Overview of the IPO
While most corporate financings source funds privately rather than from public investors or through the debt market or loans, the Initial Public Offering is the “Holy Grail” of corporate financing as the IPO can raise the most money and in the shortest time. To be sure, not all firms can pursue an IPO. It is an option available to only a select few. But the business and legal issues raised by the process are largely the same ones that would be faced in pursuing lower level corporate financing. For example, attorneys, accountants and investigators conduct very similar due diligences of the client’s business and legal affairs in preparing for an IPO or other major corporate financing.
A public offering is the sale of securities by an issuer to public investors, pursuant to a registration statement filed with the SEC.[1] An IPO in which a company sells new securities and receives all proceeds in the form of additional capital is called a primary offering. The IPO is the first primary offering made by a company to public investors. A primary offering must be distinguished from a secondary offering of securities, as a secondary offering is the sale of securities by shareholders of the company to other investors. Thus, no funds from these secondary sales flow to the company.
IPOs are almost always primary offerings, though the primary offering may be packaged together with the sale of shares held by shareholders who acquired securities via earlier private equity investments. For example, early company investors such as venture capitalists may sell their securities as part of an IPO. When these early investors, and often members of the founding team, or even employees who hold stock options, sell their shares, they pocket the proceeds. In the process of the IPO, a company may thus create hundreds of new millionaires with the primary offering.
Counseling the Corporate Client on the IPO Process
Counseling a prospective corporate client on the IPO process is a complex and challenging affair for an outside law firm retained to guide the client company through the process of preparing the registration statement and subsequent IPO. Outside law firms are typically retained since few legal departments of non-public companies possess the legal and regulatory skills to run such a complex process. The firm is like a hub on a wheel, working with the company’s corporate general counsel and the underwriters.
Preparing the SEC registration statement involves marshaling a diverse group of legal professionals covering corporate law, regulatory compliance and federal and state securities law specialties. In addition, the team may consult during the process with other firm experts in corporate and securities litigation, environmental law, real estate and federal taxation. When such additional expert resources are not available in-house, the outside law firm may retain other private counsel to provide the necessary work.
In addition, in the role of outside corporate counsel, the law firm has the further responsibility of leading and organizing the work flow required to prepare a registration statement, coordinating with the client’s corporate general counsel as well as the underwriter’s lead counsel. Thus, preparing and filing a registration statement with the SEC requires a coordinated and disciplined “army” of legal professionals.
According to PriceWaterhouseCooper, an international accounting firm, the legal expenses related to preparing an IPO run between $1.5 million for a company with less than $100 million in annual revenues to $3 million for a company with annual revenues between $500 to $1 billion in revenues.[2]
Key Reasons for Going Public
The first question that anyone should ask a business client contemplating an IPO is: “Why go public?” With the panoply of risks, costs, regulations and potential liabilities associated with going public, it is a fair question. When advising a law firm client company exploring the option of going public, several important factors must be discussed.
First, going public allows investors a way to cash in their investments, thereby encouraging them to invest in the first place. The world is awash in capital – both public and private. Publicly-held corporations rely on both sources of capital to raise funds for corporate operations and investments. However, private companies have limited options for raising capital. Historically, large sources of capital from private investors were limited to venture capital for young and growing firms. But, obtaining venture capital was extremely difficult. The growth of private capital has established a powerful incentive to entrepreneurs and young companies to pursue innovative business opportunities. For example, companies like Uber were able to postpone their IPO event for years because of the availability of massive amounts of private capital to fuel their growth.[3] However, private investors need to cash-out their private investments and they can only do that efficiently and inexpensively via liquidity provided by going public.
Second, going public provides access to the liquidity capital markets to raise equity capital efficiently and inexpensively, and maximizes shareholder value. Investors prefer liquidity. They want and need an open door to quickly and inexpensively liquidate their investments. Accordingly, the valuation of investments in private companies is discounted due to illiquidity, reducing their value.[4] A liquid ownership, such as shares sold on the New York Stock Exchange, has a higher intrinsic value. Thus, the valuation of public companies will be higher than similar private companies.
In fact, private investors may force a company to explore the IPO option by reducing or stopping their capital investments. Alternatively, the cost of additional private capital from investors may increase to unsustainable levels. In these situations, fast growing companies must seriously explore an IPO.
