The JOBS Act (Jumpstart Our Business Startups Act) purports to foster the growth of small businesses, allowing them easier access to funding by lowering bureaucratic hurdles and thus enabling the growth of their business and their ability to hire more people.
In reality, the bill—passed overwhelmingly by the House last week and now awaiting President Obama’s signature—allows small companies to avoid scrutiny of their financial statements for the first five years because compliance is too costly. What is “small”? Companies with revenues of less than $1 billion. Yep—that’s most of Silicon Valley.
These small companies need access to funding. VC funding (with astute financial inquiries) isn’t readily available, so they go to the public market where we, the investors, have only the financial statements, press releases, website content and other information the company produces. We have to trust that it is accurate, but the JOBS Act says the internal controls and third-party independent oversight mandated by SOX legislation is “too costly.” Too costly for whom?
A well-designed SOX program is not too expensive—it’s too expensive not to have those controls. Any idea how expensive a restatement is? (Think audit fees, legal fees, the army of accountants crunching through your books, regulatory inquiries, shareholder litigation, the list goes on.) Nearly one-third of companies that have had IPOs since 2004 have had to issue financial restatements—that’s a staggeringly high number.
Why do small companies get it wrong?
For starters, finance isn’t viewed as a strategic business function—it’s viewed as overhead. That means it’s often not properly funded, so there’s not enough horsepower to make sure the books are accurate, not enough access to expertise to understand complex accounting regulations and not enough rigor in the close process. Bottom line: the financial statements are not accurate. They do not serve as a basis for understanding the financial position of the business—either for making investment decisions or making management decisions about running the business.
JOBS Act advocates say that most companies will be fine without the discipline of solid internal controls. Really? Did you see the latest from Groupon? First it stumbled with its IPO, and now it has stumbled with its first 10-K. See any patterns? In this last trip-up, the company identified a material weakness in internal controls related to the financial close process and cited three contributing factors: 1) an inadequate close process, resulting in a number of manual post-close adjustments; 2) account reconciliations not performed and/or reviewed; and 3) inadequate policies for timely, adequate review of estimates and assumptions. These are pretty basic controls that every company should perform as part of its normal close process—nothing fancy or tricky here—yet Groupon doesn’t seem embarrassed about missing these controls. (And it certainly isn’t embarrassed to be taking investor money.) While Groupon wouldn’t benefit from the JOBS Act because it has revenues of $1.6 billion, it’s a great example of what often happens with young, newly public companies and the challenges they face in providing accurate financial information to the investor community.
In the wake of the massive frauds perpetrated by Enron, WorldCom, Adelphia, and others, we got SOX. In the wake of the massive frauds perpetrated by Wall Street—which drove us into the deepest recession since the Great Depression—we got Dodd-Frank. Who are we kidding with the JOBS Act? Get ready: we’ve paved the way for a lot more fraud and financial misstatements.