Good Company

Are You Ready for the Next Step? Advantages and Disadvantages of Going Public

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The following is an excerpt of Chapter 4 of the forthcoming Second Edition of Sheehan Phinney Bass + Green's booklet Raising Capital for the Emerging Business." Excerpts of the other chapters of the booklet will appear in future editions of Good Company. Hard copies of the full booklet will be available by request to info@sheehan.com and the booklet will also be available through the Firm's website at www.sheehan.com.

For many managers of an emerging business, the ultimate achievement is successfully taking their company public in an underwritten initial public offering (IPO). In an IPO, the emerging business sells its shares to public investors and typically lists its shares for trading on a recognized stock exchange or other trading system. An IPO is a way to raise large amounts of additional capital, and a public registration and listing makes it much easier for the company to conduct future offerings and acquisitions involving the company's stock as consideration. An IPO is often viewed as a goal in its own right, as it confers status and credibility on the company and its managers, and often, though not necessarily, results in the enrichment of founders or managers.

In reality, going public carries substantial burdens and risks, in addition to rewards. An IPO may allow an emerging business to part company with VC investors, who may choose to sell into the offering or, more commonly, conduct a follow-on offering of their own months after the IPO. An IPO may also allow the company to realize liquidity for founders, managers and early-stage investors. Although the legal restrictions on sales of stock by insiders of a public company are complex, a public trading facility may allow such groups to cash-out at a much higher market price than the price at which they invested. However, an IPO is a very expensive process, both in terms of the direct expenses of the offering, and also in terms of the time, attention and expenditures required to prepare the company for an IPO. An IPO also subjects the managers of an emerging business to a high degree of liability, because the registration provisions of the Securities Act of 1933 (Securities Act) make an issuer and its "control persons" strictly liable to public investors for material misstatements in the offering documents. Once a company is publicly traded, it falls under the many provisions enacted as the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Also, going public exposes the company to judgments by the equity markets, which can be a very fickle master.

A company that goes public is expected by the markets to continually enhance shareholder value. If an IPO happens in a time of high expectations, the newly public company may have difficulty meeting expectations. A company may very easily lose the confidence of the markets by stumbling (or appearing to stumble) in the aftermath of an IPO. Smaller public companies that lose the confidence of the markets may find it difficult to regain that confidence, as brokerage house analysts may stop covering a stock, and without analyst coverage a company's stock price may languish for a long time.

A public company with a low market price exists in a kind of purgatory. It may have all of the burdens of a public listing with few of the benefits. Management may be subject to change, since the markets abound with opportunistic players with colorful names such as "bottom-fishers," "bust-up artists" and "green-mailers," among others. Shady brokerage houses[1] may attempt to manipulate the stock price of the company in an effort to earn illegal profits for themselves, with negative repercussions for the company. The company is also subject to being taken over by legitimate investment groups, which typically install their own slate of officers and directors in an attempt to turn around the company's fortunes.

If the public company's market price drops very low for any appreciable period of time, it will be de-listed in accordance with each of the exchanges' rules. Since the delisting has the effect of limiting the liquidity of the company's stock, a further drop in the price of the stock typically accompanies de-listing. In such a situation, the de-listed public company has the worst of all worlds: a lack of liquidity in its stock, unfavorable regulatory action, and a continuation of public company reporting requirements.

On a practical level, it is essential for an emerging business that is considering an IPO to have available at least three years of audited financial statements. If the business has not previously had the statements from the last three years audited, it may still be possible to have those statements audited retroactively, but only if the accounting records have been sufficiently well-kept. This requirement for three years of audited financial statements also applies to businesses the emerging business may have acquired prior to an IPO.

Once an emerging business has decided to go public, perhaps the most important decision is who to select as the underwriters. For emerging businesses with the luxury of choice, it is preferable to hire one or more of the "bulge bracket" investment banking houses that all businesspeople know. These large investment-banking houses bring to the task the expertise, mutual fund contacts and retail customer base necessary to complete large and complex offerings, as well as the professional discipline necessary to assure that liability and disclosure issues are appropriately addressed. In many cases, equally valuable are the smaller, but more specialized, investment banking firms. The next tier of investment banking firms consists of the well-known regional houses. At the bottom of the investment banking hierarchy are a substantial number of firms that are best avoided. Some of these firms may employ questionable sales and trading practices, which ultimately hurt the issuer. While certain small, relatively unknown investment banking firms may be able to complete a public offering without resorting to questionable sales practices, and afterward may be able to adequately support the public market for the issuer's shares, the background of such firms should be carefully checked. Experienced counsel can assist greatly in accessing and interpreting the disciplinary records of underwriters.

The issuer typically drafts its IPO prospectus at the same time that the underwriters and their counsel perform extensive due diligence on the company. When drafting an IPO prospectus, the issuer must meet both specific and exhaustive disclosure requirements, and convey all of the risks and other information necessary to fairly apprise prospective investors of all material information concerning their investment in the emerging business. For these purposes, "material information" means all information that could, under all of the circumstances, significantly affect a decision to invest in the shares. An incomplete or defective due diligence and disclosure process leaves open the risk that, once the offering is complete, the issuer may be faced with a class action lawsuit by investors seeking to recover their money. Whether or not the class action results in the issuer paying damages to investors, the mere prospect of such a suit can lead the market to lose confidence in the issuer.

