Preparation For The Public Offering
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The planning steps prior to a public offering are outlined in a number of source materials, emphasizing the increase in formality involved in the transition from a private to a public company. Some of the less obvious points that deserve mention have to do with corporate structure. The requirement that the financial statements be audited is well known. However, issuers on occasion forget that the recent acquisition of a significant, unaudited subsidiary may make it impossible to present the requisite audited financials when desired. Moreover, it is often necessary to recapitalize the enterprise. Cross-ownership arrangements must be eliminated and multiple affiliates consolidated so that the public buys an interest in all the eggs, contained in a single basket. Some IPO candidates, veterans of multiple financing rounds, have as many as eight series of preferred stock outstanding. If an IPO does not, by its terms, trigger conversion, negotiations are in order to clean up the balance sheet and make it understandable to prospective investors.
The Prospectus
The principal disclosure document in a public financing is the prospectus, that portion of the registration statement distributed to offerees and investors. The checklist for describing the company and the offering in the prospectus is Regulation S-K, directly applicable to Form S-1 Registration Statements. Regulation S-B, a simplified version of S-K, governs the use by small business issuers of Form SB-2; for purposes of simplicity, it will be assumed in this discussion that S-K governs.
The preparation of the prospectus is, in one sense, easy. The first cut at drafting entails selecting a comparable prospectus relating to a security already public, marking it up and using the magic of optical scanning devices and word-processing equipment to take the drudgery out of the chore. Moreover, the preparation of the prospectus is governed by specific SEC advice. Regulation S-K (or Regulation S-B) and the instructions on the form used (S-1 or SB-2), which give relatively precise directions as to the topics to be covered in the document, and, on occasion, how to cover them; for example: "Describe the general development of the business during the past five years. Describe the business done and intended to be done by the registrant and its subsidiaries, focusing upon the registrant's dominant industry segment." The road map for prospectus drafting is well defined; even a first-time draftsman should have little concern that something has been totally overlooked if he studies the precedents carefully.
To do the job properly, however, it is useful to ponder what it is the SEC is trying to accomplish. Thus, the intended thrust of Regulation S-K is to reduce the amount of boilerplate that might creep into documentation, and to make the prospectus informative. For some time, the Commission has been criticized by commentators for the fact that disclosure in unregistered placements is ordinarily more meaningful than the ritualistic language in statutory prospectuses, thereby standing the whole thrust of securities regulation on its head and opening the regulators up to their most feared criticism, irrelevance; the markets would function better without them. Tired of rainy weather, the SEC legislated sunshine in Regulation S-K and the instructions to forms S-1 and SB-2, attempting to reduce formalistic disclosure and put meat on the bones of the statements made. For example, the regulation now requires a section titled, "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A), in which the SEC tries to hold management's feet to the fire, requiring the type of candor one would expect in a question-and-answer session between the issuer's chief financial officer and security analysts. The regulation calls for mention of such matters as "trends … that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way … [and] unusual or infrequent events … that materially affected reported income."
In considering how to phrase the language, one should also keep in mind a canon from which the SEC has never retreated: those public-disclosure documents should be decipherable by a non-expert, a layman. It is true, as critics point out, that more than 75 percent of the action in the public markets is the result of professionals trading with professionals. Moreover, the Commission has undergone a major reorientation in its attitude toward disclosure by mature public companies, allowing issuers which report periodically to the public to cannibalize those reports for purposes of assembling a registration statement covering newly issued securities. Nonetheless, where new entrants to the public markets are concerned, the SEC has not accepted the thesis that a document that gives up its secrets to sophisticated analysts constitutes adequate disclosure. The prospectus must be drafted with that attitude in mind: coherent information assembled coherently, not only an informative but also a "readable" document. Indeed, as a climax to its repeated attempts to render the availability of filed disclosure documents more user-friendly, on October 1, 1998 the SEC's "plain English" rules became effective for all registration statements filed after that date. (The rules do not cover reports on Forms 10K, 10Q, or 8K, or Proxy Statements filed under the '34 Act.) The rules are quite bland: use the active voice, avoid long sentences, avoid jargon and multiple negatives, and so forth. To help drafters of prospectuses, the SEC has published A Plain English Handbook, a compendium designed to persuade people to turn to the principles announced in The Elements of Style by Strunk and White and/or the Oxford English Dictionary.
The principal concern of the securities bar has been that the rules increase the threat of liability, including allegations by plaintiff's lawyers based on violations of the rules themselves. It remains to be seen whether this specter will eventuate.
The real problem, of course, is that preparation of the prospectus has become even more time consuming and expensive, despite the Commission's attempts at reform. A volatile market, back-up at the SEC staff level extending the comment period, and other factors (including increased severity by the SEC on accounting issues so as to create "transparency") is making the initial public offering process more perilous and expensive than it has been in the past.
While prospectus writing is an art that does not require years of expertise to master (the plethora of prior examples allowing one to plagiarize shamelessly from the work product of others), that is not to say that experience is immaterial. The behind-the-scenes play-by-play centers around anticipating the comments likely to be made by the SEC staff (assuming, as is likely to be the case with an IPO, the prospectus is subject to "full review"), thereby shortening the length of the "letter of comment" and, more importantly, the comment period. Counsel's primary obligation in preparing an IPO (after making sure the presentation is accurate) is to get the registration statement effective as quickly as possible; market "windows" for IPOs come along every now and then and it is up to the participants to get the issue out on the street before the window closes. Thus, if the first draft of the prospectus asserts, without more, that the issuer is the "leading manufacturer" of widgets in the country, the SEC staff will routinely respond, "prove it." If the "Use of Proceeds" section is composed of routine language (i.e., "working capital"), the staff will try to extort greater specificity. Unfortunately, the staff does not publish its letters of comment. Some source materials have, however, reproduced sample letters and a survey of those materials will give a sense of the staff's favorites.
Some information the staff may zero-in on can be confidential–the selling price of the issuer's products to major customers, for example–and the issuer will attempt to persuade the staff that such is not necessary for a complete presentation. Formally requesting confidential treatment is open to the registrant, but that course of action still leaves sensitive information in a government file, where Freedom of Information requests may uncover it; hence, informal persuasion is the preferred course. No amount of persuasion, however, is likely to eliminate certain sensitive disclosures mandated by Regulation S-K (e.g., the name of any customer representing 10 percent or more of the issuer's business).
No matter how carefully the prospectus is prepared, an IPO must await the letter of comment, and, other than nagging telephone calls, there is nothing the issuer can do but wait for it. Once a registration statement has been filed, a staff member will advise whether or not it will be reviewed. Registration statements not to be reviewed can be effective in as short a period as forty-eight hours; IPOs are routinely subjected to review and a first-time registrant can expect a 25- to 30-day period before receiving staff comments. Once the letter is received and responded to, then the procedure is to ask (two days in advance) for effectiveness at a particular date and time, a practice known for technical reasons as a "request for acceleration." Acceleration is conditioned on a widespread circulation of the preliminary or red-herring prospectus (so called because there is a legend in red on the preliminary prospectus) among the selling group. Under Rule 430A, it will no longer be necessary to file the amendment filling in the price of the security, the underwriting syndicate, underwriting discounts, etc., and awaiting Commission clearance; the registration statement may now be declared effective, and the price (and discounts and syndicate members) filled in within five days.