Qianqian Yu on Why Entrepreneurs are Ignoring Form D

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In this episode of Lehigh University’s College of Business ilLUminate podcast, we are talking with Qianqian Yu about a study she recently co-authored with her Business School colleague, Kathleen W. Hanley, examining why more than half of private firms that raise money in private markets from venture capitalists fail to file a form that's required by the U.S. Securities and Exchange Commission.

Yu is an assistant professor in the Perella Department of Finance, whose research primarily focuses on corporate finance, entrepreneurial finance, venture capital, and financial intermediation.

She spoke with Jack Croft, host of the ilLUminate podcast. Listen to the podcast here and subscribe and download Lehigh Business on Apple Podcasts or wherever you get your podcasts.

Below is an edited excerpt from that conversation. Read the complete podcast transcrip [PDF]. 

Jack Croft: Without getting too deep into the regulatory details and all that, I think it would be helpful to have a brief overview of what the Securities and Exchange Commission's Regulation D, specifically, is designed to do.

Qianqian Yu: Under the Security Act of 1933, any offer to sell securities to outside investors in order to raise capital must be registered with the SEC or meet with an exemption. So if a company registers securities with the SEC, that basically means the company goes public. … But if companies want to stay private and they still want to raise capital from external investors, then they will have to rely on some exemptions.

And Regulation D is a popular exemption rule that private firms can rely on in order to raise capital from outside investors, including both accredited investors and a limited number of unaccredited investors. So when we talk about accredited investors, we are referring to those like venture capitalists or angel investors who are sophisticated and who have experience and knowledge to make investment in private equity.

And if private firms, like many VC-backed firms do, … rely on regulation exemptions to raise capital, then they are required to file a short form called Form D, which includes the basic information about that private offering, such as the name and addresses of the companies, the names of the executive officers and board of directors, as well as the offering amount. And that form has to be filed within 15 days of the first sale.

Croft: Your study looked at 40,000 rounds of venture capital financings and found that more than half, more than 50%, do not file a Form D. So are there any general characteristics that distinguish the companies that file from those that don't?

Yu: We indeed find that some characteristics are associated with a higher compliance rate or higher filing rate of Form D, while other characteristics can predict that such firms are less likely to file Form D. And that's why we think that the decision to file Form D is predictable and therefore it is strategic.

So looking at the characteristics, we find that firms that are raising a larger amount of capital who have more investors, as well as who have a spread-out investor base, meaning they have investors spread out across different states, such firms are more likely to file a Form D because our conjecture is such firms are more likely to be caught if they fail to comply with a Regulation D.

While other companies—for example, private firms in their early stages, private firms in biotech sector or high-tech sector who have a lot of information to protect from being revealed to other competitors and so on—such firms are less likely to file a Form D. Also, we find that firms who are facing greater competition, having a greater threat from outside competition are less likely to file a Form D. So this all points to the fact that firms may strategically decide whether they want to file or not to file by weighing the potential benefit versus cost of filing Form D.

Croft: As you looked at these things and both examined some of the data that's available, which I understand is limited. … Also, I know that you talked with some lawyers and entrepreneurs about this as well. What were some of the main reasons that emerged for that strategic decision to not file the form outweighing the risk of getting caught?

Yu: For some firms—like what we have talked about, like early-stage companies or biotech companies, high-tech ventures—who have a lot of proprietary information they want to protect, the benefit from not filing a Form D is substantial because by not filing Form D, they can protect their information from being revealed to their potential competitors.

But the penalty of not filing Form D is relatively less compared to the perceived benefit. That is because under the current security regulation, the filing for Form D is not a condition to the availability of using exemptions under Regulation D in the future. Meaning that even if the firm is not filing a Form D, this does not make Regulation D exemptions unavailable to them for this particular offering.

So that's the reason we think that the penalty compared to the benefit for many private firms is much less. That gives them an incentive to not file.

Croft: The primary data-based analysis you were able to do involved firms that would be hesitant in sharing their information broadly with the public because of patent trolls. And let's explore that a little. First, what are patent trolls and what were you able to document regarding the role that they play in the failure to file?

Yu: Patent trolls, as you probably can tell from the name, … acquire patents or hold patents. Those are like trolls, so they're not the good guys. Typically, they acquire a lot of patents and then license those patents or generate revenues from licensing patents, but they do not make or sell products or services based on the patented technologies.

So what a lot of patent [trolls] actually do is they accumulate quite a number of patents and then they await an opportunity to initiate lawsuits against people who have the ability to settle a patent lawsuit. That's what patent trolls do.

So what we find in our paper is that after a private firm filing a Form D after raising a round [of funding] from venture capitalists, such firms are more likely to be targeted by patent trolls, meaning patent trolls are more likely to target private firms who just raised the capital. And they got to learn all their capital raises information through observing a Form D filed by the private firms.

That's actually considered as one … negative consequence, obviously, a private firm filing a Form D. And that's also considered as a reason we think why some private firms do not want to file Form D because it put their capital raising activities in the spot and they may be immediately targeted by outside parties who want to take advantage of the capital raise.

Croft: Now, there was some evidence of that that you found within the documentation on the firms being targeted who had filed versus those who did not. What did that involve?

Yu: In our paper, we find that filing a Form D is associated with a higher probability of being targeted by patent trolls in the next two years. That means patent trolls will take advantage of the capital raising that they observe from a Form D that a private company filed and then try to take actions to take advantage of that deep pocket.

There is another interesting result related to this that we look at—the passage of anti-patent troll laws, which are aimed to protect companies from being targeted by patent trolls for frivolous reasons. And we find that after the passage of anti-patent troll laws across different states, then private firms, venture-backed private firms, are more likely to file a Form D because now they know they're better protected. So they don't have to bear the negative consequences to filing Form D.