The decision to take a company public in the form of an initial public offering (IPO) should not be considered lightly. There are several advantages and disadvantages to being a public company, which should thoroughly be considered. This memorandum will discuss the advantages and disadvantages of conducting an IPO and will briefly discuss the steps to be taken to register an offering for sale to the public. The purpose of this memorandum is to provide a thumbnail sketch of the process. The reader should understand that the process is very time consuming and complicated and companies should undertake this process only after serious consideration of the advantages and disadvantages and discussions with qualified advisors.
ADVANTAGES AND DISADVANTAGES OF AN IPO
- Increased Capital. A public offering will allow a company to raise capital to use for various corporate purposes such as working capital, acquisitions, research and development, marketing, and expanding plant and equipment.
- Liquidity. Once shares of a company are traded on a public exchange, those shares have a market value and can be resold. This allows a company to attract and retain employees by offering stock incentive packages to those employees. Moreover, it also provides investors in the company the option to trade their shares thus enhancing investor confidence.
- Increased Prestige. Public companies often are better known and more visible than private companies, this enables them to obtain a larger market for their goods or services. Public companies are able to have access to larger pools of capital as well as different types of capital.
- Valuation. Public trading of a company's shares sets a value for the company that is set by the public market and not through more subjective standards set by a private valuator. This is helpful for a company that is looking for a merger or acquisition. It also allows the shareholders to know the value of the shares.
- Increased wealth. The founders of the company often have the sense of increased wealth as a result of the IPO. Prior to the IPO these shares were illiquid and had a more subjective price. These shares now have an ascertainable price and after any lockup period these shares may be sold to the public, subject to limitations of federal and state securities laws.
There are numerous disadvantages to going public.
- Time and Expense. Conducting an IPO is time consuming and expensive. A successful IPO can take up to a year or more to complete and a company can expect to spend several hundreds of thousands of dollars on attorneys, accountants, and printers. In addition, the underwriter's fees can range from 3% to 10% of the value of the offering. Due to the time and expense of preparation of the IPO, many companies simply cannot afford the time or spare the expense of preparing the IPO.
- Disclosure. The SEC disclosure rules are very extensive. Once a company is a reporting company it must provide information regarding compensation of senior management, transactions with parties related to the company, conflicts of interest, competitive positions, how the company intends to develop future products, material contracts, and lawsuits. In addition, once the offering statement is effective, a company will be required to make financial disclosures required by the Securities and Exchange Act of 1934. The 1934 Act requires public companies to file quarterly statements containing unaudited financial statements and audited financial statements annually. These statements must also contain updated information regarding nonfinancial matters similar to information provided in the initial registration statement. This usually entails retaining lawyers and auditors to prepare these quarterly and annual statements. In addition, a company must report certain material events as they arise. This information is available to investors, employees, and competitors.
- Decisions based upon Stock Price. Management's decisions may be effected by the market price of the shares and the feeling that they must get market recognition for the company's stock.
- Regulatory Review. The Company will be open to review by the SEC to ensure that the company is making the appropriate filings with all relevant disclosures.
- Falling Stock Price. If the shares of the company's stock fall, the company may lose market confidence, decreased valuation of the company may effect lines of credits, secondary offering pricing, the company's ability to maintain employees, and the personal wealth of insiders and investors.
- Vulnerablility. If a large portion of the company's shares are sold to the public, the company may become a target for a takeover, causing insiders to lose control. A takeover bid may be the result of shareholders being upset with management or corporate raiders looking for an opportunity. Defending a hostile bid can be both expensive and time consuming.
Once a company has weighed the advantages and disadvantages of being a public company, if it decides that it would like to conduct an IPO it will have to retain a lead underwriter to sell the securities, an attorney to assist in the preparation of a registration statement, and auditors to prepare financial statements.
THE REGISTRATION STATEMENT
The Securities Act of 1933 ("1933 Act") requires, with limited exceptions, that before securities are sold to the public that the public be provided with adequate, reliable, and timely information about the company.
The 1933 Act provides for different forms to register securities. It is important to determine which form is the proper form for the company to use. Typically, when conducting an IPO the company will file either a Form S-1 or a Form SB-2. Form S-1 is the most common registration form and the "general purpose form." Form SB-2 is available to reporting and non-reporting companies in the U.S. or Canada with revenues of less than $25 million in the last fiscal year, and which are not investment companies.
No matter which registration statement a company selects, the structure of the document will essentially be the same. The first part of the registration statement will be the prospectus, which will contain information regarding the company, the securities being offered, the manner of distribution, and the company's audited and unaudited financial statements as dictated by the 1933 Act disclosure rules.
The prospectus will be the main marketing document for the IPO. Therefore, it is important that the information in the prospectus be in plain English and be easily understandable. The prospectus should not contain statements that are ambiguous, contradicted in other sections of the registration statement, or not supportable.
Moreover, any drafter should be cautious to ensure that the document carefully reflects the risk of investing in the company and that potential investors are fully apprised of the strengths and weaknesses of the company. This includes providing the reader with information on competition, government regulation of the industry, risks associated with the company's product, and dependence on a small number of customers or contracts.
Providing this information in the prospectus should reduce the number of comments by the SEC and other regulators. Equally important, as any investment in an IPO has inherent market risks, by providing complete disclosures on the weaknesses of the company and the risks of the investment, the drafters may limit the company's, underwriter's, attorneys', and selling brokers' liability in the event that the offering does not fare well.
The other portions of the registration statement will contain required consents, exhibits (including employment agreements for key employees and material contracts), signatures, and various undertakings. These sections are not generally distributed to the prospective investor. However, they are available to the public from the SEC or on EDGAR.
