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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.
If you have any questions
regarding this publication or other related issues, please contact Mike
Colo at 252.972.7105 or mscolo@poyners.com.
This publication is
published by Poyner & Spruill LLP to provide general information
about significant legal developments. Because the facts in each
situation vary, the legal precedents noted herein may not be applicable
to individual circumstances.
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