Counsel to public companies are acutely aware that the Sarbanes-Oxley Act has imposed substantial new costs and risks on officers and directors. Boards and management may ask whether any strategy exists to mitigate those risks and reduce those costs. Such a strategy exists: going private.
"Going private" is the process by which a public company ceases to be a public company. Rules of the Securities and Exchange Commission ("SEC") permit a company to de-register its securities and thereby "go private" when it has fewer than 300 stockholders of record.
This article summarizes the business and legal factors that are causing management, directors, and stockholders to consider taking their companies private. It touches briefly on some legal aspects of realizing value after a privatization. Finally, it describes three methods for going private.
The Business and Legal Climate
The business and legal climate have changed dramatically in the last year. Public companies as a whole lost $7.7 trillion in market capitalization between March 2000 and July 2002. The activities at Enron and elsewhere inspired the Sarbanes-Oxley Act and corporate governance initiatives at the stock exchanges and Nasdaq.
The collapse in market valuations has affected the economics of remaining public. In particular, while a public company should still generally be able to raise capital more easily than a private company, the advantage is diminished if the company cannot easily tap the capital markets at an acceptable price. Companies must make similar calculations when considering whether to pay for an acquisition with stock: an acquisition may be unattractive if it is too dilutive. Options are also under pressure, as regulators urge companies to recognize a compensation expense, equal to the options' fair value, at the time of grant.
There will continue to be compelling reasons for many companies to go public and to stay public. Indeed, for enterprises that require large amounts of capital, staying public is the only feasible choice. For all companies, however, recent developments have affected the costs and risks of staying public. The increased costs and risks include the following:
- Independent audit costs have increased. The Wall Street Journal reports that accounting costs are likely to increase 15% to 25% this year. Among the factors driving this trend are (1) provisions in the Sarbanes-Oxley Act and new SEC requirements that are causing accountants to spend more time with audit committees and working on companies' Forms 10-K and 10-Q, and (2) the elimination of a market-participant, Arthur Andersen LLP.
- The Sarbanes-Oxley Act imposes new risks on officers of public companies. Among other things, the chief executive and financial officers must certify, in each of the company's Forms 10-K and 10-Q, that the report "fairly presents, in all material respects, the financial condition and results of operations of the issuer." An officer who signs this certification, knowing the report does not comply, may be fined up to $1 million and imprisoned up to 10 years; "willful" violators may be fined up to $5 million and imprisoned up to 20 years.
- Members of audit committees face new burdens. The Sarbanes-Oxley Act and corporate governance initiatives by the stock exchanges and Nasdaq generally require audit committees to oversee more actively companies' independent accountants and internal controls.
- The costs of regulatory compliance have increased. Among other things, the SEC has proposed to expand significantly the circumstances that necessitate the filing of a Current Report on Form 8-K, and the Sarbanes-Oxley Act substantially shortens the period for making filings under Section 16 of the Securities Exchange Act.
- The cost of directors' and officers' ("D&O") insurance is likely to increase substantially for public companies. A recent report by Willis Group Holdings, Ltd. concludes that financially strong companies face increases of 25% to 40% in D&O premiums while weaker companies can expect increases of as much as 400%.
Two financial developments have also fostered going-private transactions. First, large pools of capital are currently available for going private transactions. According to Buyouts, fourteen buyout funds raised a total of $5.54 billion in the third quarter of 2002. Second, relatively low interest rates may permit privatizations to be financed on attractive terms with borrowed funds.
Realizing Value After a Privatization
There are many ways to realize value after taking a company private. The business could be taken public again or could be acquired. Duracell is one of the better-known examples. In June 1988, KKR paid $1.8 billion for Duracell, of which $350 million was equity. In May 1991, KKR took Duracell public. Five years later, Gillette acquired Duracell for $7.8 billion. A privatized company can also be sold without first going public.
Finally, it is also possible to realize value from a privatized company by increasing its profitability and making distributions to its owners. Depending on the owners' tax-status and future plans, it may be tax-efficient to convert the newly-private corporation into a limited liability company or S-corporation. This has the effect of subjecting the company's income to only one level of U.S. federal and, depending on the jurisdiction, state income tax.
Methods for Going Private
A company can go private in a variety of ways, including a merger, a tender offer, and a reverse stock split. A privatization typically commences when a prospective buyer approaches a public company, which may form a special committee to consider the proposal. The special committee retains legal and financial advisors and negotiates with the prospective acquiror.
In a going-private merger, the parties execute a merger agreement, and the company sends its stockholders a proxy statement soliciting votes on the merger. If all conditions to the merger are satisfied, the parties file certificates of merger with the relevant states, and the public company merges with an entity formed by the buyer. As a result of the merger and by operation of law, the shares of the public company's stock (other than shares owned by the buyer) are converted into the right to assert appraisal rights or receive the merger consideration. The merger consideration is the cash or stock paid to the stockholders. A merger typically leaves the surviving corporation with one stockholder, a subsidiary of the buyer. The surviving corporation then files a Form 15 with the SEC and thereby goes private.
In a tender offer, the acquiror purchases shares directly from the public company's stockholders. The acquiror sends the stockholders a written offering document, the "offer to purchase," and a letter of transmittal, which stockholders use to tender shares. Tender offers are commonly conditioned on the buyer's holding at least 90% of each class of the company's stock following the offer. Ownership of at least 90% of the stock permits the buyer to complete a short-form merger, without a vote of stockholders or soliciting proxies. In the short-form merger, the shares that were not tendered are typically converted into the right to assert appraisal rights or receive the same consideration that was paid to the tendering stockholders. At the conclusion of the short-form merger, the company typically has one stockholder, a subsidiary of the buyer.
Companies can – but rarely do – go private through a reverse stock split. In a reverse stock split, each outstanding share is converted into a fraction of a new share, and stockholders receive certificates representing whole shares and cash in lieu of fractional shares. For example, in a 1-for-10,000 split, each stockholder who owned less than 10,000 shares would receive cash only, each stockholder who owned 10,000 shares would receive 1 new share, and each stockholder who owned more than 10,000 shares would receive 1 new share for each 10,000 shares owned and cash for the remainder of his shares. A reverse stock split is generally effected by amending the company's certificate of incorporation; this requires the company to disseminate a proxy statement and permit stockholders to vote on the amendment. A 1-for-10,000 split effectively cashes out holders of less than 10,000 shares and reduces the number of stockholders. If the number of record stockholders falls below 300, the company may go private.