An overview of the IPO process
If you have decided a public offering is the best financing solution for your company, you should realize that the IPO’s success depends on careful planning and the assistance of a team of qualified professionals. The IPO planning process should begin two to three years before the anticipated date of completing the offering. This lead time is important if you wish to keep IPO costs to a minimum, avoid surprises, adequately prepare the company for the due diligence process and the public scrutiny associated with an IPO, and increase the chances of good market timing.
The first thing to do in anticipation of an IPO is to develop a business plan detailing your strategic, marketing and financing plans for the future. This plan should include financial projections showing the amount of financing needed and the uses to be made of the funds raised. To help you identify areas needing special attention before you contact potential underwriters, you also should review a due diligence checklist, an example of which is included in Exhibit A of this guide.
Once you have completed your business plan and due diligence checklist, the company is ready to select a managing underwriter. The underwriter purchases the securities from the company and sells them to the public through a syndicate. Management must demonstrate to the underwriter that the company is qualified to go public. Your business plan, the company’s financing needs, the attractiveness of your company to the market, and a projected shortage of “problems” in the due diligence process will be factors in generating underwriter interest in your company. The estimated sales price per share and the number of shares to be offered are then negotiated with the underwriter.
Once the underwriter is selected, the underwriter begins the due diligence process and the preparation of the registration statement, a disclosure document filed with the SEC that consists of two parts:
- The prospectus, which is distributed to potential purchasers of the securities
- The supplemental information section, which contains other detailed information and various exhibits, including copies of key legal contracts and documents
The due diligence process and the preparation of the registration statement are usually the most time-consuming activities in the IPO process.
As the owner or manager of a private company, you likely will be surprised, and possibly frustrated, by the substantial disclosure requirements of the registration statement. The most important aspects of going public are understanding what information is required of you and then presenting it in a clear and forthright manner. To better understand the process and the role of the key team members, you should know what information will be required. The average two to three months (or more) that it takes to prepare to file the registration statement is generally due to the extensive due diligence process, the registration statement development itself and the frequent and interrelated business decisions that often must be made and implemented as part of the IPO process.
Once the registration statement is in final draft form, it is filed with the SEC in electronic format using the SEC’s Electronic Data Gathering and Retrieval (EDGAR) system. You also may be required to file the registration statement with the various states in which the securities are to be offered. The SEC thoroughly reviews the document and responds (usually within 30 business days) with comments about disclosures and accounting matters that need enhancement, clarification or modification. The comment letter process might require several rounds of SEC comments and company responses, including revisions to the registration statement. The SEC will declare the registration statement effective only after the required changes have been made and when it is satisfied with the responses to the comments. If the initial document filed with the SEC is printed, the underwriter might distribute copies of this preliminary prospectus, also known as a “red herring,” to potential investors during the period that it is under review by the SEC. However, the underwriter frequently will print a preliminary prospectus only after receipt of the initial SEC comments and the filing of an amendment to address such comments.
Prior to its IPO, a company may confidentially submit to the SEC a draft registration statement for nonpublic review by the staff of the SEC prior to public filing. This confidential treatment option permits the company to resolve accounting or disclosure issues with the SEC privately and delays exposure of sensitive competitive information until the certainty of an offering is confirmed. The initial confidential submission and all amendments to the registration statements then must be filed publicly at least 15 days prior to the IPO road show or, in the absence of a road show, at least 15 days prior to the requested effective date of the registration statement.
Although the underwriter cannot take orders or deliver securities until the registration statement becomes effective, most of the underwriter’s selling effort takes place beginning with the original filing and concluding when the registration statement becomes effective. The managing underwriter usually forms a sales and distribution syndicate. This syndicate of underwriters uses its salespeople to distribute the preliminary prospectus to clients and to obtain indications of interest in the stock. Although these indications of interest are not legally binding, they enable underwriters to evaluate the likely success and price of the offering.
