An initial public offering (IPO) presents significant opportunities for market participants that are accompanied by equally notable governance risks, new research from Audit Analytics explores.
The report, “Initial Public Offerings: Recent Trends in Corporate Governance Risks,” evaluates whether reductions in regulatory constraints easing the ability to go public were worthwhile. It examines the cost to companies of going public, measured in terms of audit fees, the quality of their internal control over financial reporting (ICFR), and how IPO capital affects their ability to continue as a going concern.
The Securities and Exchange Commission (SEC) and Congress have focused on making public markets more attractive by reducing regulatory burdens on smaller and pre-IPO companies over the last decade. As a result, the number of IPOs have increased from a 10-year low in 2016.
The 475 IPOs (including special purpose acquisition companies, or SPACs) during 2020 were the most in a single year in over a decade, and the number of traditional IPOs (excluding SPACs) in 2020 was the third highest in the last decade, according to Audit Analytics.
“Depending on one’s perspective, reducing regulatory burden can be perceived as reducing investor protection,” the research firm said.
Many companies avoid going public because of the higher costs. The report found there are significant initial and recurring incremental audit expenses for companies of all sizes, though small (under $75 million) and medium ($75-$250 million) IPOs shoulder the largest audit fee increases.
Audit Analytics attributes this to additional procedures to assess internal controls and increased litigation risk because of more scrutiny by investors and regulators.
There can be opportunity costs for companies devoting more resources to audit fees and diverting resources away from spending on financial systems, hiring financial talent, and designing internal controls. “Ironically, the high costs of compliance might prevent smaller entities from adequately adapting controls and financial systems necessary to meet the increased pressures of operating in the public marketplace,” Audit Analytics observed.
Public companies and their auditors are required by SOX 404 to assess the effectiveness of ICFR, so many companies are faced with extensive efforts and costs to develop a system to do so before they can go public. Smaller companies can take advantage of exemptions from auditor attestation requirements.
Audit Analytics acknowledges the importance of strong internal controls for companies and their investors. However, the research firm questions whether the corporate resources required could be better spent on other activities that provide more value to companies post-IPO, like expanding operations and identifying new opportunities for growth (especially for small and medium IPOs).
Although having ICFR in place would seem to benefit investors, Audit Analytics points to research that challenges this assumption.
“According to a 2016 study, firms that do not comply with SOX 404 at the time of IPO exhibit the least underpricing and exhibit the highest levels of post-IPO performance over the six- and twelve-month performance periods,” the report cited. That study also noted companies that were not SOX-compliant IPOs had substantially greater median buy and hold returns over the 24 months following going public.
Audit Analytics used Luckin Coffee as an “extreme example of the risks an IPO can present to investors.” The China-based coffee shop chain had a successful IPO in May 2019 and raised more than $500 million, despite disclosing historical operating losses and material ICFR weaknesses, including lack of personnel with knowledge and experience in GAAP and SEC requirements and lack of policies and procedures. Luckin qualified to take advantage of exemption from auditor reporting on its ICFR and reduced disclosure requirements.
In 2020, the company was alleged to have materially overstated revenues through fraudulent sales. Its stock price dropped 75 percent, it was delisted from Nasdaq, and it agreed to pay $180 million in a settlement with the SEC before filing for bankruptcy.
“When examining the factors that contributed to the Luckin Coffee scandal, many of the red flags associated with this company are not uncommon to new filers,” Audit Analytics said.
A going concern opinion indicates there is substantial doubt about the company’s ability to continue operations for a reasonable period of time. According to the report, going concern opinions are common for companies going public (14 percent for all companies in the period preceding the IPO; almost 30 percent for small IPOs).
Although IPO capital may help a company address going concern issues, many are not prepared to manage the proceeds they receive because they do not have a strategic plan. Coupled with higher audit fees, there can be a strain on operations and resources during the transition period and liquidity and growth issues in the near term that pose a greater risk to investors.
“Should a distinction be made between a successful company raising capital to expand growth and a failing company wishing to raise capital to sustain operations?” Audit Analytics asks. “Is there a point at which restricting access to public capital formation protects investors?”