Third, publicly traded stock is an excellent tool to attract and retain talented employees. In a competitive environment for top talent, companies must use every advantage available. Offering potential employees the opportunity to buy publicly traded stock via employer stock option plans becomes a major competitive advantage in attracting and retaining top management talent and even lower level talent.[5]
Fourth, an IPO can optimize the capital structure of a company. An optimal capital structure is built around the finance theory that long-term corporate capital must be constructed on both debt and equity capital. Primary reliance on debt may expose a company to unnecessary risk. For example, a default on debt payment may open the company to an involuntary bankruptcy. Therefore, spreading the risk among debt and equity holders reduces corporate financing risks.
Still, it should be noted that corporate financing often presents reasons to delay or cancel it. There are general reasons such as the state of the global or national economy or company-specific factors such as a delay in introducing a new product to the market. In these situations, lawyers are called upon in their capacity as business counselors to help clients weigh the options and come to a sensible decision.
The SEC Registration Process
Under Section 5 of the 1933 Act, an issuer making a public offering of securities through the use of interstate commerce instrumentalities or the US mails must file a registration statement with the SEC, unless an exemption is available.[6]
The Registration Statement is composed of two parts.[7] A copy of the preliminary prospectus document must be attached to Part 1. Part 2 contains other information about the company and its business that is not included in the preliminary prospectus. The information provided in Part 2 is available to the public and prospective investors via the SEC’s EDGAR website.[8]
The preliminary prospectus is the cornerstone of the Registration Statement. Its purpose is to ensure that potential investors in the public offering will be provided with sufficient accurate information to make informed decisions. The issuer of the securities to be offered via interstate commerce must distribute the preliminary prospectus to any potential investors solicited by the issuer or its underwriters prior to the effective date of the Registration Statement.[9] The effective date is determined only after the SEC has reviewed the Registration Statement. Therefore, prior to the effective date of the Registration Statement, solicitation of investors is prohibited unless those investors have been provided with a copy of the preliminary prospectus.
Schedule A of the 1933 Act lists the information required in the registration statement.[10] Among the information required under Schedule A is:[11]
(1) The name under which the issuer is doing or intends to do business;
(2) The general character of the business actually transacted or to be transacted by the issuer;
(3) The securities to be sold by the issuer pursuant to the Registration Statement;
(4) The use of the proceeds from the offering;
(5) How the price for the securities was set.
This is not an exhaustive list.[12] The general concept behind the preliminary prospectus is to provide a robust source of information to potential investors concerning the issuing company’s business and products, management team and structure, financial and operating history, current financial condition, use of the proceeds from the offerings and the beneficial owners of the company’s equity securities. Most importantly, the Registration Statement must provide current, audited financial statements of the company.
In addition, the Registration Statement must provide to the SEC copies of the following corporate documents[13].
- Any material acquisition, merger, reorganization, disposition, succession or liquidation plan of the company;
- Articles of incorporation;
- Corporate by-laws;
- Agreements that define the rights of shareholders, such as voting trust or shareholders voting agreements, or proxy agreements;
- Copies of every contract entered into by the company outside the normal course of business and which is material to the company;
- Names of all of the company’s subsidiaries, the state or country of their incorporation, and the names under which such subsidiaries do business.
Any failure by the legal team to provide these documents to the SEC in a timely manner will result in costly delays in obtaining an effective date for the Registration Statement.
Questions for The Company’s Management Team
An IPO changes everything for the incumbent management team, so the legal team must be prepared to ask tough questions as it begins the initial steps in preparing a Registration Statement. Legal teams should look closely at these issues, among others, during the early, pre-planning stage.
1. Does the client company have an attractive business and financial business model and developing or existing track record?Generally, a strong IPO candidate is one that is outperforming industry competitors, exhibiting a high growth rate in revenue, gross profit, market share, and product growth. An ideal IPO candidate will be able to show:
- Potentially large addressable market for its products or services;
- A unique and differentiated business model that will produce a sustainable cash flow and net profit over the long-term;
- An attractive product or service, preferably having a competitive advantage or having first-mover advantage in an emerging industry;
- A well-thought-out, focused business plan that will lay the foundation for the Registration Statement;
- An experienced, public company-ready management team; and,
- The ability to create or already have strong financial, operational and compliance controls in place.
