JOBS Act: Something for Nothing?

The so-called JOBS act is a victory of faith over basic logic. The motivating idea seems to be that if we reduce the regulations that govern the process of raising capital, small companies will find it easier to raise money, and that money will translate into jobs. Many people have pointed out some of the problems with the bill: recently, for example, Andrew Ross Sorkin highlighted the potential for companies to take advantage of investors, and Steven Davidoff pointed out that regulation is probably not the reason for the decline in the number of small company IPOs.

There are a couple of more fundamental misunderstanding I want to focus on, however. First, it’s not clear that relaxing regulations will actually make it cheaper for companies to raise money. Sure, eliminating the independent audit requirement will save companies a few bucks. But what really affects the cost of capital is not out-of-pocket fees but the price that investors are willing to pay for equity. The less confidence that investors have in a company’s prospects, the cheaper that company will have to sell its stock. If small companies are allowed to provide less information to investors, that could simply make it more expensive for them to raise money.

Second, and more important, it is definitely not true that more capital for everyone is always a good thing. The point of the financial system is to allocate capital to its most productive uses. The housing bubble, if nothing else, should have convinced us of that point. There are plenty of startups that are are risky and should face a high cost of capital; there are plenty of others that have no business raising money at all. (Think back to the Internet bubble, for example.) Making it easier for such companies to raise money is a bad thing, not a good thing. From a public policy perspective, making it easier for small companies to dodge reporting requirements and thereby raise money from gullible investors is no better than raising taxes and having the government loan the proceeds to small companies with political connections: in either case, you’re mucking around with the ordinary process of capital allocation.

Two more points on this topic: Relaxed reporting requirements can actually be bad for good companies. Good companies benefit from tougher disclosures because it makes it possible for them to differentiate themselves from bad companies. The effect of the JOBS Act will be to divert capital from good companies to bad companies, since investors will find it harder to tell the difference. (Or, in a best-case scenario, good companies will voluntarily comply with the old requirements in order to differentiate themselves—in which case the JOBS Act will have done nothing.)

In addition, the JOBS Act has reporting standards precisely backward. If you’re going to have different standards for large and small companies, the requirements for small companies should be higher. One theory of securities markets is that regulation is unnecessary because market participants will police issuers—basically by studying them very carefully. I have doubts about this theory, but it is certainly more true for large companies, which get tons of attention from institutional investors, than for small ones. Sure, if you don’t require independent audits, you could have fraud in any size company. But you are probably going to find it in a big company simply because so many more people will be looking at it more closely.

It is possible that, on balance, our current system includes too many regulations. I don’t think so—because it is precisely those regulations that encourage broad participation in the markets, which is what lowers the cost of capital for everyone—but that’s a plausible argument. But less regulation does not automatically mean provide more capital for investment—nor is more capital for small companies always a good thing.