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IPO: Is it Appropriate?

8.21.2008

Advantages of an IPO

For a growing, private corporation, there are a number of alluring reasons for and advantages to undertaking an IPO. The most obvious, and perhaps the most powerful, reason a private corporation would take this step is the access to much needed capital at, typically, much higher multiples than would be available in private transactions. This infusion of new money might allow the company to reduce its outstanding debt, enhance product development, or commit to expansion or to a more sophisticated, broader-based advertising campaign. The capital provided by an IPO will also increase the company’s net worth, making the company more attractive to lenders, who might then loan the company additional funds at more favorable rates, providing a means of entry into different capital markets from which the company might obtain financing for future projects.

An IPO also offers the advantage of providing greater liquidity for the company’s publicly registered stock. Once a market is established for a company’s stock, the owners, who at that stage often include venture capital investors, need no longer rely on another insider or the company to purchase their interests should they decide to withdraw from the enterprise. More importantly, an IPO that includes some of the owner’s own shares among the shares offered holds the promise of an even more immediate return on the owner’s investment. As a practical matter, however, the emerging company may need to sell as many "new" shares as possible, and many underwriters will refuse to participate in an IPO that includes significant insider shares.

Another advantage of going public manifests itself once a market is established for the company's stock. If a sufficient volume of shares trade on a daily basis at a positive, balanced multiple of the company's earnings, the company may be able to use its own stock as currency to acquire other companies, thereby preserving cash for other purposes. Such a company would also be more able to accomplish an acquisition that is not taxable to the selling company or its shareholders, which could reduce the acquisition purchase price. A similar, and advantageous, use of a distribution of stock in lieu of cash arises in the area of employee compensation. It becomes easier to attract and retain highly qualified personnel if, in addition to normal cash compensation, the company can offer an ownership interest in the company that is readily tradeable. Stock awards, stock options, and stock appreciation plans are valuable tools in the quest to build a qualified and dynamic work force.

In addition, an IPO gives the small company a measure of national or regional exposure. The mere undertaking of an IPO is a strong advertisement of a company’s strength and financial well being. A successful IPO only serves to enhance this reputation. One drawback should be noted, however: as positive as a company’s exposure may be as a result of a successful IPO, it can be just as devastating to a company’s reputation to be the victim of a failed IPO.

Disadvantages of an IPO

While the picture might seem rosy, and the choice of whether to undertake an IPO an easy one, the undertaking, like all business ventures, is not without its disadvantages. The biggest consideration for many companies is the substantial out-of-pocket expense that is involved in preparing an IPO for market. As compensation, the underwriter who agrees to take on the IPO in a firm commitment offering purchases the stock to be offered to the public at a discount from the public offering price, sometimes as much as 9% or more but more typically 6 or 7%, depending on the size of the offering and the risks the underwriter might face in bringing a company to the market. Attorneys, accountants, financial printers, and financial analysts will also command significant cash outlays months before an IPO even hits the market. The national stock exchanges and automated quotation systems on which the company’s stock may be listed also have fees. Altogether, these expenses can easily surpass $1,000,000, depending, again, upon the size and nature of the IPO. Even in an IPO raising a modest amount of proceeds, such as $10,000,000, for a relatively small company, fees and expenses, not including the underwriting discount, can easily exceed $250,000.

Bringing a corporation to the market also exerts a number of new pressures on the management team. As an initial matter, the members of management can expect to spend from three to six months deeply involved in the mechanics of the transaction. This precious time is added to that already spent attending to their other responsibilities with the company. Added to this additional time demand is the potential liability attendant to intentional or negligent misstatements contained in the company’s stock offering documents. Ongoing periodic disclosure of financial information, management’s compensation, insiders’ dealings with the company, and the equity ownership of directors and key management personnel is required by federal securities laws and the regulations of the Securities and Exchange Commission (the SEC). Information, both positive and negative, is subject to disclosure obligations throughout the life of the corporation. Compliance with these ongoing disclosure obligations and with the Sarbanes-Oxley Act of 2002 necessarily means that expenses for legal and accounting advice and consultation, as well as other services of the type outlined above, are going to continue to accrue, oftentimes in significant amounts, year after year.

For the first time, perhaps, insiders face bringing new players into what has been, in essence, a private party, diluting their ownership interest and losing at least a measure of control over the direction that the corporation ultimately takes. Public scrutiny resulting from disclosure of a company’s operations may be painful enough to a formerly private corporation, but actually letting a large number of "outsiders" have a voice in corporate governance is an entirely different matter to a management team not accustomed to shareholder oversight.

