How Do Small Issuers React to Innovation in Securities Offering Methods?

In 2015 the U.S. Securities and Exchange Commission adopted amendments that significantly expanded Regulation A, a previously little used provision that allows companies to conduct small public securities offerings without having to comply with all the requirements applicable to traditional registered public offerings (referred to as “Regulation A public offerings” below). The amendments implemented JOBS Act Title IV and included raising the annual offering limit from $5 million to $50 million as well as other changes. This regulatory shock had the potential to expand the financing options available to small growth companies. Previously, the main alternatives to a securities offering of this size were a private placement or a small registered securities offering on the over-the-counter (OTC) market or potentially a small-cap exchange tier (“small registered public offering” below). The legal structure of Regulation A combines many of the features of a registered public offering with those of private placements. Yet Regulation A offerings are different in important ways. Compliance costs are lower than in traditional public securities offerings, making Regulation A offerings more easily available to small companies. But a stock exchange listing is more difficult to obtain, underwriter involvement is limited, best efforts offerings are prevalent, and liquidity is low. As a result, Regulation A offerings may attract a distinct pool of small companies.

The working paper “Financial Innovation in Microcap Public Offerings” examines the use of this public offering method by small growth companies unable to access traditional public markets. The findings relate to the recent policy debate about ways of expanding access to capital for small and growth companies.

Regulation A offerings, particularly Tier 2 offerings, share certain similarities with small registered initial public offerings (IPOs), including the participation of retail investors and the filing of offering materials and certain disclosures for review with the SEC. However, traditional IPOs usually involve larger and more established companies, underwriters, and relatively high costs of compliance and underwriting. Regulation A offerings generally have fewer disclosure requirements and are more likely to be conducted as direct public offerings without underwriters. Regulation A offerings also share certain similarities with private placements. They are exempt from federal securities registration, usually lack a secondary market, involve issuers that disclose less information than reporting companies do, and are associated with limited participation of investment banks. Similar to companies that receive venture capital (VC) financing, Regulation A companies may be small, at an early stage of development, unprofitable, and have more growth opportunities than assets. In contrast to private placements and VC financing, the investor base in Regulation A offerings mostly consists of retail investors, who are less likely to monitor issuers or gather information about issuers compared with VCs or large private investors.

The analysis reveals pronounced differences between the types of issuers that undertake Regulation A versus small OTC or small cap tier exchange-listed registered offerings. Regulation A issuers are typically smaller and in an earlier stage of development, and they are more likely to be first-time issuers and financial companies. Regulation A issuers are also more likely to be early-stage companies that have high external financing needs and limited collateral or assets. Compared with smaller reporting companies, Regulation A issuers tend to disclose less information to investors and typically lack third-party certification of their quality. As a result, Regulation A issuers realize lower offering proceeds. Since they are in relatively earlier stages of development, their historical financials carry less weight. Regulation A offerings are closer to OTC direct public offerings in their use of a best-efforts, self-underwritten strategy. Thus, while Regulation A issuers make larger offerings, they typically raise fewer proceeds than comparable issuers in small registered offerings.

The analysis also identifies a pecking order, from Regulation A Tier 1 to Regulation A Tier 2, registered OTC offerings, and registered small cap tier exchange-listed offerings. Compared with Tier 1 offerings, companies in Tier 2 offerings tend to be larger, seek and raise more financing, and rely more on intermediaries. There is some evidence of continuity between historical use of Regulation A before the 2015 amendments and the use of Tier 1 after the amendments, which is consistent with the similarities of legal requirements of the two, as well as evidence of a positive relation between private placements and the use of Tier 2 of Regulation A.

The paper also examines aggregate effects of the amendments on the use of Regulation A and the relation between traditional financing methods and the use of Regulation A for small offerings. The tests in the paper exploit geographic variation in the use of traditional financing methods and Regulation A around the adoption of the amendments. The results point to increased use of Regulation A after the amendments as well as to a positive relation between private financing and Regulation A use after the amendments. At the local area level, small registered offering activity is positively associated with Regulation A activity, consistent with potential spillovers across companies and with these offering methods drawing different types of issuers.

This post comes to us from Anzhela Knyazeva, a senior financial economist in the Division of Economic and Risk Analysis at the Securities and Exchange Commission. It is based on her recent working paper, “Financial Innovation in Microcap Public Offerings” available here. The SEC disclaims responsibility for any private publication or statement of any SEC employee or commissioner. This post expresses the author’s views and does not necessarily reflect those of the commission, the commissioners, or other members of the SEC staff.

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