In my paper, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, I explore the possibility of doing away with initial public offerings. In their place, I propose an expanded system of company registration under which companies would have to trade in private markets for a seasoning period, with mandatory disclosure, before they would be allowed to sell their shares to the public at large. I argue that such system would promote not only efficient capital formation, but also investor protection.
Under the current regime, companies can stay private until one of three triggering events occurs: 1) the company lists its shares for trading on a securities exchange; 2) the company makes a registered public offering; or 3) the company exceeds 2,000 shareholders. Typically, companies trigger public company status through an initial offering of shares, with simultaneous listing of those shares on an exchange. The decision to make an initial public offering, however, is frequently made because the company is pushing the limit on the number of shareholders as a result of prior private issues to employees and early-round investors.
The evidence consistently shows that IPOs are inefficient, combining (on average) short-term underpricing with long-term underperformance. I argue that this combination results from the difficulties of determining the correct valuation an unknown company that is making public disclosures for the first time. Without the benefit of a trading market to process that disclosure and develop a consensus valuation, mispricing in the public offering is inevitable; the market for IPOs falls far short of the ideal of the efficient capital market hypothesis. Moreover, the influx of retail traders into the secondary market, fueled by speculative enthusiasm, drives the trend toward long-term underperformance. Thus, the current system of IPOs has neither efficient capital formation nor investor protection to recommend it.
I propose a two-tier market system to replace IPOs as the avenue for companies to transition from public to private. The lower tier would be a private market restricted to accredited investors along the lines of SecondMarket and SharesPost. Only after a company had reached a minimum market capitalization or trading volume in that private market would it be eligible for elevation to the top-tier public market. That top tier would have unlimited access for institutional and retail investors alike. Issuers that chose to make the transition to the public market would be required to make public company disclosures – the current 10-K – followed by 10-Qs for an appropriate seasoning period. During that seasoning period, trading would be limited to the private market. The seasoning period in the private market would allow investors to arrive at a a consensus valuation of the company informed by mandatory disclosure. Only after the seasoning period would the issuer be allowed to sell shares to the public at large. Investors would then also be free to resell their shares to retail investors.
The full paper is available for download here.