Think of the largest and most well-known American companies such as Apple, General Motors, Wells Fargo and ExxonMobil. All are publicly traded companies, driving business activity in the United States.
A public company is one that sells shares of ownership to the public, initially through an initial public offering and these are then traded on a stock exchange, like NASDAQ or the New York Stock Exchange, or “over the counter.” Unlike a closely held corporation that has a tight-knit group of shareholders, there can be millions of shareholders owning stock in a public company and these shareholders have no personal liabilities for the actions and obligations of the business.
The public company must follow strict financial reporting and disclosure requirements established and enforced by the Securities and Exchange Commission. The SEC designs regulations to keep shareholders informed of the company’s financial condition. Additionally, the SEC regulates all stock offerings and requires that a company register new stock offerings and describe these offerings in a document called a prospectus made available to prospective and active shareholders.
Process of Going Public
Most public companies started out as private companies, but then decided to go public because it provides an advantage that no private business entity can provide. A public company can raise capital quickly by reaching a larger number of investors through public trading. Going public is also a signal to the world that the company is making moves and it draws attention to a company and its owners.
For example, assume Ted is a rising entrepreneur who designs and manufactures stylish dress shoes. When he started his company, he only had two investors, his brother and sister, and organized it as a traditional C corporation. A year after forming the C corp., his company’s dress shoe sales take off. Ted wants to grow the business and start selling them across the United States. If he feels that a lot of people would invest in his company, he may decide to have his company go public to raise as much money possible to achieve his goals. The capital raised can not only help Ted expand into new markets or grow through acquiring other dress shoe makers, but it can help him attract and hire new talent and employees.
The IPO is the public’s first opportunity to invest in the company and the IPO price will typically be lower than the general market price when the shares are on an exchange. The IPO process takes about six months to complete, from the first step to the launch date.
First, the company hires an investment bank for guidance through the series of steps. It will typically choose an investment bank based on the bank pitches, its IPO track record and its relationships with institutional investors. The investment bank will advise the company and provide underwriting services, the general process of preparing for and raising money. As an underwriter, the investment bank will be a broker between the company and potential investors. The investment bank can guarantee that a certain amount of money will be raised by buying the entire offer itself and then reselling the shares to the investing public or soliciting other banks to assist with selling shares to investors.
Second, the lead investment bank files an S-1 registration statement with the SEC. This document provides information about the investment bank and company data such as financial statements, management background, legal problems, where the money will be used and insider holdings and the proposed ticker symbol that the company will trade under once listed on a stock exchange. At this time, the company will make its first public announcement that it will be going public by issuing a press release to the media to generate publicity and interest.
After filing the S-1 statement, there is a cooling off period when the company and the bank conduct their due diligence and disclose all material information. During the cooling off period, the underwriter puts together what is known as the “red herring” document. Referred to it as this because of the cautionary disclaimer printed in red text on its cover page, the red herring document is a preliminary prospectus with most of the information that will appear in the final registration statement. It does not contain the number of shares available or the price at which they are offered.
Following the cooling off period, the underwriters and company officials market the company’s shares to public investors through a series of “road shows” in large cities such as Chicago, New York, and Los Angeles. At these meetings, the banker and company management court institutional investors and evaluate early demand for shares. The purpose of a road show is to generate excitement and interest in the IPO. A road show will cover several topics such as the company’s history, its current assets, and plans for growth. The road show provides a potential investor her first opportunity to ask questions and express concerns regarding the company.
Fifth, the underwriter and company hold a pricing meeting. Here, the parties decide the IPO price, which is the price at which the company will initially sell its shares. The price must be fair, and regulators assess the fairness of the offering price by examining the company’s earnings history, the potential for future earnings, the company’s ambitions, the interest the road shows generated, and most importantly, market conditions. Initially, the company may underprice its offering to ensure that there are enough public investors buying shares. However, should the government decide that the proposed public offering price is too high in relation to the market value, it can deny registration.
