Emerging Growth Companies Will Start To Grow Up
The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed. Those companies that will lose status as a result of the passage of time are almost unilaterally not pleased with the impending change and concurrent increase in regulatory compliance.
Title I of the JOBS Act, initially enacted on April 5, 2012, created a new category of issuer called an “emerging growth company” (“EGC”). An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO (for example, if the issuer has a December 31 fiscal year-end and sells equity securities pursuant to an effective registration statement on November 2, 2012, it will cease to be an EGC on December 31, 2017); (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).
The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process.
Since the passage of the JOBS Act, the FAST Act provided additional benefits to an EGC, including the omission of certain historical financial statements in registration statements, a benefit that the SEC has now extended to all companies (see HERE). Moreover, the ability to file confidential registration statements has also been expanded to include all companies (see HERE).
Many but not all of the benefits available to an EGC are also available to a smaller reporting company. For a summary of the scaled disclosure available to an EGC as well as the differences in disclosure requirements between an EGC and a smaller reporting company, see HERE. In addition, I have included a chart at the end of this blog listing the differences in reporting requirements.
However, more than 85% of IPO’s since passage of the JOBS Act have been completed by EGC’s, a large percentage of which will not qualify as a smaller reporting company. Currently a smaller reporting company is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.
In June 2016 the SEC published proposed amendments to the definition of a smaller reporting company to include companies with less than a $250 million public float as compared to the $75 million threshold in the current definition. In addition, if a company does not have an ascertainable public float, under the proposed amendment a smaller reporting company would be one with less than $100 million in annual revenues. Once considered a smaller reporting company, a company would maintain that status unless its float drops below $200 million or its annual revenues below $80 million. For more information see HERE.
This rule is listed as being in the final rule stage on the most recent SEC Regulatory Agenda, but it is unknown what changes will be included in such final rule. The June 2016 proposal specifically declined to amend the public float threshold qualifications for “accelerated filer” and “large accelerated filer,” while eliminating the exclusion for smaller reporting companies. As a result, under the current proposed rule change companies with $75 million or more in public float would still be subject to the accelerated filer rules, including shorter periods in which to file their periodic reports and the requirement to provide auditor attestation over internal controls under Section 404(b) of the Sarbanes-Oxley Act of 2002.
Accordingly, a company that exits EGC status and does not qualify as a smaller reporting company will either be a non-accelerated filer, accelerated filer or large accelerated filer with the concurrent disclosure requirements. The following chart summaries the categories:
|CATEGORY OF FILER||PUBLIC FLOAT1 TO ENTER STATUS||REVNEUES2 TO ENTER STATUS||CRITERIA TO EXIT STATUS||PUBLIC FLOAT TO RE-ENTER STATUS||REVENUES TO RE-ENTER STATUS|
|Emerging Growth Company (EGC)||N/A||<$1 billion||
|Smaller Reporting Company||<$75 million||<$50 million4||Float > $75 million||<$50 million||<$40 million|
|Non-Accelerated Filer||<$75 million||N/A||Float > $75 million||<$50 million||N/A|
|Accelerated Filer||>$75 million but <$700 million||N/A||Float <$75 million or > $700 Million||<$500 million but > $50 million||N/A|
|Large Accelerated Filer||>$700 Million||N/A||Float <$700 million||N/A||N/A|
1 Public float is calculated as of the last business day of the company’s most recently completed second fiscal quarter.
2 Revenues as reported in the company’s most recently completed fiscal year
3 Ineligibility begins on last day of the fiscal year in which the 5th anniversary occurs.
4 Revenue test applies only if public float is zero.
Under Section 404(a) of the Sarbanes-Oxley Act, companies are required to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment. Although a complete review of Section 404(b) is beyond the scope of this blog, in order to review, report on and attest to management’s ICFR, an auditor must, in essence, independently audit the ICFR.