Once the SEC is satisfied with the registration statement, but before it is declared effective, you will complete negotiations with the underwriter regarding the selling price per share, and the number of shares to be offered. A final amendment to the registration statement, the “pricing amendment,” is filed when this negotiation is completed. Subsequently, the registration statement is declared effective by the SEC and the securities commissioners of the various states, and the final prospectus is printed and sent to the underwriters’ customers along with the confirmation of sale.
The prospectus might appear to be a contradictory document. On one hand, it is a selling document and is used to persuade the public to purchase shares. At the same time, it must adequately inform investors of the offering’s risk factors and disclose all relevant information to protect against potential liability for material misstatements or omissions of fact. Accordingly, the prospectus can be a somewhat unpersuasive document. Your team of professional advisors can help you walk this fine line between salesmanship and liability protection. Obviously, full disclosure must be your paramount concern.
The final step in the registration process is the closing. The closing is the date on which you give the underwriter the shares of stock and, in return, receive the net offering proceeds. The closing generally is held three business days after the effective date, giving underwriters time to receive most customers’ payments before the closing date.
Legal and housekeeping issues
Start early! You should begin the registration process well before the anticipated offering date. The following paragraphs summarize some of the steps that should be completed before the registration process begins.
Some of the steps that should be taken early in the IPO process are probably things your company already is doing. First and foremost, you should develop a thorough and sound business plan, together with financial projections. These documents will be important in convincing the underwriter that your company is an IPO candidate.
You also should consider whether shares of common stock will be gifted to others or whether options are to be granted to management, employees or others. There are many different views on what percentage of the company’s common stock can be set aside in a stock-option plan. Additionally, there are specific accounting and SEC disclosure rules related to the exercise price of options issued within one year prior to a public offering if the estimated fair value is substantially below the IPO price. Therefore, it is never too early to consider this matter.
Further, you should evaluate whether each member of your management team is capable of leading the company following the IPO. As stated previously, there are differences in how decisions are made in a private company versus a public company. Certain management styles that succeed in a private setting might not work in the public setting. You need to decide whether each team member can adjust appropriately. If not, this evaluation might result in changes to your team.
Financial issues
Most private companies that maintain their records in accordance with U.S. generally accepted accounting principles usually do not follow some of the unique accounting principles or disclosures that generally are required of public entities. Some of the most common accounting and financial reporting matters a private company will encounter during the IPO process include stock-based compensation issues, the computation of earnings per share, the treatment of preferred and mandatorily redeemable stock, segment reporting and the discontinued use of private company accounting alternatives.
Further, many smaller privately owned companies do not have adequate accounting or internal control systems in place that will be required once they are publicly owned. These issues must be addressed long before the offering is undertaken. Starting with and following the offering process, accurate and timely financial reporting is essential. You must ensure that your company’s accounting and internal control systems are capable of meeting these demands.
Historical financial statements are a cornerstone of the registration process. Investors view an audit as an independent validation of financial reporting standards. The audit of the financial statements must be performed by an audit firm that is registered with the Public Company Accounting Oversight Board (PCAOB). Further, all periods presented in the financial statements must be audited in accordance with PCAOB standards. If the audit of prior years was performed in accordance with generally accepted auditing standards, the audit firm will need to perform certain procedures to ensure it can issue its opinion in accordance with PCAOB standards.
The SEC has specific requirements for audited financial statements, which must be met before it will review the registration statement. The SEC will not waive the requirements for the number of years of financial statements that must be audited. If your company has been in existence for more than two years, the financial statements presented would generally include balance sheets as of the end of the two most recently completed fiscal years and statements of comprehensive income, shareholders’ equity and cash flows for each of the past three fiscal years, together with related footnotes. Certain IPO registration statement rules for smaller reporting companies and emerging growth companies (as defined) require audited financial statements that include balance sheets as of the end of the two most recent fiscal years and statements of comprehensive income, shareholders’ equity and cash flows for the last two fiscal years. However, the smaller reporting company and emerging growth company rules might not be available to your company. It is a good idea to review these requirements early in the process.
