Entrepreneurship and Public Policy Lecture 6 Regulation of

Entrepreneurship and Public Policy Lecture 6: Regulation of Capital Markets and Corporate Governance

Lecture Overview • Overview of corporate governance structures and their impact on small business – Incorporation – Business organization – Public held status • Sarbanes-Oxley Act (SOX) and small business – Overview – Impact on small firm – Impact on shareholder litigation • Discussion Questions Gates EPP Lecture 6 -2 Spring 2009

Organizational Form is a Critical Decision for New Businesses • • • New businesses are often formed with an eye to becoming large firms Small firms face three key organizational decisions – The decision to incorporate – The choice of organizational structure – The decision to be publicly held Corporate and securities law influences the benefits and costs of different business forms and capital structures – Can have a major impact on the future growth potential of small businesses Gates EPP Lecture 6 -3 Spring 2009

Incorporation Creates a Legal Distinction Between a Firm and its Owners • Benefits of incorporation – Limited the liability of firm’s owners for the firm’s debts and obligations – An unlimited life span – Transferability of shares – The ability to raise capital – Independent credit rating • Costs of incorporation – Administrative paperwork burden – More complicated accounting requirements – More taxation Gates EPP Lecture 6 -4 Spring 2009

Incorporation Influences the Legal Environment Faced by Businesses • • • Unincorporated businesses can impose more financial risk on business owners – Distinction varies by state due to court actions to “pierce the corporate veil” A majority of small businesses are unincorporated About 70 percent of self-employed individuals are unincorporated Research suggests that unincorporated firms are: – less likely to take risks – less innovative – have distinct growth trajectories It is difficult to disentangle cause and effect – Barriers to incorporation are, in fact, pretty low Gates EPP Lecture 6 -5 Spring 2009

Businesses Must Chose Among Many Organizational Options • Sole proprietorship – A business with one owner who essentially does business in his/her own name • May use a trade name – Business is not considered to be a separate legal entity – Owner pays personal income taxes on business profit • General partnership – Allows for co-management, profit-sharing, and losssharing, with governance tailored to the firm’s individual needs; receive pass-though treatment for tax purposes; – Holds all partners jointly and severally liable for liabilites and torts of other partners incurred on behalf of the partnerships Gates EPP Lecture 6 -6 Spring 2009

Other Organizational Options • C-Corporation – Allows flexibility in issuing stock and structuring decision making arrangements – Creates a separate taxable entity – Provides owners with limited personal liability for firms’ liabilities – Fringe benefit can be deducted as business expense • S Corporation – Allows professional corporations to take advantage of pass-through taxation – Limited to companies with no more than 100 shareholders, who must be U. S. citizens – Allowed to have only one class of stock Gates EPP Lecture 6 -7 Spring 2009

Other Organizational Options • LLC and LLP – Combines the flexibility and pass-through taxation attributes of partnerships with a form of limited liability akin to that accorded to corporate status – Required to have a limited life span – Must carry a minimum amount of insurance against claims of third-party creditors • Non-profit – May apply for tax exempt status – A non-profit is barred from distributing any profits it ears to persons who exercise control over the firm Gates EPP Lecture 6 -8 Spring 2009

LLCs and LLPs are Relatively New Organizational Options • Introduced in most states in the 1990 s to combine tax benefits and liability reduction for firms – Often limited to firms in specific industries or fields • It is unclear the take-up of these forms among smaller businesses • It also remains unknown how these new forms of organizations affected small businesses’ growth path and innovative activities Gates EPP Lecture 6 -9 Spring 2009

Publicly Held Status • • • Publicly held firms are subject to federal securities regulations – Firms with more than $10 million in assets and a class of equity securities with more than 500 shareholders Other regulations may also be applied to publicly held firms Small businesses receive some special treatment (SB-1 and SB -2) in the form of simplified registration procedures Gates EPP Lecture 6 -10 Spring 2009

