By Alixe Cormick
Today, private markets play a bigger role than the public markets in developing high growth companies. The ability to raise capital with any and all potential investors used to be reserved for public companies only. This is no longer true. Recent regulations enacted by securities regulators in Canada and the United States are about to further accelerate the blurring of the differences between a public versus a private companies.
Private companies now have access to the same investors as public companies under new securities exemptions. Certain disclosure is required to use this disclosure is far less stringent than that required in a public company registration statement. These exemptions also introduce ongoing reporting obligations on private companies raising capital imposing a parity of information between public and private company ongoing disclosure. This article discusses the significance of these changes to our capital markets.
Decline in Public Company Listings
Public company listings have declined significantly in North America over the last twenty years. Private capital markets have taken on a greater role in capitalizing early to later stage development companies.
Some of the commonly communicated advantages often cited for a company to go public are: greater access to capital to fund growth; higher market valuation, creation of liquidity and potential exit for current stockholders, enhancement of the company’s public profile to partners, suppliers and clients, ability to use stock to motivate employees and acquire target companies, and greater financial transparency enhancing equity and debt financing terms.
Despite these perceived advantages, recent newspaper and magazine articles, research papers, and industry professionals have all called attention to the fact fewer companies are going public in North America. This is not just a loss of initial public offerings (IPOs) but also fewer going public transactions through reverse mergers and qualifying transactions with capital pool corporations.
There is disagreement as to why this is happening. Some university researchers believe this is a structural market change similar to the disappearance of the family farm in favour of corporate agriculture. Smaller companies just don’t deliver the returns investors expect of public companies. Other university researchers suggest that private companies are replacing public companies in North America because private companies are more efficient. The capital companies need to advance their business can be raised faster and more cost effectively in the private markets.
Research associates from the Kauffman Foundation suggest mutual funds, exchange traded funds (ETFs) and low transaction-cost computerized markets (ATS) are the blame for fewer companies listing. It is their view that mutual funds and ETFs have damaged the role of stock exchanges and ‘going public’ used to play for small high growth companies. ATSs in turn have fragmented the market and pulled profit away from market makers and investors eliminating a level playing field. In their opinion these changes have had, and will continue to have, a high cost to investors and our economy.
Industry professionals and exchanges like the TMX Group point to protracted difficult market conditions for public companies and onerous regulations. The CBOE’s Volatility Index (VIX) has long been correlated with a healthy going public market (80% of IPOs occur when the VIX is under 20). The VIX was blamed by many industry commentators for a complete shut-out of IPOs in the United States in January of 2016. Over regulation in Canada and the United States, has made being a public company costly and undesirable, outweighing any of the perceived benefits of being public.
Growth in Private Markets
Many of the advantages of being a public company have arguably been taken over by technology. Companies can leverage their name recognition and enhance their public profile using social media and a myriad of other outlets on the internet. Private deal rooms can be created online to ensure potential investors have access to current information about the company in print, video, and real time question and answer conference calls. Investors can be located anywhere in the world increasing the pool of potential investors substantially.
Valuations of private tech, biotech and industrial companies have grown as non-traditional investors and foreign investors seek out returns in a low-yield environment. Being a public company is no longer a requirement for a high market valuation. CB Insights has identified 166 private tech companies valued at over $1 billion USD. Two Canadian companies made this list: Kik Interactive and Hootsuite.
Capital raised in the private placement market is outstripping capital raised in the public markets in Canada and the United States. In the United States it is becoming common to see private tech companies raise over $10 million USD or more in an exempt offering. A handful of these companies have raised over $1 billion USD. Snapchat raised $1.3 billion USD from 120 investors in the private markets over the last twelve months, and in June of this year Uber raised $3.5 billion USD from Saudi Arabia's sovereign wealth fund. In 2015, the National Venture Capital Association tracked 74 deals raising over $100 million each. In Canada, amounts raised are modest in comparison but still substantial. Going public is no longer a requirement for companies to raise significant capital.
At one time only public companies had a large shareholder base. In this new world order it is not uncommon to come across private companies with over 1000 beneficial shareholders. Facebook had 1,180 stockholders of record at the time it filed its prospectus in 2012. Google had 2,107 stockholders of record at the time it went public in 2004. The actual number of beneficial stockholders of Facebook was likely much higher, as the stock traded on both SharesPost and SecondMarket, two private market trading platforms operating in the United States. Companies going public in Canada can have as few as 150 beneficial shareholders. The average number of shareholders of record for a NASDAQ listed company is under 500.
Recent regulatory changes are about to further accelerate the blurring of what it means to be a public versus a private company.
An equity crowdfunding exemption now exists at the federal level in the United States and in every state and seven of the provinces in Canada. Private companies can now offer their securities to any and all potential investors within the borders covered by the crowdfunding exemption they are relying on. There are no minimum wealth requirements or relationship requirements. Instead, there are caps on how much can be raised under the exemption (varying from $500,000 to $5 million), and how much an individual investor can invest ($1,500 to $10,000, unless accredited). Companies cannot advertise or solicit for investors using most of these crowdfunding exemptions. A tombstone statement about the terms of the offering, factual information about the company and its business, and what funding portal is being used, is all the information that can be disclosed.