Sixth, banks will allocate a certain number of shares to long-term investors once the deal is priced. Finally, once the deal is allocated and long-term investors have their shares, the stock starts trading on public exchanges and people can buy and sell shares.
Management of a Public Company
Three parties are involved in a public company’s ownership and management: shareholders, directors and officers.
A shareholder is “an owner” of the company, as each portion of ownership interest in a company is a “share.” The shareholder is not personally responsible for the company’s debts and actions. Shareholders can profit by owning stock, which often entitles them to dividends, which are shares of the after-tax profit of the company and are distributed to the shareholders according to the number and class of shares they hold. Smaller public companies distribute dividends at the end of an accounting year, whereas larger, publicly held companies often distribute them more frequently.
A shareholder can own common stock or “preferred” stock. The public company’s charter specifies how many shares and what types of stock can be issued. The charter will also specify each class of shares’ separate voting rights. Preferred stock usually means stock with dividend preference, as preferred shareholders usually receive a stated dividend before common shareholders and their dissolution of dividends have precedence over common shareholders in the event of a liquidation. A company may have several classes of preferred shares with differing rights.
Holders of common stock elect the board of directors and vote on certain fundamental changes to the company. Preferred stockholders may not have voting rights, though the company’s articles or state law may provide them with such rights.
Like common shares, preferred shares represent partial ownership in a company. Also, unlike a common share, a preferred share may pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. In fact, courts apply what is called a “solvency test,” meaning that a dividend payment may not be made if it leaves the company insolvent. Another test utilized by the courts is the “balance sheet test.” Under this standard, the company’s assets must be sufficient to cover its liabilities after it distributes a dividend.
For example, assume a public company called Legendary Baseball Bats capitalized with two classes of stock: one million shares of preferred stock that each carry a $50 liquidation preference and an annual dividend of $5 per year, and ten million shares of common stock initially offered at $10 each. Five years later, Legendry’s net assets have grown to $200 million. If the company were liquidated at that point, the preferred shareholders collectively would collect $50 million, and the common shareholders would receive $150 million, or $15 per share. On the other hand, if Legendary’s assets had shrunk to $60 million, the preferred shareholders would still collect $50 million, while the common shareholders would divide the remaining $10 million. Each year, Legendary would pay $5 million in dividends to the preferred, and profits earned in excess of that amount would be paid to the common shareholders in the form of dividends.
Shareholders, regardless of their ownership status, have several informational rights pertaining to the public company. These rights entitle the shareholder to inspect corporate books and records for certain purposes, such as to determine the company’s financial condition, determine values, discover whether the company is mismanaged or to gather information in aid of litigation.
Every year, every public company must hold an annual shareholder meeting. At this meeting, common shareholders will elect the company’s board of directors and vote on other important issues that affect the company. A majority of votes cast decides an issue put to a vote unless the bylaws state otherwise. All shareholders, even those owning a single share, have the right to offer resolutions, debate the merits of proposed resolutions and ask officers questions regarding a decision. Some public companies stave off resolutions and debates by activists who may buy a single share specifically to obtain those rights by limiting who can participate in shareholder meetings and how that participation may be conducted.
Votes may be cast in person or by proxy. A proxy vote is a vote cast by a person appointed by the shareholder to act on his behalf at the meeting. A proxy owes her principal the duties of a fiduciary relationship. A proxy’s ability to cast votes may be limited to a specific act, or she may have the same voting power as the shareholder would have, depending on the proxy agreement. In the event of a conflict over how an issue should be voted on, it is common for each side to solicit proxies from shareholders to achieve a majority.
The board of directors establishes corporate policy, makes major decisions, and runs the public company to maximize profits for shareholders. The full board typically meets only occasionally, with day-to-day duties delegated to committees, including an Executive Committee, which acts on behalf of the full board. The directors are also in charge of hiring, firing and supervising the officers of the company.