Public Held Status and Small Businesses • Few entrepreneurs choose public status at the inception of a small business • However, the issue becomes increasingly important as the firm grows and requires access to additional capital • Securities regulations are therefore a central consideration for small businesses seeking to go public or to sustain and expand that status – Particularly relevant for high growth potential firms Gates EPP Lecture 6 -11 Spring 2009

Lecture Overview • Overview of corporate governance structures and their impact on small business – Incorporation – Business organization – Public held status • Sarbanes-Oxley Act (SOX) and small business – Overview – Impact on small firm – Impact on shareholder litigation • Discussion Questions Gates EPP Lecture 6 -12 Spring 2009

Sarbanes-Oxley Was a Response to Corporate Financial Scandals • • • In early 2000 s, the nation was rocked by scandals at Enron, World. Com, and Arthur Anderson Sarbanes-Oxley law passed in 2002 to strengthen corporate governance and restore investor confidence “SOX” significantly changed the corporate environment for financial reporting and auditing for publicly traded companies Gates EPP Lecture 6 -13 Spring 2009

SOX Imposed Several New Requirements on Publicly Traded Firms • • • Internal Controls (section 404) – Requirement of firm’s annual report to include assessments by CEO, CFO and an outside auditor of the effectiveness of the firm’s internal controls over the accuracy of financial statements Management Certification of Financial Statements – CEOs and CFOs are required to certify the accuracy of the firm’s periodic reports and are subject to criminal penalties for false certification Source: Kamar et al. , 2007 Gates EPP Lecture 6 -14 Spring 2009

SOX Imposed Several New Requirements on Publicly Traded Firms (2) • Extends Statute of Limitations for Shareholder Lawsuits – To within earlier of five years of the occurrence of the fraud or two years of its discovery • Executive compensation – Bans loans by firms to directors or officers – Prevents directors and officers from trading in firm securities during pension-plan backout periods – Requires directors and officers to report their trades in firm securities within two business days Gates EPP Lecture 6 -15 Spring 2009

SOX Imposed New Requirements for the Auditing of Public Firms • Audit committees – All firms listed on national stock exchanges have audit committees composed exclusively of independent directors – Small businesses are exempted • Separation of audit and nonaudit services – Auditors are prohibited from providing certain nonaudit services to the firms they audit Gates EPP Lecture 6 -16 Spring 2009

What Effect Does SOX Have on Small Firms? – Advocates for small firms argue they face relatively greater costs and lower average benefits • Fewer resources, lack economies of scale • Relatively little investor attention – Responding to these concerns, SEC relieved firms with value less than $75 M of complying to internal controls— for now • “While the intent was laudable, the new regulations [have] made it extremely difficult for smaller companies to compete and grow in this regulatory environment…. • the current system now threatens to stifle entrepreneurship and deter companies, domestically and overseas, from accessing the U. S. capital markets…” Neal Wolkoff (CEO, AMEX) WSJ, August 15, 2005 Gates EPP Lecture 6 -17 Spring 2009

What Effect Does SOX Have on Small Firms? – Advocates for small firms argue they face relatively greater costs and lower average benefits • Fewer resources, lack economies of scale • Relatively little investor attention – Responding to these concerns, SEC relieved firms with value less than $75 M of complying to internal controls— for now • “While the intent was laudable, the new regulations [have] made it extremely difficult for smaller companies to compete and grow in this regulatory environment…. • the current system now threatens to stifle entrepreneurship and deter companies, domestically and overseas, from accessing the U. S. capital markets…” Neal Wolkoff (CEO, AMEX) WSJ, August 15, 2005 Gates EPP Lecture 6 -18 Spring 2009

Other SOX Provisions May Impose Disproportionate Burdens on Small Firms Complex New • Lack of in-house staff to respond Audit Standards • Large fixed costs • Increased demand for audit Rising Audit services Costs • Imbalance in the audit market Increased • Liability exposure and Competition and independence standards Costs for • Difficulty in attracting directors Directors Preoccupation • Potentially stifling effect on riskwith Compliance taking Gates EPP Lecture 6 -19 Spring 2009