The equity crowdfunding exemption enacted by the United States Securities and Exchange Commission (SEC) under Title III of the Job’s Act and the equity crowdfunding exemption adopted under Multi-lateral Instrument 45-108 in Canada (the Integrated Crowdfunding Exemption), both impose ongoing disclosure requirements on companies using these exemptions such as filing annual financial statements. The Integrated Crowdfunding Exemption’s ongoing disclosure requirements also include disclosure of use of proceeds, notice of specified events, and regulatory access to certain books and records. The ongoing disclosure period under each exemption varies, with the Integrated Crowdfunding Exemption having fewer opportunities for companies to ever be released from these requirements. These ongoing disclosure requirements are a first in North America for private companies, but not the only exemptions which now contain such requirements.
There are two other exemptions private companies can use to access any and all potential investors. Both of these exemptions allow advertising. You are likely already familiar with one of these exemptions in Canada: the offering memorandum exemption. The offering memorandum exemption requires companies to prepare a disclosure document in the required form and provide audited financial statements. Companies can offer their securities to any and all investors as long as they provide them with a copy of the offering memorandum. In certain provinces there are limits on investment based on wealth and professional advice requirements (investor cap of $10,000 if a non-eligible investor; $30,000 if an eligible investor and $100,000 if suitability advice received). There are no caps on how much can be raised. Ontario adopted a form of the offering memorandum exemption in January of 2016. The Ontario version of the exemption imposes ongoing disclosure requirements identical to those required under the Integrated Crowdfunding Exemption. Alberta, New Brunswick, Nova Scotia, Ontario, Québec and Saskatchewan amended their version of the exemption on April 30, 2016 to substantially conform to the Ontario version of the exemption.
In the United States, the SEC amended Regulation A+ in May of 2015. Regulation A+ is similar to Canada’s offering memorandum exemption except that the Regulation A+ disclosure document is vetted by the SEC before being made available to the public. Under Regulation A+, Canadian and the United States issuers who are not reporting issuers under the Securities and Exchange Act of 1934 can raise up to US $50 million annually. Tier 2 of Regulation A+ provides an exemption from state securities regulation. It also allows ‘testing the waters’ prior to preparing any documentation to see if there is any interest in the securities being offered. Companies using the exemption are not considered a reporting issuer on close of the offering. The securities issued under the exemption are immediately freely tradable in the United States.
Tier 2 of Regulation A+ imposes ongoing disclosure requirements on companies using the exemption. These ongoing disclosure requirements include filing an annual report with audited financial statements; a semi-annual report with unaudited interim financial statements, and a current report on occurrence of specified events. The SEC justifies these ongoing reporting requirements as they satisfy a broker-dealer’s obligations under Rule 15c2-11 to review and maintain records of basic information about an issuer and its securities before trading those securities over the counter. The requirements to file ongoing disclosure ceases one year after the offering if the company has fewer than 300 stockholders of record and sales under the exemption are not ongoing.
Many of the advantages of being a public company are now available to private companies because of technology. The private markets have grown in importance while the public markets have diminished in their role to develop high growth companies. Equity crowdfunding specific exemptions and tweaking of pre-existing exemptions to allow private companies greater access to any and all investors are further blurring the line between what it means to be a public versus a private company.
Ironically, the new exemptions introduced by securities regulators may actually reignite the public markets as more non-accredited investors hold private company stock. It may be the ‘right-sizing’ of regulations and disclosure the small cap markets in North America have been lacking to make being a public company viable again. Going public at an early stage after all has its benefits. A recent research study found graduates from the TSX Venture Exchange outperformed venture capital backed initial public offering on the TSX by 28.2 percentage points in the three years following the TSX listing.
Alternatively, securities regulators may kill the private capital market in a similar fashion to how they contributed to the demise of the small cap public market.
 See: “The Amazing Disappearance of the Canadian Public Company” in the Financial Post, and “Yes, But Why are there so Many Fewer Publically Traded Companies?” The D&O Diary.
 See: “Where have all the IPOs Gone? Published by SEC Advisory Committee on Small and Emerging Companies, September 2012; and “Why are There so few Public Companies in the US?” published by the US National Bureau of economic Research.
 See: Choking the Recovery: “Why New Growth Companies Aren't Going Public and Unrecognized Risks of Future Market Disruptions” available on SSRN; and “Fragmentation in Canadian Equity Markets” Bank of Canada Review.
 See: “Has the Canadian Small-Cap Market Become a Victim of Over-regulation?” posted on equities.com; and “Reducing the Burden on Small Public Companies Would Promote Innovation, Job Creation, and Economic Growth” by David R. Burton.
 For US data: SEChttp://www.sec.gov/dera/staff-papers/white-papers/unregistered-offering10-2015.pdf, and for Canadian Data: OSC http://www.osc.gov.on.ca/documents/en/Securities-Category4/nr_20151105_osc-proposes-four-capital-raising-backgrounder.pdf
 The Start-up Crowdfunding Exemption adopted by various securities regulators in Canada under Multilateral CSA Notice 45-316 allows advertising. The Integrated Crowdfunding Exemption does not allow advertising.
 “Does Spending Time in the Minors Pay Off?” May 1, 2016, available on SSRN.