In addition, as the officers of a newly-public company quickly learn, the company’s new owners will expect a certain return on their investment, subjecting management to performance pressures it may have never before experienced. Substantial time and effort, and thus dollars, must be expended in dealing with the investing community in order to ensure that investors and analysts remain satisfied with the company’s performance over the short term, while at all times keeping in mind, and working towards, management’s long term goals for the company. Finally, fiduciary obligations with respect to minority ownership interests have been expanded by the courts in recent years and cannot be taken lightly when planning to let others into a previously closed circle of ownership.

Considerations

Undertaking an IPO is a business decision that must be based on consideration of a number of factors that indicate whether an IPO is an effective use of the company’s, and its management’s, time and resources. Balancing key characteristics of a company, such as size, stability, product lines, markets, and management, determines whether an IPO is advisable and, ultimately, whether it will be successful.

Underwriters often utilize several size benchmarks to determine whether a company is a good IPO candidate. However the right "story" in the right industry may overcome any of these size issues. For traditional industries, however, significant and growing sales and net income are generally required for at least the three to five year period prior to the IPO. This assures investors that a company has a firm foothold in its market, and hopefully produces a revenue stream to support a rise in the company’s stock price after the IPO.

Investors often look for companies whose debt-to-equity, liquidity, and debt coverage ratios meet or exceed industry averages. In addition, investors generally look more favorably upon an IPO, the proceeds of which are to be used for long-term growth and expansion, rather than to pay off debt, or fund a return of investment to certain insiders.

A solid management team composed of active and involved professionals can go a long way towards ensuring that an IPO is successful. A company must be able to depend upon its financial systems and the managers that control these systems for sound advice on the financial positioning of the company. An independent member of the Board of Directors, a so-called "outside director," can be helpful in injecting an objective voice into decisions regarding company policy and direction. Above all, the top positions in the company must be staffed with people in whom the investment community can have confidence that the ultimate goals of the company will be met with speed and integrity. These top people will form a crucial marketing tool, "selling" the company through contacts with the media and other similarly situated business men and women.

Stability, both in management and in product lines, is also an important consideration for investors. Confidence in the management of a company undertaking an IPO is bred by consistent leadership and active participation by all members of the management team. Production of high quality products or services and quick response to changing consumer demand help to ensure a stable income stream to the company. Development of new products cannot be ignored as investors seek diversity as a means of obtaining growth with little risk that a downturn in a particular product line could destroy the company’s entire earnings base.

Finally, the company’s position in its relevant market is also very important to the success or failure of an IPO. A company in a trendy industry that is likely to fade with the fickle consumer’s loss of interest will have greater difficulty completing an IPO. Generally, a company must have a solid position in an industry with a proven track record. It is possible, however, for a company that offers a unique product in an entirely new market or, in the case of an internet play, a company that is first to market in its given space, to pull off a successful IPO. Stability and a proven market, however, are much more likely to produce success.

Advance Preparations for an IPO

Once the decision to consider an IPO at some time in the near future is reached, preparations can begin to better position a company for the long and complicated IPO process. A company should have experienced, securities counsel review its organizational documents to determine whether any additional provisions are desirable in light of the potential for public ownership.

The company’s state of incorporation may well be an important factor in the successful undertaking of an IPO as underwriters typically prefer states whose corporate laws afford a great deal of flexibility in corporate governance. North Carolina’s Business Corporation Act, as amended in 1990, provides as much flexibility as is found in any other state forum. To date, however, judicial interpretation of this Act has been minimal, far less than the wealth of precedent available under Delaware’s permissive corporate statutes, the historical favorite for public companies. Consideration of other issues, such as limitations on liability and annual costs, should be given serious thought if choosing a state of incorporation is an issue. A change from one’s current state of incorporation to a state with a more favorable corporate climate may, in certain cases, be worth the time and effort.

Company counsel should also address whether the company has historically complied with state and federal securities laws in connection with its pre-IPO stock sales. If the company has violated any of those laws, purchasers may have a right to rescind their purchase (i.e., demand a return of their stock purchase price plus interest and attorneys’ fees in exchange for their stock) or sue for damages if they no longer hold the stock. This liability may be imposed against the company or its controlling persons (i.e., directors and officers, personally). If this potential liability exists, it would have to be rectified or disclosed in the IPO prospectus. In addition, when commencing the IPO process, the company must comply with applicable securities laws. If the company violates certain of these laws, it could cause delays in the IPO process and impair the offering’s likelihood of success. Informing insiders on their duties and certain holding periods applicable to their ownership of the company’s stock during and after an IPO should also be on a company counsel’s pre-IPO checklist.

Securities laws should not be the only legal considerations explored in a pre-IPO review. Counsel for the company should review the company’s compliance with all relevant state and federal laws, including environmental, anti-trust, labor, tax, and commercial law before declaring the company ready to enter the public market. The additional attention that going public focuses on a company necessitates strict compliance with all laws so that a "clean house" is presented to investors.