After the registration statement has been completed, it will be filed with the SEC, on EDGAR, sent to the NASD and respective listing exchange(s) and the Blue Sky administrators in the states that the company and the underwriter want the IPO to be sold.
THE REVIEW PROCESS.
Once the regulators receive the registration statement, they will start a review process or comment period. The SEC, the NASD, the specific listing exchanges, and Blue Sky regulators, may all instruct the company or the underwriters to make certain changes to the disclosure in the registration statement, company's by-laws, and may designate to whom the securities may be sold. The company cannot sell any securities during this time period and must await approval from the various regulators. This is called the "waiting period."
Technically, a registration statement becomes effective with the SEC twenty days after it is filed with the Commission, unless it is subject to a refusal order or a stop order by the SEC or unless it is declared effective sooner. However, do not expect a registration statement to become effective twenty days after the initial filing. The SEC review process can take several months. To prevent registration statements from becoming effective before a complete review by the SEC, delaying amendments are deemed automatically filed by merely providing language on the facing page of the registration statement at the time of the original filing.
The SEC review process is undertaken by the Division of Corporate Finance. Inside the Division of Corporate Finance, there are five branches that have been set up among industry lines to review the registration statement focusing on areas of a specific industry. Each registration statement will be assigned a team of a staff examiner, a staff accountant, and a branch chief or assistant branch chief who manages the review. In the case of an IPO, the registration statement will typically receive a full review by the SEC. During this review the SEC will advise the company through a "comment letter" of areas of the registration statement or other reviewed documents that the SEC believes are deficient, need clarification, or any other issues that the SEC deems relevant. The SEC does not review the registration statement for merit, but simply to make sure that it complies with the disclosure rules of the 1933 Act and SEC releases. The company will have to make revisions to the registration statement and resubmit it to the SEC. In addition, the SEC may provide comments that require a letter from the company, the accountants, or counsel for the company that may not be incorporated into the registration statement. This process may take several comment letters and responses before a registration statement becomes effective and company can sell the offering.
NASD and Blue Sky Review:
In addition to SEC review, a company and underwriter should expect to engage in a similar review process from the NASD, exchanges, and the Blue Sky regulators (however, unlike the SEC, several states will conduct a merit review of offering). Before any security can be sold in a specific state that security must be subject to an exemption from review or be reviewed by that state's regulators. The lead underwriter's counsel will typically respond to the comments submitted by the Blue Sky regulators. However, the lead underwriter's counsel will have to work closely with the company and its counsel to make sure that all requests by the regulators are complied with by the company. In situations where the lead underwriter and/or the company oppose the requests from a specific state, they may decide not to sell securities in that state.
The NASD: The NASD will primarily be working with the lead underwriter's counsel and will be concerned with the compensation and conditions of the underwriting agreement. The SEC will not provide a company with effective status, until it receives from the NASD an opinion that the underwriter's compensation is not excessive. The NASD may also request information on various other areas of the offering.
Specific Exchanges: Whether the securities are to be listed on NASDAQ NMS, or Small Cap or listed on one of the various regional exchanges, the offering will also have to be reviewed by these exchanges to make sure that that exchanges listing requirements are satisfied before listing is permitted. A company whose shares are traded on NYSE or NASDAQ NMS are preempted from registration and qualification, review and imposition of requirements and conditions on the registration statement, and restrictions or conditions based on the merits of the company or the offering, by a Blue Sky regulator. This is due to the NYSE's and NASDAQ NMS's restrictive registration requirements.
RED HERRING AND ROAD SHOWS
Although the securities cannot be sold until the effective date, the 1933 Act does permit oral offers or written offers by means of a preliminary prospectus once a registration statement has been filed. Prior to the filing of the registration statement, no oral or written offers may be made. Thus, during the waiting period, the underwriter will conduct road shows and distribute a "red herring." The red herring is a preliminary prospectus that is essentially complete except for financial statements, the offering price, and final changes by the regulators. The purpose of the red herring is to determine the interest in the offering among potential purchasers. The prospectus will clearly state that it is not complete, may change, and that the securities may not be sold until the registration statement filed with the SEC is effective. It will further state that the prospectus is not an offer to sell the securities and that the company and underwriter are not soliciting offers to buy the securities in any state where the offer or sale is not permitted.
As stated above, the red herring is often distributed to institutional investors, portfolio managers, analysts, and securities sales personnel at meetings which are called "road shows." The underwriters will often use the interest in the securities as determined by the road shows to decide the size and the pricing of the securities. The road show usually starts with a presentation by a representative of the lead underwriter, who will provide the investors with an overview of the offering. Representatives from the company's management will present next and provide more detailed information regarding the company - there will often be slides and other visual aids. Hard copies of materials and written information, other than the preliminary prospectus, may not be distributed to the investors at the road show as such material may be deemed to be an illegal prospectus (one that does not meet the requirements of the 1933 Act).
Once the SEC staff is satisfied with the disclosure and the registration statement, the SEC will order the registration statement to be in effect in other words that the securities may be sold to the public. It is important to remember that the SEC does not do approve the merits of the offering, but rather the registration statement and a party should not state that the SEC has approved the securities.
There are precise rules that must be followed regarding mailing of the final prospectus once the company receives effective status. For example, once a company has effective status, the final prospectus must be mailed to any investor who is expected to receive a confirmation of a sale of the company's securities prior to or at the same time as the confirmation is sent to that investor. In addition, a final prospectus must be supplied in connection with all offers and sales that occur 25 days after the effective date.
Once the registration statement is effective, it is difficult for a company to change its mind and return to a private status. The company must now be cognizant of disclosure rules of the SEC, NASD, and any other exchange that the securities are listed on and be cautious not to violate these regulations.
The purpose of this memorandum is to provide a brief overview of the going public process. The focus of the memorandum was on the legal side of the process and not on the selling or underwriting aspects.