2. What are the company’s future prospects for maintaining strong sales and earnings growth rate?
Are the products or services highly visible and of interest to the consuming and investing public? The investing public must be able to understand and appreciate the value of the Company’s products in order to get their attention and investment dollars to support the IPO. Established companies may be able to answer this question with historical sales data; however, an early-stage company must convince investors with the use market research projections and demonstrated product superiority. An early-stage company may qualify as an IPO candidate due to the uniqueness of its product or service, particularly within the technology or sciences-based industries. Still, investors may not fully understand the value created by these technology companies, forcing companies to sell their IPO shares at lower prices to attract unconvinced or partially-convinced investors.
3. Does the company have a commitment to implementing an effective system of internal control to support management’s reporting obligations as a public company?
The Sarbanes-Oxley Act of 2002[14] holds public companies to very high standards, requiring significant investments of time and money to implement management accounting and financial control systems. Legal teams are well suited to evaluate the statutory requirements of Sarbanes-Oxley Act and to raise any questions about the sufficiency of the management control systems and reporting.
4. Is Company leadership capable, committed and ethical?
A successful IPO depends on the quality of the corporate leadership team. Are the members of the board of directors ethical, experienced and strong representatives of the shareholder-owners? What is the experience level of the officers and senior managers of the company? Often, young entrepreneurs lack experience. It is vital to ensure that both the board of directors and management have the right blend of experience and skills to operate a public company. To address the lack of experience, law firms may play a role by bringing into play their corporate contacts to recruit experienced managers. To have a successful IPO, management must be prepared to invest time and effort without which the Registration Statement will be delayed.
5. Is the timing of the IPO right?
The most important external factor for a successful IPO will be the health of the overall stock market. A depressed (or “bear”) stock market may be unwelcoming to an IPO and so there are significantly fewer IPOs that come to market during times of depressed market cycles. A depressed stock market may also mean lower-priced IPOs that will lead to smaller amounts of proceeds for the companies. Accordingly, many IPOs will be delayed or postponed in weak or highly volatile stock markets. Instead, companies may turn to private equity capital to meet their operational funding needs.
In a rising, or “bull” markets, the market window for new IPO offerings opens wide. As many companies simultaneously announce planned IPOs, bottlenecks are created at the SEC, which suddenly must review large numbers of Registration Statements.
For legal teams assisting in the IPO process, market timing is critical. Legal teams must be highly flexible in gathering the materials and information to prepare the Registration Statement while not knowing exactly when the market window will close or open for the IPO. Not being prepared for changes in market timing may result in missing the all-important market window for launching the IPO. Also, delays may be caused by backups at the SEC, with limited resources to review massive amounts of data and information contained in the Registration Statements.
For legal teams advising companies in the IPO process, the only proper approach is to plan well, anticipate the likelihood of delays and position the client to launch with very short notice when the market window opens. In an unpredictable stock market, missing the ideal market conditions for an IPO, even by one day, can result in a postponed or withdrawn IPO or a lower market valuation.
Conclusion
Most companies in the US are privately-held[15] and will stay that way. However, understanding the reasons companies chose to go public guides legal and business advisors in counseling clients who are contemplating it. Furthermore, while the IPO is the Holy Grail of corporate financings, the same business and legal questions may apply to lesser corporate financings, such as a private placement. Thus, studying and understanding the IPO process is an excellent way to become a more knowledgeable and effective legal team member advising corporate clients on financing options.
In our next module, we’ll focus on due diligence investigations and the other steps necessary to carry forward the IPO process.
[1] https://www.sec.gov/smallbusiness/goingpublic
[2] “Considering an IPO to fuel your company’s future?” https://www.pwc.com/us/en/deals/publications/assets/cost-of-an-ipo.pdf
[3] https://theweek.com/articles/835973/uber-giant-ipo-hopes-equally-big-losses
[4] https://www.privco.com/knowledge-bank/private-company-valuation/
[5] “When Uber and Airbnb Go Public, San Francisco will drown in Millionaires” New York Times, March 7, 2019; see also https://www.entrepreneur.com/article/253438
[6] 15 U.S.C. Section 77a, et seq
[7] https://www.sec.gov/smallbusiness/goingpublic/registrationstatement
[8] Visit www.sec.gov/edgar/searchedgar/companysearch.html
[9] 15 U.S.C. Section 77e(b)(1)
[10] 15 U.S.C. Section 77aa, Schedule A
[11] Id.
[12] Schedule A actually lists 32 different categories of information that must be filed, if applicable.
[13] Id.
[14] https://www.govinfo.gov/content/pkg/PLAW-107publ204/pdf/PLAW-107publ204.pdf
[15] https://www.sba.gov/sites/default/files/advocacy/2018-Small-Business-Profiles-US.pdf