Chapter 12 - How To Go To The Promised Land - Whether Or Not To Go Public
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
There are two major issues facing a start-up considering an IPO: how to do it most effectively, and, secondly, whether to do it at all. The second is the threshold question. Will the issuer be able to raise capital cheaply and more efficiently on the wings of an IPO than with any other method, taking into account the long-range consequences of becoming a public company (going public)?
On the plus side, the culture of venture capital is heavily involved with the proposition that the terms "public company" and "rich entrepreneur" are synonymous. Indeed, the home-run payoffs for celebrated founders are usually identified with a public stock sale. A public market entails (although not for everybody) liquid securities, a classic exit strategy for founders and other shareholders. Moreover, to the extent equity is being raised for corporate purposes, the price of capital obtainable from the public will usually be cheaper because any commodity that can be freely sold is intrinsically more valuable than its illiquid counterpart.
There are collateral benefits as well, beyond price and liquidity. Thus, its customers and suppliers often purchase the company's stock and their interest in the company's profits and products is stimulated. A public company can do a broad, national public-relations job; a well-prepared prospectus projects the company's image favorably from the start. A public market helps stockholders with their estate-tax problems, it allows them to diversify, and it simplifies appraisal problems. And, the company now has so-called Chinese Currency with which to make additional acquisitions, meaning shares selling at a high multiple of earnings and, therefore, preferable to cash when buying other companies. Finally, with exceptions imposed by state securities administrators and the stock exchanges, the regulatory issues in an IPO process entail only adequacy of disclosure; ostensibly, the SEC is not authorized to delve into the merits of the offering.
There are, however, significant minuses. For example, an IPO takes time: the issuer and underwriter need sixty to ninety days to get ready, and the period between filing with the SEC and the effective date takes at least another month or so. Many an issuer undergoes the time-consuming and expensive process, only to see the process abort at the last instant because the IPO "window" has closed; if the issuer has counted on the proceeds of an IPO, the result can be a disaster. Moreover, there are significant transaction costs. Underwriters can receive up to 15 percent (more or less) of the price of the offering; legal and accounting expenses can bring the total costs up to 25 percent of the money raised. Fees and expenses involved in private placements, on the other hand, are ordinarily well under 10 percent. Moreover, once the issuer is public, a number of new legal requirements attach to the conduct of its business. Thus, a public company has to file periodic reports with the SEC (quarterly and annually) plus flash reports when significant events occur. The thrust of these documents is financial, letting the auction markets know how the company is doing on a short-term basis, in itself a potential problem for a management which is unconvinced that the market's avarice for short-term results is sensible business strategy. The burden of public reporting has been significantly stiffened in the post Enron era with the enactment of Sarbanes Oxley, the multiplicity of class action law suits over an accounting hiccup and indeed criminal prosecution. The annual meeting becomes a major event. Proxies are solicited with an expensive, printed information document complying with the SEC's proxy rules. Beyond the required reports, the public company must give daily consideration to current disclosure of important events. As yet, the courts have not required instant press releases; absent insider trading, issuers are not, explicitly at least, required to go beyond compliance with the SEC's periodic (monthly on certain issues, otherwise quarterly and annually) disclosure rules. Thus Regulation FD calls selective disclosure to favored analyst: you tell one, you tell the public as well. Thus, the New York Stock Exchange lectures issuers on the desirability of instant news and special exceptions to the general rule threaten the company's ability to remain silent (e.g., a duty to correct false rumors). Further, a public company is exposed to "strike suits," litigation initiated by underemployed lawyers ostensibly on behalf of a shareholder (usually with an insignificant stake), but in fact designed to corral legal fees. The courts countenance such claims because they are thought to have therapeutic value, restraining management excesses in an era when the public shareholders are otherwise disenfranchised. Finally, a public company can be taken over by a raider in a hostile tender. It is possible to insert "shark-repellent" measures in the charter prior to the IPO–supermajority provisions, staggered boards, blank-check preferred stock–but the underwriters may balk.
Difficult rules also impact individuals associated with a public company: the directors, officers, and major shareholders. They are, for example, subject to a curious rule that recaptures any profit–called "short-swing" profit–they realize on sales and purchases of the company's stock matched within a six-month period. The statute becomes hard to follow at the margin, and its consequences are severe. Moreover, the threat that an insider will be deemed to have traded on "inside information" means that insiders can safely trade only during specified window periods, that is, immediately after the annual or quarterly reports come out; in a curious sense, insiders are not more liquid than they were before the IPO. Moreover, apart from requirements, the onset of a public venue can be embarrassing. The Antar family, when it sold one million common shares of Crazy Eddie, Inc. to the public, had to disclose that the family had been virtually using the company as a private bank. Spendthrift Farms, the breeding stable owned by the Combs family, has now been liquidated. When stock was sold to the public, a number of insider dealings between the family and the stable were revealed. Apparently those practices continued after the company became public, litigation ensued, and the result has been a more or less forced liquidation.