On September 5, 2017, the U.S. House of Representatives overwhelmingly approved a bill that would allow already-public reporting companies to use the provisions of so-called Regulation A+ to make securities offerings. Regulation A+ in its current form is, in essence, a mini-IPO, allowing private companies to raise up to $50 million, offerings that are too small to attract the interest of large investment banks who underwrite traditional registered IPOs. If the current bill is enacted, public companies could take advantage of this process, which involves somewhat less disclosure than required for a full Form S-1 registration statement.
William D. Cohan, writing in the New York Times’ DealBook, characterizes the third-party valuations of private companies under Section 409A of the Internal Revenue Code as Silicon Valley’s “dirty little secret” and a “shell game.” Especially in the aftermath of the financial crisis, there has been plenty of populist rhetoric about practices in the business world, and much of that criticism has had basis in fact, but this take on 409A valuations seems awfully strained.
As described in Cohan’s article, Section 409A and the related rules require that companies obtain independent valuations in connection with their issuance of equity-based awards to employees, and failure to comply results in tax penalties. Cohan details the fact that various service providers charge significant fees to undertake these valuations, using words like “supposed” experts to make the whole enterprise seem like a racket, but the reality is that the rules do exist, and these valuations have to be done. If it was possible for just anyone to make up a valuation for a bargain-basement fee, heck, I would consider doing it as a side gig from my legal work. But the rules actually go into detail as to the required qualifications for firms providing these services. Cohan notes in the article that the SEC would not comment on these practices, but this is really more of an issue of tax law than securities law. What constrains companies and their hired valuation help from simply making up numbers out of thin air is the fact that their decisions are subject to later IRS scrutiny and sanctions.
Felix Salmon argues, convincingly in my view, in favor of Spotify’s reported plan to go public by direct listing, not a traditional IPO. A little background, for those unfamiliar with the term: The usual way to go public is via an initial public offering of shares, where the company creates new shares in addition to the ones in existence, sells them to the public through an underwriter, and all old and new shares are thereafter publicly traded on an exchange. However, it’s not always the case that the company actually needs the new capital it ends up raising by selling new shares. Direct listing skips this step; instead, the company just flips a switch and becomes public. (Of course it’s more complicated than literally flipping a switch – you hire, well, me to help you through the process. But it’s certainly simpler than having to market and complete a new offering of stock as part of it.)
The Financial Samurai personal finance blog posted an argument against angel investing, based in part on the writer’s own experience with a seemingly successful investment that really wasn’t so great, upon reflection. Toward the end of the post, the author says that if you do angel investing, you should devote no more than 5-10% of your funds towards it, and don’t expect anything good to come of it. But who is really advocating for devoting half or more of your nest egg to illiquid, speculative investments, even if you have a lot of financial leeway? There are legitimate reasons for wealthy individuals to want to participate in angel investing, like the satisfaction of helping a founder with a promising idea to realize a dream. As long as these investors aren’t blowing their whole fortune on it, what is the harm?
The SEC’s Division of Economic and Risk Analysis (DERA) recently issued a paper about over-the-counter stocks, i.e., stocks of publicly traded companies that are not listed on a national securities exchange like the New York Stock Exchange or Nasdaq. While the main subject of the paper is on the inadvisability of individual investors purchasing OTC stocks, my focus here, briefly addressed in the paper, is on whether the companies themselves should consider transactions that result in them having OTC stock. For example, companies that are not in a position to complete a traditional IPO may be able to go public via a backdoor method such as merger with a SPAC or a reverse merger.
For these companies, the usual plan is not to remain an OTC company forever, with thinly traded stock and low institutional ownership. Rather, the hope is that, with the capital usually raised concurrently with the transaction that made the company public, it can successfully execute its business plan such that it can meet the listing standards for admission on the NYSE or Nasdaq at a later date. However, this scenario rarely plays out in practice. Studies cited in the DERA paper find that, over a nine-year period, less than 9% of OTC companies became listed on an exchange, and even those that do have a poor average investment return.
Accordingly, any company planning to go public by alternative means has to consider the possibility of remaining in OTC status indefinitely. There are some advantages to being public. It may be easier to attract employees with equity compensation packages, since there is an easier path to eventually selling shares than would be the case with a private company. Also, public company stock can be used to acquire other companies (though a target company may be skeptical about receiving OTC stock). Finally, there are forms of financing like PIPEs that are available only to public companies (though the terms of those transactions are not necessarily any more company-favorable than investments that private companies can secure). [Read more…]