporting under the Exchange Act) and to report to Congress within 180 days following the enactment of the JOBS Act with rule-making proposals to modernize and simplify the registration process and reduce the costs and other burdens of these rules for emerging growth companies.  This report, as well as additional SEC rulemaking and guidance relating to the matters described above, may result in further changes to the IPO process. 

* * * * *

Overall, while this new legislation has clearly changed the rules of the game, the real practical impact of these changes remains to be seen as market practice develops.

Summary of Changes

The IPO Basics chart attached here summarizes the provisions intended to reduce the costs and risks associated with initial public offerings for emerging growth companies. It includes a comparison to pre-JOBS Act in order to highlight key changes.

Please note that this Client Alert does not necessarily describe the specific impact of the provisions of the JOBS Act summarized above on voluntary filers, foreign private issuers, smaller reporting companies, asset-backed issuers, registered investment companies and others subject to unique requirements.