OVERVIEW
The U.S. public capital markets are the largest, most flexible and most attractive source of capital to companies raising money through the sale of equity or debt securities. In 1994, companies raised $66.5 billion in public equity offerings, including $23.2 billion raised in initial public offerings (IPOs). The equity markets have been particularly receptive to offerings by companies in technology, life sciences and other emerging growth industries. As a result, an increasing number of non-U.S. companies in emerging growth industries are recognizing the opportunity to raise money in an IPO in the United States, and to do so at a relatively favorable valuation. Companies considering an IPO can benefit from an understanding of the basic market dynamics, investor expectations, the public offering process and requirements imposed upon public corporations after the offering, as well as the corresponding implications for corporate governance, financial reporting, internal information systems, investor relations, corporate culture and management. This article is intended to provide, for companies who may be considering such an offering, an introduction to some of the issues that should be considered.
CANDIDATES FOR A U.S. IPO
Non-U.S. issuers that are particularly attractive candidates for an IPO in the United States are companies in emerging growth industries, such as information technology, telecommunications, life sciences and specialty retailing, in which companies generally may be expected to have a rate of growth in excess of more mature industries. The market will be most interested in an issuer that expects to achieve an annual growth rate of at least 20% and has developed its business sufficiently to support an initial valuation in the U.S. market of at least $75-100 million. In addition, a company is generally a better candidate for a U.S. offering if it conducts business in the United States or is expanding into the United States, and is in an industry understood by U.S. investors. A company should also have achieved a relatively stable and predictable level of operations, reflected by the experience of the management team, the adequacy of internal financial reporting and accounting controls, the predictability of operating and financial results, and the company's business and financial outlook.
ISSUES TO CONSIDER IN ADVANCE OF AN IPO
In determining to undertake an initial public offering in the United States, and in preparing itself for the offering process, a non-U.S. company should take steps to make the Company more accessible to U.S. investors. The institutional investors who are the principal purchasers and holders of publicly offered stock in the United States are continually presented with a large number of investment options. Accordingly, these investors generally are unwilling to devote significant time and effort to understand the unique legal and corporate attributes of a non-U.S. issuer unrelated to the business itself. Thus, non-U.S. issuers can help ensure a more receptive market for their shares by anticipating the expectations of U.S. investors and providing assurances regarding a number of corporate and other issues important to U.S. investors. The issues to be considered in advance of an IPO include the following:
Corporate governance
Some aspects of corporate governance may need to be modified specifically in order to meet the requirements of U.S. securities regulations, the individual exchange on which the securities are to be listed, and the expectations of investors. For example, investors in the U.S. capital market expect a company's board of directors to exercise independent judgment and serve as the ultimate fiduciary representative of shareholder interests. Accordingly, U.S. investors expect, and the Nasdaq National Market and New York Stock Exchange require, that the board of directors include at least two disinterested, non-insider members, that the company establish an audit committee of the board composed primarily of disinterested directors, and preferably that the company also establish a compensation committee. There may also be differences between the shareholder rights expected by U.S. investors and the rights accorded to shareholders by the company's country of origin. Shareholder rights should generally be brought in line to the greatest extent possible with practices of U.S. companies. For example, U.S. investors expect that the board of directors will have the flexibility to issue additional equity of the company to meet business needs, out of authorized but unissued shares, without the requirement of further shareholder approval or compliance with shareholder preemptive rights.
Financial reporting
Although U.S. financial reporting requirements for companies whose shares are traded in the U.S. markets are generally less stringent for non-U.S. companies than for U.S. companies, these requirements may differ from the issuer's current practices. The legal technicalities of registration and reporting can be addressed during the offering process itself, but some advance planning may be warranted.