A dearth of information and guidance is available on an auditor’s duties under Section 404(b), including PCAOB Auditing Standard No. 5. Although many estimates exist, based on a high-level review, there is some consensus that the average annual cost of Section 404(b) compliance for a company with a public float between $75 and $250 million is in excess of $250,000 and sometimes much higher.
At a meeting of the SEC Advisory Committee on Small and Emerging Companies (“Advisory Committee”) on September 13, 2017, an executive of a biotechnology company that is losing EGC status and will not qualify as a smaller reporting company pled for relief. Of all the changes that his company will face, the auditor attestation requirements under Section 404(b) of the Sarbanes-Oxley Act loom large.
Sutro Biopharma CEO William Newell gave a presentation to the Advisory Committee advocating for the increase in the definition of a smaller reporting company, as proposed, but also continuing to exempt smaller reporting companies from Section 404(b) compliance. Sutro is pre-revenue, as are many bio-pharma companies. Companies that are pre-revenue, but that may have a large public float, currently are required to comply with Section 404(b) with funds that would otherwise be used for growth, including increased staffing.
Also, Sutro is currently private and cites burdensome compliance costs as a deterrent to accessing public markets. The SEC has publicly talked about the need to energize the U.S. IPO market, including in a speech by Chair Jay Clayton (see HERE) and one by Commissioner Michael Piwowar (see HERE). The topic has also been the subject of multiple press releases and a paper by NASDAQ that is the subject of a future blog.
There is some hope for these companies. The current SEC administration is supportive of capital-raising efforts and decreased, unnecessary regulation, for companies both large and small. The pending Financial Choice Act would increase the threshold for compliance with Section 404(b) to companies with a public float of $500 million or more. See HERE. The SEC Government-Business Forum on Small Business Capital Formation encourages both the change to the definition of smaller reporting company and increase in threshold for compliance with Section 404(b). See HERE.
Differences between EGC and Smaller Reporting Company Disclosure Requirements
The scaled-down disclosures for smaller reporting companies and emerging growth companies include, among other items: (i) only 3 years of business description as opposed to 5; (ii) 2 years of financial statements as opposed to 3; (iii) elimination of certain line-item disclosures, such as certain graphs and selected financial data; and (iv) relief from the 404(b) auditor attestation requirements. However, although similar, there are differences between the scaled disclosure requirements for an emerging growth company vs. a smaller reporting company. In particular, the following chart summarizes these differences:
|Scaled Disclosure Requirement||Emerging Growth Company||Smaller Reporting Company|
|Audited Financial Statements Required||
|Description of Business (Item 101)||Standard disclosure requirements apply.||
|Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters (Item 201)||Standard disclosure requirements apply.||Not required to provide the stock performance graph.|
|Selected Financial Data (Item 301)||Not required to present selected financial data for any period prior to the earliest audited period presented in initial registration statement.||Not required.|
|Supplementary Financial Data (Item 302)||Not required until after IPO.||Not required.|
|MD&A (Item 303)||May limit discussion to those years for which audited financial statements are included.||
|Quantitative and Qualitative Disclosures about Market Risk (Item 305)||Standard disclosure requirements apply.||Not required, but related disclosure may be required in MD&A.|
|Extended Transition for Complying with New or Revised Accounting Standards||
||Standard disclosure requirements apply.|
|Internal Control over Financial Reporting (Item 308)||
||Non-accelerated filers, a category that includes SRC’s, are not required to provide an attestation report of the registered public accounting firm.|
|Executive Compensation Disclosure (Item 402)||
|Scaled Disclosure Requirement||Emerging Growth Company||Smaller Reporting Company|
|Certain Relationships and Related Party Transactions (Item 404)||Standard disclosure requirements apply.||
|Corporate Governance (Item 407)||Standard disclosure requirements apply.||
|Risk Factors (Item 503(c))||Standard disclosure requirements apply.||Not required in periodic reports.|
|Ratio of Earnings to Fixed Charges (Item 503(d))||Required for the same number of years for which it provides selected financial data disclosures.||Not required.|
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