The capital structure of a company is also an important consideration in positioning the company for an IPO. Investors need to be able to understand this structure, so it should not be unnecessarily complex. If at all possible, the company should attempt to restrict its business to related lines of products and simple, clean patterns of parent-subsidiary relationships. Any internal or external merger or acquisition activity should be completed long before an IPO is contemplated, unless, of course, some of the proceeds of, or stock sold in, the IPO will be used to complete an identified acquisition. As soon as possible, prior to the IPO, the company should also consider whether awarding stock options to certain insiders is appropriate. By awarding these well in advance of an IPO, the company will have greater flexibility in establishing an exercise price below the IPO price.

In addition, a company actively considering an IPO should bring in outside financial experts and accountants experienced in SEC and IPO matters for review of the company’s accounting practices and overall financial situation. Registration statements required by the SEC to complete an IPO generally require three years of audited financial information ( a balance sheet for each of the two fiscal years ended prior to the filing of the registration statement and income statements for each of the three prior fiscal years) which should be prepared by experienced accountants. Establishing contact with an experienced accounting firm early in the company’s existence is crucial to later success in the public market, as they can help the company avoid the serious pitfalls in SEC and IRS regulations.

Another area that company counsel should review when conducting a pre-IPO investigation is transactions between the company and its insiders. The SEC requires that the registration statement disclose certain such transactions. These transactions include loans to insiders, transfers of assets between insiders and the company, and leases of real estate or equipment to or from insiders. Although not necessarily critical, a company should seek to minimize insider transactions in the years immediately preceding an IPO since investors typically do not look favorably upon companies that appear to be run as a conduit for self-dealing insiders.

Company counsel must also make all directors and officers aware that all of the company’s "dirty laundry," including any poor financial performance by the company or bankruptcies or criminal activities by its insiders, will be disclosed in the registration statement. Careful screening of potential candidates for office and directorships will limit potentially embarrassing disclosures that might have to be made in the registration statement. A company should also expect that salaries, as well as bonuses and other compensation paid to officers, will be scrutinized carefully. Excessive compensation is generally viewed in a poor light by investors and can damage the chances of a successful IPO.

Alternatives to an IPO

The preparation that is necessary before undertaking an IPO can be quite daunting, especially to a small, new company that may be on the fringes of the acceptable size and other characteristics necessary for its IPO to be a success. As a result, there are a number of alternatives that should be explored. A company short on capital might explore the possibility of bank or other financial institution financing, a possible joint venture with another company or a sale of some of the assets of the company as other methods of finding ready capital.

Another important alternative is a private placement of securities, either to angel investors or, in appropriate circumstances, venture capitalists. The biggest advantage of the private placement over the IPO is cost – the cost of completing the IPO and the cost associated with periodic disclosure and reporting obligations following the IPO. At just a fraction of the cost of an IPO, but typically at much lower multiples, a private placement may be possible. It is also easier for the management of a company to control a small group of qualified and well-informed private investors than to deal with the public every time a critical decision involving the company needs to be made. All of these benefits, however, come with the caveat that one or more of the new private investors might want to be more involved in the operation of the company than management may desire. If the investors are professional venture capitalists, management can expect that these investors will demand significant control of the company as a means of protecting their investment. Typically, a venture capitalist will invest only in preferred stock that is senior in liquidation preference to the company’s common stock and that often accrues dividends. As such, on any liquidation of the company, the venture capitalist will receive all of its investment back, plus accrued dividends, before the holders of the common stock receive anything. Venture capital investors also will demand representation on the board of directors and prohibit the company form engaging in various transactions without their prior consent. To account for the greater risk being taken by the venture capital investor, the price the venture capital investor will pay for the stock is also typically at a much lower multiple that that which the company should expect to receive in an IPO. Statistics show, however, that a company that has received venture capital financing is much more likely to later complete a successful IPO. Although there are reasons for this, both favorable and unfavorable, before commencing an IPO, a company should carefully consider whether a private placement would better meet the company’s current objectives. Of course, careful negotiation of placement agreements with private investors is imperative to ensure that the company does not give up more control than necessary.

Conclusion

Preparing a company for an IPO takes a good deal of planning. It requires management to take a hard look at the way it does business with the same objective eye that an outsider would use to evaluate management’s performance. Determining whether or not to undertake an IPO means deciding whether the time, effort, and costs inherent in the process are worth the ultimate rewards of a successful IPO. The risk of a failed IPO must also be considered by management before undertaking an IPO. Like any business decision, careful consideration and the advice of professionals experienced with IPOs will be necessary before a company leaps off the high dive into the great public pool.

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