Generally, a non-U.S. issuer will be required to provide at least three years of audited financial results (balance sheet as of the end of the two most recently ended fiscal year and statements of income and cash flows for each of the three most recent fiscal years), but is free to select the currency in which it reports its financial results. It may prepare its financial statements in conformity with any body of generally accepted accounting principles (GAAP) so long as it provides a reconciliation to U.S. GAAP. The preparation of these statements often requires a significant amount of effort, and accordingly work may need to be undertaken in advance of the offering process. Moreover, in light of the greater familiarity of U.S. investors with U.S. GAAP, many foreign issuers with a significant U.S. presence and/or significant functional operations in U.S. dollars may wish to elect to report their results in U.S. dollars and in conformity with U.S. GAAP in anticipation of an offering in the U.S. Following the offering, non-U.S. issuers are required to provide to U.S. investors annual reports on Form 20-F, plus such additional periodic reports as may be required under the laws of their home country or the foreign exchange on which they may also be listed. Although many non-U.S. jurisdictions only require annual and semi-annual reports, U.S. investors will typically expect to receive reports on a quarterly basis. Moreover, U.S. investors will typically expect the company to provide in the IPO prospectus quarterly financial information for the prior one to two years. Accordingly, the Company may need to develop historical quarterly financials and to implement systems to support quarterly financial reporting in future periods, and may also need to undertake changes within the organization to permit the company to operate on a quarterly reporting basis.
Disclosure and publicity
An initial public offering in the U.S. markets, as well as an issuer's subsequent responsibilities as a publicly traded corporation, impose significant public disclosure challenges. In the IPO prospectus, the issuer must balance promotion of the company's success to date and the company's future potential against the need to identify the risks associated with the company's business. During road show presentations to prospective investors in connection with the offering, management should avoid making statements or projections that could be construed as inaccurate or misleading while trying to promote the sale of its shares. Following the offering, this tension continues as companies try to maintain interest in the company and its stock within the investment community while avoiding liability for inaccurate, improper or untimely disclosure of information to the public. An issuer of shares in the U.S. market is liable for any material misstatements or omissions in the prospectus for the offering, and will be liable to public investors following the offering for any material misstatements or omissions in public communications if intentionally or recklessly made. Accordingly, companies preparing to go public must become sensitive to their disclosure obligations in dealing with the public, and investor relations should become an important focus of management. Companies must know how to provide the market the information it needs without making predictions or projections that will create unrealistic expectations and could generate a class action lawsuit by shareholders who feel they were misled or inadequately informed. Handling disclosure issues with acuity, knowing what to say and when and how to say it, and knowing what not to say, is a skill that public company management must understand and implement.
Corporate culture
The U.S. public capital market for emerging growth stocks tends to make valuation decisions based not only on long term prospects but also short term, quarterly operating results. Accordingly, share prices can be highly volatile. Management must be prepared for increased complexity in balancing near term solutions with long term strategy. Employees, whether or not they hold stock options, should understand the difference between the long term vision and value to which they are personally committed and short term swings in stock price, or the company may risk demoralizing its work force at a critical time in its growth.
Employee benefits
Many issuers may wish to review their existing employee benefit plans and adopt certain plans that can be advantageous to public companies. Most smaller U.S. public companies do not have retirement or pension plans as are common to many European companies, but almost all have employee stock option plans. If the issuer contemplates commencing or increasing operations in the U.S., it may consider adopting an employee stock option plan and a payroll deduction stock purchase plan, each of which can provide significant tax advantages to U.S. employees. The issuer may also consider adopting a director stock option plan which can help the company attract qualified independent, outside directors. It is often easier to adopt these plans and obtain requisite shareholder approval before the company is publicly traded.
Companies that decide to adopt some form of share option plan will also need to be sensitive to the dilutive effect of employee stock options on earnings per share (EPS) and the impact of employee stock option pricing on the company's market valuation in the offering. Under U.S. GAAP, options that are vested and exercisable for a price lower than the current market price will be considered as outstanding shares for purposes of determining EPS. In addition, if options have been issued to employees at an exercise price below the fair market value of the underlying shares at the time of grant, the difference between the exercise price and such fair market value is treated as compensation expense and is charged to earnings immediately or, if the option is subject to vesting over time, in connection with the vesting schedule. Accordingly, options should be priced at fair market value at the time of grant. For a public company this is the publicly traded share price. For a private company, it is appropriate to grant options at a lower price than the expected publicly traded price, due to the discount inherent in illiquid securities, but the company must ensure that grants are not at such a low value as to give rise to a compensation charge.