Only board decisions made with unanimous consent can bind the company unless the company’s bylaws allow director action by simple majority or specified supermajority. Board actions and decisions may be taken at director meetings, which are frequently held by conference call in lieu of an actual meeting. Meetings may only be held upon the giving of requisite advanced notice; however, the board members and shareholders may waive the notice requirements.
In addition to regular meetings, the board may call special meetings for a relevant purpose. In such case, notice is required. If a meeting is held without proper notice, the meeting and actions taken, are void.
For a meeting to be valid, a quorum of directors must be present. Usually, the quorum is a majority of directors. There are certain instances where, pursuant to the by-laws, some sort of designated super-majority may be required. Unless otherwise provided in the company’s charter, each director has one vote at any given meeting.
The board of directors will elect or appoint the public company’s officers. The term “officer” is a generic term for individuals with decision-making authority for the company. Officer titles typically include:
- President and Vice President
- Chief Executive Officer (or “CEO”);
- Chief Marketing Officer;
- Chief Financial Officer
The officers’ powers are derived from the company’s bylaws, board direction and the job description. The board gives officers authority to run the different daily operational aspects of the company, to develop products and earn profits. For example, the board may grant the CEO general authority to manage and supervise the company, which creates the implied authority to do all that is incident to the ordinary course of business.
The company’s officers make day-to-day decisions. Decisions involving the company’s assets outside the ordinary course of business, such as amending articles of incorporation, mergers, and dissolution of the company, must be authorized by the directors and shareholders. Like the notice to directors for a board meeting, notice of any shareholder meeting must be given to shareholders and the notice must state the meeting’s purpose. Normally, the board will set a date reasonably close to the meeting, referred to as the record date, and it is shareholders as of that date who are legally entitled to vote even if they no longer own the shares on the date of the meeting. A quorum of outstanding shares must be present, either personally or by proxy.
Director and Officer Duties
Like in a partnership, where partners owe several fiduciary duties to one another and the partnership, directors and officers owe fiduciary duties to the company and shareholders.
The first is a duty of loyalty, the most demanding fiduciary duty. A director or officer must place the interests of the company above his own personal interests and he cannot usurp opportunities that rightfully belong to the company. Plus, the director or officer may not compete with the company, even in the absence of a non-compete agreement.
Second is a duty of care. Directors and officers must use appropriate care and diligence when acting on the company’s behalf. They must meet the standard of the ordinarily prudent business person in similar circumstances, which is explained by the business judgement rule. Under this standard, a court will not second guess the decisions of a director if the decisions are made in good faith. with the care that a reasonably prudent person would use and if the director has the reasonable belief that he is acting in the best interests of the company. An officer nor a director will have to make the “best” or “optimal” decision; he simply must make an informed one.
One Delaware case illustrating the duty of care and the business judgment rule involved Walt Disney Co. There, several Walt Disney stockholders filed a lawsuit against the Disney directors claiming that the directors’ approval of generous no-fault termination provisions in Disney’s employment agreement with Michael Ovitz, the company’s former President, and the subsequent payment of approximately $130 million to Ovitz when he left Disney was a violation of their duty of care obligation. In arguing that the directors couldn’t avail themselves of the business judgment rule, the plaintiffs alleged that the directors hadn’t sufficiently informed themselves of the costs of no-fault termination provisions, which led to an onerous severance payment obligation.
The Delaware Supreme Court held that even though the directors didn’t follow best practices with research and negotiation when approving Ovitz’s employment agreement, they had nonetheless acted in a sufficiently informed manner to satisfy the fiduciary duty of care by meeting with employment attorneys, reviewing a term sheet outlining the Ovitz employment agreement and discussing the hiring decision for a “not insignificant length of time.” It wasn’t the “best” decision but it was an informed one.
Third is a duty of obedience: A director or officer must remain faithful to, and pursue the goals of, the company and follow the company’s governing documents and laws.
Finally, there is a duty of good faith and fair dealing stipulating that officers and directors must act honestly and with fairness when handling corporate obligations. This continuing duty runs through their daily tasks and operation of the corporation.