Do Mandatory Disclosure Requirements for Private Firms Increase the Propensity of Going Public?

• Published date: 01 June 2022
• Author: CYRUS AGHAMOLLA,RICHARD T. THAKOR
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/1475-679X.12396

DOI: 10.1111/1475-679X.12396

Journal of Accounting Research

Vol. 60 No. 3 June 2022

Printed in U.S.A.

Do Mandatory Disclosure

Requirements for Private Firms

Increase the Propensity of Going

Public?

CYRUS AGHAMOLLA∗AND RICHARD T. THAKOR∗

Received 20 January 2020; accepted 26 May 2021

ABSTRACT

This paper investigates the effect of mandatory disclosure requirements for

private firms on their decision to go public. Using detailed project-level data

for biopharmaceutical firms, we explore the effects of a legal reform that

exogenously required firms to publicly disclose information regarding clin-

ical trials. Exploiting cross-sectional heterogeneity in firms’ exposure to the

regulation based on their internal development portfolios, we find that af-

fected firms are significantly more likely to transition to public equity mar-

kets following the reform. Moreover, firms that go public because of the in-

creased disclosure requirements subsequently reduce the size of their project

portfolios while shifting to safer investments acquired externally. We provide

additional evidence for the main hypothesis using a second setting: a 2006

German reform which enhanced the enforcement of mandatory disclosure

requirements for private firms. The results suggest that private firms’ general

∗University of Minnesota

Accepted by Rodrigo Verdi. We thank two anonymous reviewers, Chris Boone, Joan Farre-

Mensa, Murray Frank, Pinar Karaca-Mandic, Andrew Karolyi, Hyunseob Kim, Jinhwan Kim,

Jack Liebersohn, Josh Madsen, Seungjoon Oh (discussant), Tjomme Rusticus, Kristen Valen-

tine, Vladimir Vladimirov, Tracy Yue Wang, and seminar and conference participants at Cor-

nell University, the University of Minnesota, University of Rome III, and the 2020 Midwest

Finance Association Annual Meeting for helpful comments and discussions. We also thank

Xuelin Li for data assistance. An online appendix to this paper can be downloaded at http:

//research.chicagobooth.edu/arc/journal-of-accounting- research/online-supplements.

755

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

756 c. aghamolla and r.t. thakor

information environment and disclosure requirements influence the propen-

sity of going public.

JEL codes: D82, G31, G32, G34, G38, O31

Keywords: initial public offerings; innovation; mandatory disclosure; pro-

prietary cost; private firms

1. Introduction

Private companies in the United States typically face limited public disclo-

sure requirements. Unlike public companies, which must publicly release

financial statements as well as information that is materially relevant for

shareholders, private firms generally face no such obligations. Indeed, one

of the primary benefits of remaining private is often said to be limited trans-

parency (e.g., Farre-Mensa [2017]). Although the effects of mandatory dis-

closure for public firms have been well studied, the effects for private firms

are not yet well understood (Minnis and Shroff [2017]). In this paper, we

seek to address the following question: How do public disclosure require-

ments for private firms influence the decision to transition to public equity

markets?1Furthermore, being public may lead to different investment in-

centives for firms, which may illuminate important real downstream conse-

quences for altering the information environment firms operate in.

Conceptually, information disclosure can affect the going-public decision

because firms face a tradeoff between the cost of revealing confidential in-

formation that could be used by competitor firms and the benefit of raising

external financing at a lower or more efficient rate (Bhattacharya and Rit-

ter [1983], Maksimovic and Pichler [2001]). Hence, if the proprietary costs

of disclosure from becoming a public firm are sufficiently low or are out-

weighed by the financing benefits, the firm is inclined to go public. An

implication of this analysis is that the introduction of mandatory disclosure

requirements of proprietary or confidential information would make go-

ing public relatively more attractive; firms can no longer avoid proprietary

disclosure costs by remaining private and hence the net marginal benefit

from going public becomes relatively higher.

However, cleanly testing the effect of disclosure requirements on pri-

vate firms is difficult. First, one needs data on private firms as well as the

information they disclose, but the vast majority of privately held firms in

the United States are subject to almost no public disclosure requirements.

Second, because the amount of disclosure by firms is endogenous, an

1The determinants of what drive a private company to go public are of significant interest

to both academics and policy makers. For example, Lowry, Michaely,and Volkova [2017] note

that “Why firms go (or do not go) public is perhaps one of the most important questions re-

lated to IPOs, with significant possible implication on policies, governance, and on firms’ cost

of capital. It would be wonderful to have more, and more complete evidence on this issue”

(p. 165-166). The interest of this issue to policy makers is evidenced by recent legislative at-

tempts to encourage more IPOs, such as the 2012 Jumpstart Our Business Startups (JOBS) Act.

mandatory disclosure and ipo propensity 757

exogenous shock to mandatory disclosure requirements is needed in order

to ascertain its effect on private firms.

We attempt to overcome these difficulties and investigate the afore-

mentioned question using detailed project-level data for a particular

industry—the biopharmaceutical (biopharma) industry. The biopharma

industry provides an ideal setting to empirically test these questions be-

cause of the importance of proprietary information costs for firms in

the industry, an active market for initial public offerings (IPOs), and the

existence of a legislative change where public disclosure of information was

directly mandated.2Specifically, we use the passage of the Food and Drug

Administration Amendments Act (FDAAA) by the U.S. government in

2007 as an exogenous shock to information disclosure requirements. The

FDAAA required that the results, as well as other important information,

of all clinical trials in Phase II or above of the drug development process

be publicly reported. Prior to the reform, firms faced limited reporting

requirements; however, the government mandated that companies have a

legal obligation to make such disclosures in the FDAAA. Importantly, the

law applied to all companies conducting clinical trials, including private

firms. Consistent with this, we show that general disclosures per drug by pri-

vate firms increased relative to those by public firms, and at the same time

disclosures related to drugs in Phase II or above rose sharply compared to

disclosures related to Phase I drugs following FDAAA enactment.3

We employ a difference-in-differences (DID) methodology over a six-

year window around the reform, 2004–09, to investigate the effects of

strengthened mandatory disclosure requirements for private firms on

the propensity to transition to public equity markets. Our sample includes

1,264 private biotechnology and pharmaceutical firms, with 53 IPOs among

these firms. Our data set includes detailed information concerning firms’

(both public and private) project portfolios, such as the status, phase,

therapeutic (disease) area, and likelihood of approval, of each firm’s drug

development project at any point in time, as well as other actions such

as trial suspensions and initiations. These detailed data are an important

2The disclosure of project-level information by biopharma firms is especially salient given

that the industry is extremely competitive, reliant on innovation, and information releases can

work to the detriment of the disclosing firm (Guo, Lev, and Zhou [2004], Krieger [2021]).

Mandatory disclosure of information pertaining to innovations can thus impose substantial

proprietary costs on private firms.

3Public firms faced greater pressure to publicly disclose details related to their R&D prior to

the reform because of materiality disclosure requirements, demand for information by capital

market participants, and a greater risk of shareholder litigation for withholding information

(see section 2 for more discussion). Therefore, an increase in mandated disclosure should af-

fect public firms relatively less than private firms, which is what we find. See also Kankanhalli,

Kwan, and Merkley [2019], who study redacted information by firms and show evidence in an

additional test consistent with biopharma firms experiencing a decreased incentive to redact

information following the FDAAA, which is in line with the effect of increased mandatory dis-

closure.