THE IPO PROCESS
Structuring the offering
The company, in consultation with its investment bankers, will need to determine the number of shares to be offered to the public and the price per share. Typically, the investment bankers will want to ensure that the transaction involve the offering of shares having a value of at least $20 - 25 million in order to create a sufficient market float following the offering to constitute a liquid market. In addition, investors will typically expect an initial public offering price in the range of approximately $10 to $15 per share, and the company's capital stock may need to be adjusted via a stock split or combination to achieve this end. The number of shares to be offered is a function of a number of factors, including the amount of capital to be raised, the valuation of the company, the need to create a sufficient market float, and the desire to avoid too great a reduction of existing shareholders' ownership interest or dilution of EPS figures.
A company will also need to determine whether shareholders will be permitted to offer shares in the IPO. If the company does not need to raise a large amount of capital, the company may wish to solicit shareholder participation to increase the size of the offering and the size of the public float. In addition, existing shareholders may desire to achieve liquidity for a portion of their shares immediately when the offering happens. In setting expectations as to selling shareholder participation, however, the company must be aware of certain limitations. First, investors typically will want to ensure that a substantial portion of the total offering proceeds will benefit the company itself, to meet its working capital needs. Thus, it is unusual for selling shareholder participation to be more than 50% of the total offering. In addition, investors will not react favorably if management is selling a significant portion of their holdings, and accordingly it is unusual for management selling shareholders to constitute more than 10% of the offering or for any individual insider to sell more than a small portion of his or her holdings. Significant sales by insiders in the IPO can create a perception on the part of prospective investors that insiders are reducing their commitment to the company, which would make the offering more difficult to sell.
Underwriting arrangements
Typically, IPOs are underwritten on a firm commitment basis, in which the underwriters commit to purchase the shares from the company at a negotiated discount and then resell the shares to the public. This commitment is made pursuant to an underwriting agreement signed by the company, the managing underwriters and any selling shareholders. Most firm commitment underwritings include an over-allotment option (sometimes referred to as the green shoe), under which the company or the selling shareholders or both grant a thirty day option to the underwriters to purchase additional shares (generally 15% of the number of shares sold in the offering) on terms identical to those on which the original shares are sold. The over-allotment option is of substantial use in ensuring the success of an IPO, as it enables the underwriters to over-allot the shares it is purchasing from the company in order to create excess market demand, and to satisfy this demand through exercise of the over-allotment option.
In the underwriting agreements, issuers should expect to make significant representations and warranties regarding the business and financial condition of the company, to covenant to provide ongoing financial reports to the underwriters and investors and otherwise to comply with the legal obligations of a publicly traded corporation, and to indemnify the underwriters against any liabilities to which they may be subject as a result of the public offering. Underwriting arrangements vary from investment bank to investment bank but each generally involves similar provisions designed to protect the underwriters from liability in connection with the public offering, under the theory that the issuer and the selling shareholders typically receive the bulk of the proceeds of the offering and are in a better position to know whether the prospectus is accurate.
Lockup agreements
An important structuring issue, and one that can be controversial, is the lockup arrangement. In order to ensure orderly trading for the company's stock following the IPO, managing underwriters generally require the company and its directors, officers and major shareholders to agree not to sell any securities of the company for a specified period of time (typically 180 days, but on rare occasions as few as 90 or as many as 360 days) after the commencement of the IPO. After making the decision to effect an IPO in the United States, a company should focus on the need for the support of its directors and shareholders and for their consent to enter into lockup agreements, especially if, as is often the case with non-U.S. companies, there are no prior contractual arrangements for obtaining lockup agreements from such persons.