Once the registration statement and prospectus are ready in preliminary form, the issuer files them with the SEC for review. With the filing of the preliminary prospectus, the issuer and the underwriters are free to begin pre-marketing the shares to the public. Typically, representatives of the issuer and the underwriters will launch a "road show" marketing effort, traveling to key money centers and making presentations to sophisticated financial players and other customers of the underwriters. If the lead underwriters have not already done so, they will line up other underwriters to form an underwriting syndicate. Until the SEC clears the registration statement and prospectus, however, the issuer and underwriters are not allowed to consummate sales of the stock.

At the end of the review and comment process, the SEC declares the registration statement and prospectus "effective" under the Securities Act. That is, the documents can then be used as the basis for consummating actual sales of shares to investors. Upon effectiveness, the offering is priced, an underwriting agreement is signed, and the members of the underwriting syndicate can consummate the previously-arranged sales.

Pricing an IPO is more art than science, with the typical price falling by design somewhere between $15 and $25. Since they have the job of selling the offering, the underwriters will have the greatest input into the pricing decision. Consciously or not, underwriters will often prefer to somewhat under-price a public offering. Skeptics have expressed the theory that some underwriters do so in order to please both sets of customers: the issuer who wants offering proceeds and the customer who wants a bargain-priced stock in his portfolio. Defenders of underwriters point out the benefits of pricing an offering conservatively in order to improve the stock's price in the "aftermarket" following the offering. That argument may have some merit, because the performance of a stock in the immediate aftermath of an IPO often sets the tone in the trading market for a considerable time. Whatever the motivation, underwriters will always seek to price the offering in such a way that it is effectively pre-sold by the time the underwriting agreement is signed, so that they are not at risk of holding an unsold block of shares.

The underwriters in an IPO are compensated by taking a negotiated spread between the public offering price at which they sell the shares to investors and the price at which they buy the shares from the issuer. IPOs of equity securities of reputable issuers by reputable underwriters almost invariably are priced to yield a 7 percent spread to the uderwriters.

An integral part of the decision to go public is where to list the issuer's shares after the IPO. A listing on the New York Stock Exchange (NYSE) is usually considered preferable for the prestige and market efficiency that it brings. This is important for the issuer because it ensures that sellers of the stock will receive the highest price for their holdings. Trading on the NYSE still takes the form of exchanging bid prices and asks prices through a single physical location on the floor of the exchange. However, many IPO issuers do not meet the high standards for NYSE listing and instead list their shares on the NASDAQ Stock Market. NASDAQ operates through a computerized system linking thousands of terminals around the country, and orders are matched and executed through an automatic system. In fact, some issuers (the most famous of which is Microsoft) began their publicly traded existence on NASDAQ and have remained there long after it was clear that they could meet the listing requirements of any exchange.

An essential part of the decision to go public is a consideration of the substantive rules and reporting obligations that attach to companies registered under the Exchange Act. Since the passage of the Exchange Act in 1934, public companies have been required to file with the SEC annual and quarterly reports on Forms 10-K and 10-Q containing financial statements that meet the requirements of SEC Regulation S-X. In addition, a wide range of material developments like contracts, changes in officers and directors, acquisitions and divestitures must be promptly reported on Form 8-K. The goal of these disclosure requirements is to require the issuer to disclose all material developments on a current basis, except for certain very limited circumstances and for a very brief period of time.

Following the revelation of various management and accounting abuses in the late 1990s and early 2000s, Congress hurriedly passed the Sarbanes-Oxley Act in 2002. The Act imposed several new and quite onerous requirements and restrictions on public companies. In a departure from the underlying philosophy of the Securities Act and the Exchange Act to only require disclosure and leave corporate conduct largely to the discipline of the marketplace, Sarbanes-Oxley imposes a large number of normative rules on public companies. Among other things, Sarbanes-Oxley requires public company executives to certify to the financial statements and other disclosures in SEC-filed reports; requires publicly-traded companies to institute tight internal financial controls that the auditors must publicly evaluate; establishes conflict of interest rules for auditors who render non-audit services to the issuer; prohibits loans to executives; imposes independence and financial literacy requirements on boards of directors; and mandates whistle-blower protections. The same regulatory climate that gave rise to Sarbanes-Oxley also encouraged the stock exchanges to impose a substantial number of corporate governance requirements on the companies listed on their facilities. The result was to greatly multiply the burden and expense of compliance on public companies.

Public companies also have the obligation to solicit proxies according to SEC disclosure rules in advance of annual and special shareholder meetings. These disclosure rules subject the company's executive compensation practices and decisions to public scrutiny (and often misinterpretation). Even where only relatively mundane matters are subject to a shareholder vote, the proxy statement disclosure requirements are very extensive. Public company status also subjects management to the possibility of a public takeover through the tender offer rules and the rules governing proxy contests.

The decision to take a closely held company public presents a very complex proposition for the management of an emerging business. The emerging business must decide whether conditions in its business and conditions in the stock markets are advantageous for the IPO. The business must also weigh the benefits and burdens of public company status well in advance of any decision to do so. One the one hand, access to capital and a readily marketable currency with which to make acquisitions are very powerful tools for a growing company. However, for a company without huge growth prospects, the costs and restrictions of publicly traded status can stifle the company's management and expose them to sudden changes and even a loss of control of the company. A failed public company creates several layers of profound trouble for its managers, who may spend years attempting to put their careers back on track. An emerging business should consult with experienced counsel and have extensive discussions with prospective underwriters before making the decision to go public.