Emerging growth companies

What Is Emerging Growth Companies?

An emerging growth company (EGC) is a specific classification under U.S. securities law, part of the broader financial regulation framework, that offers certain benefits to smaller, relatively young companies seeking to access public capital markets. This designation allows these companies to navigate the process of becoming a public company with reduced regulatory burdens, easing their transition from private to public status. The primary aim is to encourage entrepreneurship, facilitate capital raising, and stimulate job creation by making initial public offerings (IPOs) more accessible for developing firms.⁵⁷

History and Origin

The concept of emerging growth companies was introduced with the passage of the Jumpstart Our Business Startups (JOBS) Act, signed into law on April 5, 2012, by President Barack Obama.⁵⁵, ⁵⁶ Prior to the JOBS Act, smaller companies faced significant compliance costs and regulatory hurdles when considering an Initial Public Offering. The Act aimed to address a decline in IPO activity and a perceived “jobless recovery” following the 2008 financial crisis by making it easier for smaller businesses to raise capital and expand.

Th⁵³, ⁵⁴e JOBS Act created the EGC category, providing an "IPO on-ramp" that allows eligible companies to gradually adopt the full range of disclosure and corporate governance requirements typically imposed on more established public companies. Thi⁵²s legislative change was intended to reduce the cost and complexity associated with going public, thereby incentivizing more companies to pursue IPOs and, in turn, contribute to economic growth. The⁵⁰, ⁵¹ Securities and Exchange Commission (SEC) subsequently issued rules and guidance to implement the provisions of the JOBS Act.

##⁴⁹ Key Takeaways

• Emerging growth companies (EGCs) are a category of issuers designed to ease the burden of going public for smaller, newer firms.
• The status was established by the JOBS Act of 2012 to encourage IPOs and stimulate economic growth.
• EGCs benefit from scaled-down financial reporting and disclosure requirements compared to larger public companies.
• A company can retain EGC status for up to five years post-IPO or until it meets certain revenue or debt thresholds.
• While offering advantages, the reduced disclosures of emerging growth companies can sometimes lead to increased information uncertainty for investors.

Interpreting the Emerging Growth Company

The emerging growth company designation signals a company that is in an earlier stage of its public market journey, with scaled disclosure requirements reflecting this status. For investors, recognizing a company as an EGC means understanding that it may provide less extensive financial statements and other disclosures than a fully compliant, larger public company. For instance, EGCs are generally required to provide two years of audited financial statements in their IPO registration statements, rather than the three years typically required. The⁴⁷, ⁴⁸y may also be exempt from certain requirements of the Sarbanes-Oxley Act related to auditor attestation of internal controls. Thi⁴⁵, ⁴⁶s streamlined approach is intended to allow these companies to focus resources on growth rather than on extensive compliance.

##⁴⁴ Hypothetical Example

Consider "Quantum Leap Innovations," a biotechnology startup that has developed a groundbreaking new gene-editing technology. Quantum Leap has been operating for four years and has generated approximately $100 million in annual gross revenues from preliminary partnerships and research grants. The company decides to pursue an Initial Public Offering to raise significant capital markets funding for clinical trials and further development.

Given its annual revenues are well below the current EGC threshold of $1.235 billion, Quantum Leap Innovations qualifies as an emerging growth company. Thi⁴³s status allows them to confidentially submit their IPO registration statement to the Securities and Exchange Commission for review, providing flexibility to make adjustments before public disclosure. The⁴²y can also provide only two years of audited financial statements in their initial filing, reducing the immediate accounting burden compared to a more established firm. This enables Quantum Leap to streamline its IPO process and allocate more resources toward its core research and development.

Practical Applications

Emerging growth companies primarily utilize their status to streamline the process of going public and managing ongoing regulatory compliance. The benefits extend across various aspects of their operations:

• Initial Public Offerings (IPOs): EGCs can confidentially submit their draft registration statements to the SEC, allowing them to gauge market interest and address regulatory feedback before public disclosure. Thi⁴⁰, ⁴¹s "test-the-waters" approach can de-risk the IPO process.
• Reduced Disclosure Requirements: EGCs are permitted to provide less extensive narrative disclosure, particularly concerning executive compensation. The³⁸, ³⁹y are also allowed to present two years of audited financial statements in their IPO registration statement, compared to the three years typically required for non-EGCs.
• ³⁶, ³⁷ Exemptions from Certain Regulations: Emerging growth companies are exempt from certain provisions of the Sarbanes-Oxley Act, such as the requirement for an auditor attestation report on internal control over financial reporting. The³⁴, ³⁵y also have an extended transition period for complying with new or revised accounting standards, aligning their compliance timeline with that of private companies.
• ³², ³³ Capital Raising: The reduced compliance burden aims to make public offerings more attractive, potentially increasing the flow of capital to these developing companies. Beyond IPOs, EGCs may also engage in private placement offerings.

