Small-Cap Public Companies Gain Compliance Relief Under New SEC Rule Changes
By Procopio Attorney Christopher L. Tinen
The U.S. small-cap public market will receive some welcome relief from certain securities disclosure requirements when new rules implemented by the Securities and Exchange Commission (SEC) go into effect on Monday, September 10, 2018.
The small-cap market is traditionally full of companies that are either newly public (via an initial public offering or other “going public” transactions) or low-revenue companies looking to mature into higher levels of corporate growth. The small-cap public market is often defined as public companies with market capitalizations below $1 billion.
Under the old SEC rules, most of these small-cap public companies and their management teams were forced to comply with the disclosures required of much larger, more mature public companies. The stark challenge of the sheer time and expense of being a public company and complying with the SEC regulatory regime has often been seen as overly burdensome and a barrier to entry of certain established private companies looking to reach larger investor audiences in the public capital markets. Beginning September 10, 2018, however, the SEC will expand the definition of “smaller reporting companies” to reach nearly 1,000 additional existing public companies. As a result of this expansion, these companies, and other private companies looking to go public, will now be subject to scaled-back disclosure requirements in many aspects of public reporting. Let’s dig into the changes.
1. Old Rules Limited Scaled Disclosures to Microcap Companies ($75 Million Public Float or Less)
Under the past rules, a “smaller reporting company” was defined as a public company that is not an investment company, an asset-backed issuer, or a majority-owned subsidiary of a parent that is not a smaller reporting company; and that had a “public float” of less than $75 million or, for an issuer with no public float, annual revenues of less than $50 million as of its most recently completed fiscal year with audited financials.
The “public float” is calculated by taking the aggregate worldwide shares of common equity of the issuer and multiplying that number by the price at which the common equity was last sold, or the average of the bid and asked prices of common equity, in the principal market for the common equity. This figure is different from, but often confused with, the issuer’s overall market capitalization.
This determination is made on an annual basis as of the last business day of the second fiscal quarter of the issuer’s previous fiscal year.
Additionally, once an issuer failed to qualify as a smaller reporting company, it remained unqualified until it determined that its public float was less than $50 million or had less than $40 million in annual revenues calculated in the manner described above.
As you can see, a single trading day in an issuer’s fiscal year governs its disclosure requirements for the entire following fiscal year. Small-cap public companies typically find themselves in pre-revenue or early growth phases with limited compliance budgets, and thus are often caught off guard by the calculation of their public float and their loss of smaller reporting company status due to the wide volatility in trading prices seen in small-cap public companies. This volatility results from the lack of developed financial metrics or an established trading market.
2. New Rules Expand Scaled Disclosures to Companies with Public Floats of $250 Million or Less; or $700 Million or Less with Less than $100 Million Annual Revenue
The SEC listened to criticism regarding the burdensome reporting requirements on small-cap public companies and enacted changes to the smaller reporting-company definition to reduce compliance costs and promote capital formation for smaller players in the public markets while maintaining what it sees as adequate investor protections.
The news threshold under which an issuer can qualify as a smaller reporting company will increase significantly to include (i) issuers with a public float of less than $250 million as well as (ii) those companies with annual revenues of less than $100 million and either no public float or a public float of less than $700 million. The same triggering dates and methods for calculating the definition remain intact.
The effects of these changes are two-fold. First, on public float alone, a large block of the small-cap public market will no longer have to fret about toeing the $75 million line as of an arbitrary calculation date. This will ease the enhanced compliance burden that sometimes comes due to an inopportune spike in a small-cap company’s often volatile market price and bring that burden more in line with the resources companies of that size have available.
Second, small-cap companies creeping towards the middle-cap market will be free from the burdens of heightened disclosures so long as their revenues are less than $100 million per year and their public float is less than $700 million. Companies in this category are typically pre-revenue, high-growth public companies that may benefit from the reduced compliance costs. Their savings can be redirected into research, development and corporate growth. The revenue qualifier is a key step forward in the SEC’s disclosure requirements as it acknowledges, for the first time, that companies with high valuations may not yet have the capital of more seasoned, revenue producing counterparts in the same valuation range.
3. What are the Scaled Disclosures?
So if your public company qualifies for the scaled disclosures under the new rules, what does that actually mean? Well, the scaled disclosure regime eliminates certain more burdensome disclosure rules that are often inapplicable or irrelevant to companies of this size. The benefits are modest but not insignificant, especially in the scope of periodic reporting under Form 10-Q and Form 10-K and certain proxy statement disclosures. Here are some of the key changes for scaled disclosures:
- Description of Business – description of last three years instead of five; less detailed disclosures required
- Stock Performance Graphs not required
- Selected and Supplementary Financial Data not required
- Management’s Discussion and Analysis of Financial Condition (MD&A) – Two-year comparison instead of three years, and elimination of certain tabular disclosures on contractual obligations
- Quantitative and Qualitative Disclosures About Market Risk not required
- Significant reduction of required executive compensation disclosures, including limiting the disclosures to three executive officers instead of five, two years of summary compensation instead of three years, and several additional disclosures not required
- Related party transaction policies/procedure descriptions not required
- Scaled corporate governance disclosures
- Less stringent age of financial statements requirements as well as two years of annual financial statements required instead of three years
Alhough this list is modest when viewed in the grand scheme of SEC disclosures for small-cap public companies, the consistency under which these companies can report from year-to-year without concern over a heightened compliance duty (until they reach a substantially higher threshold of maturity) presents the greatest benefit to the small-cap public company world.
4. What does this mean for the Small-Cap Public Market?
In the short-term, many existing small-cap companies will see a reduction in their compliance burden, especially for some with heavy volatility in their stock price that is often emblematic of the micro/small-cap markets. These “tweeners” often had to keep an eagle eye on their market capitalization to avoid falling out of technical compliance of complex disclosure rules. We will likely also see small-cap companies with market capitalizations on the high end of the smaller reporting company range voluntarily reporting under the more rigorous requirements applicable to mid and large-cap companies due to a familiarity with those existing requirements and a desire to conform to investor expectations at the higher ends of the public markets.
In the long-term, SEC Chairman Jay Clayton articulated the SEC’s goals with this move:
“I want our public capital markets to be a place where smaller companies can thrive and thereby provide our Main Street investors with more access to investing options where our public company disclosure rules and protections apply. Expanding the smaller reporting company definition recognizes that a one size regulatory structure for public companies does not fit all. These amendments to the existing [smaller reporting company] compliance structure bring that structure more in line with the size and scope of smaller companies while maintaining our long-standing approach to investor protection in our public capital markets. Both smaller companies — where the option to join our public markets will be more attractive — and Main Street investors — who will have more investment options — should benefit.”
In the end, the SEC’s ultimate goal is to attract more private companies into the public market that may have been discouraged with the potential compliance burden of being a public company, while reducing the technical compliance burdens on existing small-cap companies to allow them to focus on their corporate growth.
Christopher L. Tinen is an Attorney in Procopio’s Corporate and Securities, Emerging Growth and Venture Capital, and Mergers & Acquisitions and Strategic Joint Ventures practice groups. His practice focuses on corporate and securities law representing public and private companies handling all aspects of securities law compliance, startup formation, and a wide array of financings including registered offerings, crowdfunding offerings, PIPE’s and venture financings.