If the filing (or effective) date is more than 134 days after the most recently completed fiscal year-end, interim-period financial statement information is required. The interim-period financial information might be unaudited but must be reviewed by the company’s auditor. Occasionally, underwriters will require interim financial statements to be audited if they believe this will add credibility to the prospectus. In addition, the underwriter usually will require the independent auditor to issue a “comfort letter,” designed to assist the underwriter in the performance of due diligence procedures. As a result, the auditor will be required to perform additional procedures on financial data included in the registration statement.
A common, significant problem in companies pursuing IPOs involves the audited financial statement requirements for businesses acquired during the reporting period. This issue focuses on whether a business (as opposed to assets) has been acquired and the relative significance of this acquired business to the company.
The determination as to whether a business has been acquired requires an evaluation of the facts and circumstances involved and whether there has been or will be sufficient continuity of operations of the acquired business. Generally, it is assumed that the acquisition of an entity, subsidiary, division, and even generally, a lesser component of an entity, might constitute the acquisition of a business.
If a business has been acquired, the audited financial statements of the acquired business might be required for certain periods prior to the acquisition date. The number of years to be included in the registration statement generally is based on the significance of the assets and net income or losses of the acquired business to the acquiring company. The periods required to be presented include the number of months of the acquired business that are already part of the company’s financial statements presented in the registration statement (i.e., the period since the acquisition was consummated). The requirements to determine the number of years of the acquired business’ financial statements are complex and beyond the scope of this document. You should discuss this issue with the company’s auditor early in the IPO process. It is difficult to obtain a waiver from the SEC regarding these requirements.
The board of directors
Most private companies have a board of directors composed of some or all the shareholders and, in some instances, other members of the company’s management, family members or other acquaintances. A strong, credible board of directors consisting of some independent (not affiliated with the company) board members is an excellent management practice. In addition, the SEC and the stock listing requirements of the various exchanges require a majority of outside independent board members. It is never too early to consider likely additions to your board of directors. Outside directors should be chosen for their business or industry knowledge and reputation, rather than for personal relationships. Further, you should implement a board of directors’ compensation program early in the process to attract qualified board members as the company will be required to get a commitment from most independent board members.
The board of directors of public companies typically will have one or more committees, including an audit committee, a compensation committee and a nominating committee. The audit committee must be directly responsible for the appointment, compensation and oversight of the company’s auditor. SEC rules and stock exchange listing requirements require a public company to have an audit committee consisting of independent members and at least one “financial expert” serving on its audit committee. For an IPO, the issuer’s audit committee must have at least one independent member at the time of the IPO, a majority of independent members within 90 days, and a fully independent committee within one year.
The players
There are a number of players, each of whom is involved in, and critical to the success of, any public offering. Selection of the proper professionals who will do a quality job for your organization should be one of your major objectives. Additionally, it is critical to establish the costs of the services to be provided by all members of your IPO team. A brief description of each of the major players is summarized below.
Sometimes referred to as the managing underwriter or the investment banker, the underwriter is responsible for getting your company’s stock sold and determining at what price it will be sold. Typically, the underwriter forms a syndicate of other investment bankers who participate in the purchase of securities from your company (or the shareholders, if there are selling shareholders) at the closing date. The underwriter and syndicate members resell the shares to the public in the open market.
In addition to arranging for the sale of a company’s shares, the underwriter provides market support for shares after the offering has been completed. The underwriter also can provide assistance in structuring the transaction and the timing of the actual offering, based upon its knowledge of the market and the company’s industry. In addition, the underwriter’s research capabilities should be evaluated and considered in your selection process. You can sell your shares to the public without an underwriter, but the process is extremely difficult and seldom done. Further, the absence of an underwriter usually has an adverse effect on the after-market support for your company’s shares.