Th³¹e existence of the EGC category under the JOBS Act has been cited as a factor in the increase of IPOs by smaller companies. For³⁰ example, the IPO market, while subject to broader economic factors, continues to see new companies going public.

##²⁹ Limitations and Criticisms

While the EGC designation offers significant advantages, it also faces limitations and criticisms. A primary concern is that the reduced disclosure requirements for emerging growth companies may lead to increased information uncertainty for investors. Som²⁷, ²⁸e studies suggest that these relaxed rules could result in lower-quality IPOs and potentially expose individual investors to more risk, as companies that opted for reduced disclosures have, in some instances, underperformed broader market indices in the years following their IPOs.

Cr²⁶itics argue that scaling back disclosure requirements might diminish the transparency that helps investors make informed decisions, particularly for companies with limited operating histories. Thi²⁴, ²⁵s can make it more challenging for investors to fully assess a company’s financial health and future prospects. While EGC status can simplify the path to public markets, the market's acceptance of these scaled disclosures can vary, and some institutional investors may still prefer companies that adhere to more stringent reporting standards.

Addi²³tionally, the benefits of EGC status are temporary. A company loses its emerging growth company designation when its annual gross revenues exceed $1.235 billion, it issues more than $1 billion in non-convertible debt over a three-year period, it becomes a "large accelerated filer" (a designation based on market capitalization), or after the fifth anniversary of its IPO. Once ²⁰, ²¹, ²²EGC status expires, the company must fully comply with all standard SEC regulations, which can entail increased compliance costs and regulatory scrutiny.

E¹⁸, ¹⁹merging Growth Companies vs. Small Reporting Companies

Emerging growth companies (EGCs) and Small Reporting Company (SRCs) are both classifications designed to provide scaled regulatory relief for smaller public companies, but they serve different purposes and have distinct qualification criteria and benefits.

While both classifications offer reduced regulatory burdens, EGC status is temporary and specifically geared towards facilitating the IPO process for growth-oriented firms, whereas SRC status provides continuous relief for companies that remain below certain financial thresholds. A com⁹pany can potentially qualify for both, but the EGC status provides additional, albeit temporary, accommodations related to the IPO process itself.

FAQs

Q1: What are the main benefits of being an emerging growth company?

A1: The main benefits include reduced financial reporting and disclosure requirements, such as providing fewer years of audited financial statements in an IPO registration and scaled executive compensation disclosures. Emerging growth companies can also confidentially submit their IPO filings to the SEC and delay compliance with certain new accounting standards.

⁷, ⁸Q2: How long can a company remain an emerging growth company?

A2: A company can typically maintain its emerging growth company status for up to five fiscal years after its Initial Public Offering. However, it will lose this status earlier if its total annual gross revenues exceed $1.235 billion, it issues more than $1 billion in non-convertible debt over a three-year period, or it becomes a "large accelerated filer."

⁴, ⁵, ⁶Q3: Does being an emerging growth company mean less investor protection?

A3: While emerging growth companies benefit from reduced disclosure requirements, which can mean less publicly available information compared to larger companies, the SEC still requires essential disclosures to protect investors. Investors should conduct thorough due diligence and be aware of the scaled reporting that comes with EGC status.

³Q4: Are foreign private issuers eligible for emerging growth company status?

A4: Yes, the emerging growth company category is not limited to domestic companies. Foreign private issuers that otherwise meet the definition and criteria can also qualify for EGC status and take advantage of the associated benefits.

²Q5: What happens when a company loses its emerging growth company status?

A5: Once a company no longer qualifies as an emerging growth company, it must transition to full SEC compliance. This means it will be subject to the more extensive financial reporting, disclosure, and corporate governance requirements that apply to larger, more established public companies, including potentially needing to provide three years of audited financials and comply with Sarbanes-Oxley Act Section 404(b) auditor attestation.¹