American Depository Receipts
Initial public offerings of U.S. companies are typically effected through ordinary, common shares. Companies incorporated in certain other jurisdictions may offer common shares without significant administrative burden (such as The Netherlands). However, in some jurisdictions (such as France) the legal, tax and administrative burdens associated with common shares may make it advisable to consider offering American Depository Receipts (ADRs).
An ADR is a negotiable instrument issued by a third party depository which represents a specified number of underlying securities of the issuer. ADRs alleviate certain legal restrictions and practical problems which could affect trading in the underlying securities. For example, ADRs are transferable on the books of the depository bank without the need to record the transfer of the underlying securities on the books of the issuer. ADRs can expedite the processing of securities transactions, can eliminate transfer taxes, and can reduce any practical problems with respect to foreign exchange controls.
Due diligence process
The registration statement used to effect the IPO contains certain required information describing the company and its business. Each participant involved in the preparation of a registration statement is potentially liable for material misstatements or omissions in the prospectus (and the company is strictly liable for material misstatements or omissions in the prospectus). Accordingly, all parties must undertake a thorough due diligence effort to ensure the accuracy and completeness of the disclosures in the prospectus.
The issuer can facilitate the public offering process by preparing in advance for the due diligence that will be required. Based upon a sample due diligence request list that the company's legal advisors will provide, the company should begin to accumulate material agreements and critical business and financial data to be reviewed in connection with the preparation of the registration statement and to be made available to the underwriters and their counsel. The company should also begin to identify those agreements that may be required to be included as exhibits to the registration statement early in the offering process.
Additionally, the due diligence process will involve extensive due diligence interviews with the chief executive officer, chief financial officer, chief technical officer, senior marketing and sales managers and other key managers with knowledge of significant aspects of the company's business.
The auditors of the company will also be interviewed and asked to discuss both the company's financial statements and its accounting staff, policies, systems and controls, including material weaknesses and areas for improvement, if any. During these interviews, the company should be open and frank, in order to ensure that the offering document is prepared accurately. Because the due diligence process is likely to be new to management, it can be helpful to review the process with management in advance in order to help management prepare for their interviews and accumulate relevant data.
Pre-filing publicity issues
Prior to the commencement of the IPO process, company counsel should review with management the legal restrictions on publicity relating to the offering. U.S. securities laws provide that, without an exemption, it is unlawful to offer to sell any security unless a registration statement has been filed. The securities laws broadly define what constitutes an offer, and the U.S. Securities and Exchange Commission has made it clear that publicity which has the effect of conditioning the public or arousing public interest in the issuer should be construed as an offer to sell. Consequently, certain activities or publicity prior to the filing of a registration statement may result in a violation of the securities laws, even if the activity or publicity was not phrased in terms of an express offer to sell stock and regardless of whether it was made orally or in writing.
Once a company has begun the process towards launching an IPO, it generally may continue to issue press releases in the normal course of business with respect to factual business developments, to advertise products, and to communicate with its shareholders, provided that such disclosures are consistent with prior practice and do not contain projections, forecasts or opinions regarding valuation. However, a company generally should not conduct interviews with newspapers and magazines, or effect speeches to special groups covering the company's business or financial condition or outlook. Normal product marketing activities, such as articles in trade publications relating to specific product lines, are generally permitted, but comments by management relating to the company's performance, prospects or related matters are suspect. Any such violation could result in sanctions from the Securities and Exchange Commission, including a delay in the offering itself. Restrictions on publicity, and on the limited manner in which offers may be made, continue after the filing of the registration statement as well.
Conclusion
We have attempted to provide a general overview of certain of the issues that arise when a non-U.S. company is considering an IPO in the U.S. The laws and rules that govern the IPO process and that apply to public companies are complex and constantly changing. Accordingly, a non-U.S. company should consult with experienced U.S. counsel well in advance of a proposed U.S. IPO in order to prepare the company to address the numerous issues that will arise in connection with such an undertaking.