The company must file a registration statement with the SEC before offering securities for sale in the public markets. The SEC thoroughly reviews the registration statement for compliance with its disclosure requirements, but does not pass on the merits or accuracy of the prospectus or the quality or worthiness of the underlying securities, or in any other way approve the registration statement. However, the registration statement cannot become effective without the consent of the SEC. The SEC has the authority to pursue civil and criminal prosecution against those who breach established procedures and disclosure requirements. Because of these regulations, disclosure documents must contain complete and accurate statements of material fact and not omit any required or other disclosure, which, by its absence, might mislead potential investors.
The registration statement typically is reviewed by the SEC’s Division of Corporation Finance. Teams of SEC attorneys and accountants, and frequently industry specialists, review the registration statement and issue a letter of comment on perceived deficiencies or inaccuracies (commonly referred to as a “comment letter”). An IPO typically will involve at least one comment letter. Upon receipt of the comment letter, the company, its legal counsel and registered public accounting firm together with the underwriters and their legal counsel meet to discuss the required response to the comments. When this group believes a comment letter issue is in need of discussion with the SEC, the SEC examiner is contacted to provide further relevant information. Otherwise, the registration statement is modified to satisfy the SEC’s concerns.
The period needed to respond to the SEC’s comments usually ranges from a few days to two weeks, depending on the nature and number of comments. When the registration statement has been amended to reflect responses to the SEC’s comments, the company refiles with the SEC as an amendment. The typical review period for the original filing is 30 days, and the review period for amendments is usually a few days to a week. If the registration statement contains unusual disclosures or complex financial transactions, the SEC might have several rounds of comments. Each additional round of comments can add seven to 14 days to the filing process. The registration statement is declared effective only after the SEC is satisfied that all of its concerns have been resolved.
Additionally, the various state securities divisions might review the registration statement. Unlike the SEC, many states also review the offering for fairness. These reviews can cause delays and, in some instances, major changes to the document. In some cases, the state securities divisions have precluded a company from selling its securities in that particular state due to concerns over the merits of the offering. Further, Blue Sky laws are not uniform among states, thereby increasing the chance for delays. To avoid potential Blue Sky issues, it is essential that you, your legal counsel and the underwriters determine where the securities will be sold and identify potential problems that might be encountered. If significant issues are anticipated, it might be necessary to avoid registering the shares in a particular state or states.
The underwriter will be represented by separate legal counsel. While you have no input into which firm the underwriter decides to use, it is beneficial if your SEC counsel and underwriter’s counsel have previously worked together.
You should expect periods of frustration as the underwriter’s counsel and the company’s counsel seem to be duplicating work. The underwriter’s counsel is a necessary member of the IPO team and helps ensure that the underwriter is thorough in its due diligence process and is legally protected from inadvertent liability that could arise out of the registration process.
The due diligence process
Due diligence is the process of investigation of the company by the underwriters and their counsel to determine whether the company is fit for an IPO and that all material and pertinent disclosures are included in the prospectus and the registration statement. Additionally, the due diligence process allows the underwriter to develop a marketing strategy to help ensure the successful sale of the securities offered in the IPO. The due diligence review typically includes, but is not limited to, a review of the company’s business plan, market research, management team, articles of incorporation, bylaws, legal issues, patents, financial statements, other financial information and major contracts and agreements. In addition, the due diligence process encompasses the underwriters and counsel meeting with your key management team members and select employees, customers and suppliers.
This investigation effort is critical since, under the securities laws, any person who has signed the registration statement, was a director of the issuer at the time the registration statement became effective, consents to be named in the registration statement as becoming a director, or is an accountant, appraiser or engineer who consents to be named as an expert in the registration statement might be held liable if the registration statement contains any untrue statement of a material fact or if the registration statement fails to disclose materially important information. Be prepared for an in-depth probe of your company, its operations and marketing activities and its management personnel.