Other SOX Provisions May Impose Disproportionate Burdens on Small Firms Complex New • Lack of in-house staff to respond Audit Standards • Large fixed costs • Increased demand for audit Rising Audit services Costs • Imbalance in the audit market Increased • Liability exposure and Competition and independence standards Costs for • Difficulty in attracting directors Directors Preoccupation • Potentially stifling effect on riskwith Compliance taking Gates EPP Lecture 6 -20 Spring 2009

Evidence on Accounting and Audit Costs • Various studies show SOX has led to increased • accounting and audit costs across the board – They differ about the relative impact on small firms Studies looking at the effect of SOX on market valuations provide – Mixed evidence of an effect on large firms – Evidence of a negative effect on small firms Gates EPP Lecture 6 -21 Spring 2009

Evidence on Accounting and Audit Costs • Various studies show SOX has led to increased • accounting and audit costs across the board – They differ about the relative impact on small firms Studies looking at the effect of SOX on market valuations provide – Mixed evidence of an effect on large firms – Evidence of a negative effect on small firms Gates EPP Lecture 6 -22 Spring 2009

SOX May Induce Firms to Leave the Public Market Entirely • “Going private”: arranging for private acquirers to • buy firms’ entire stock – Going private also gives firms more managerial freedom and leverage “Going dark”: cashing out small shareholders to reduce the number of shareholders to below 300 – Going dark is more clearly related to avoiding the cost of being public Gates EPP Lecture 6 -23 Spring 2009

SOX May Induce Firms to Leave the Public Market Entirely • “Going private”: arranging for private acquirers to • buy firms’ entire stock – Going private also gives firms more managerial freedom and leverage “Going dark”: cashing out small shareholders to reduce the number of shareholders to below 300 – Going dark is more clearly related to avoiding the cost of being public Gates EPP Lecture 6 -24 Spring 2009

Evidence on SOX’s Impact on Deregistration • Block (2004) found firms that went private or dark with an interest to reduce costs, especially after SOX enactment • Engel et al. (2004) showed a moderate post-SOX increase in deregistration; small firms experienced higher returns at the announcement of deregistration • Leuz et al. (2006) found firms that went dark were in poorer standing than those went private • However, deregistration might have also been a result of the weakness of the public capital market around the time of SOX enactment Gates EPP Lecture 6 -25 Spring 2009

The Impact of SOX on Shareholder Litigation and the Changed Liability Picture • Extended statute of limitations on shareholder litigation – Potential to increase a firms’ liability risk • Increased compliance with SOX may increase probability of securities class action lawsuit dismissal – Potential decrease in a firms’ liability risk Gates EPP Lecture 6 -26 Spring 2009

Discussion Questions • A combination of information issues and costs associated with public equity issue and debt underwriting create a size threshold below which an IPO is not attractive. Berger and Udell estimated that threshold at 10 mil for public equity and 150 -200 mil for public debt. Some argue that SOX has increased that threshold significantly. – If so, why would this be potentially important for entrepreneurship? – What effect might it have on small firm finance? – What outcomes might you look at? – How might you approach an analysis of this question? – What challenges might you run into? Gates EPP Lecture 6 -27 Spring 2009

Student Presentations Engel, Ellen , Hayes, Rachel M. and Wang, Xue, "The Sarbanes-Oxley Act and Firms' Going-Private Decisions" (2007). Journal of Accounting Economics, vol 44, no 1 -2 (September) pp. 116 -145. Carney, William J. , "The Costs of Being Public After Sarbanes-Oxley: The Irony of 'Going Private'" (2006). Emory Law Journal, Vol 55, p. 141. Available on-line at: http//papers. ssrn. com/sol 3/papers. cfm? abstract _id=896564 Gates EPP Lecture 6 -28 Spring 2009