Taking Your Company Public — Part IV
February 24, 2011
W. Ian Palm
George S. Takach
In this second-last instalment in a series on what is involved in taking a company public (the "initial public offering," or IPO, process), we look at various particular requirements of the prospectus, and the due diligence process that needs to underpin the document. The first and second instalments debated the advantages — and disadvantages — of being a public company, while the third article focused on the IPO process itself and introduced the all-important prospectus document, which must provide "full, true and plain" disclosure about the shares being sold, including disclosure about your company and its business.
Description of the Business
So important is the prospectus that the law expressly mandates the minimum information that it must contain. One such section — not surprisingly — is a description of the business. This is where you will recount some history of your company, and then explain what it does, by reference to your markets, products, competitors and the like.
The description of your business is not a simple section to write. It’s easy to describe the particular segment of the market that you serve, but more challenging is to explain your particular strategy for success within that market. On which sub-sets of customers do you focus? How do you ensure that your value proposition resonates for them? What are you doing that your competitors are not? In essence, what is your "secret sauce"?
If you have a detailed business plan (that you may have used previously with investors), you may be able to start with this pre-existing text as the basis for the description of the business section of the prospectus. But even so, it will simply take appropriate members of your senior management team a lot of time and effort to develop a first draft — and this will then be picked apart, sentence by sentence, by your investment banker, your lawyers and your banker's lawyers, until the story is both accurate and easy to understand. It will be a painful process, but when completed you will actually have a very useful document that explains — including to your own employees — the principal drivers of your business.
The prospectus will have to contain audited financial statements for the past three years and the most recently completed quarter (some exceptions are allowed, for example, if your company is not yet three years old). Your financial statements are obviously a critical part of the prospectus. Accounting is the language of business, so of course prospective investors will be keen to understand your balance sheet and your income statement, as well as the other financial information that underpin them.
Your competitors will also be very interested in this information. They probably already have a general sense of your top-line revenues. But until they see your prospectus, they will not know your bottom-line profitability, or other metrics that are particular to your sector. For example, if you are a software company, your mix of licence revenue versus recurring maintenance and support revenue may be important measures that investors will want to see and your banker will require disclosure of as part of the prospectus. All of this can be very useful insight for your competitors, and they will use it against you (just as you do with such information about your public company competitors).
As such, it will pain you to allow your competitors to have access to your detailed financials (not just once in the prospectus, but continually after you are public through your quarterly and annual financial statements). But this is simply a cost of being a public company — that exalted status comes with the requirement that the investing public have visibility into your affairs, including financial matters.
Predicting the Future, Financially
Interestingly, some companies go even further in their prospectus and include financial projections, that is, estimates for how the company will do financially over the next couple of years. This is a risky activity and expensive, too. Your projections will be reviewed by your auditors as part of the process and the auditors charge quite a handsome fee for this service (partly because it is fraught with risk for them as well).
Predicting the future, however, is fiendishly difficult. A few years ago, the Ontario Securities Commission reviewed the subsequent actual results of companies that previously made financial projections in their prospectuses. The track record for the predictions was not good at all. The bottom line is, it’s just very hard to predict the future. So it is really worth thinking twice before putting financial projections in your prospectus.
How Much Do You Make?
It is a long-standing rule of polite society that you don’t ask others how much money they earn at work. Securities law has no such reservations. Indeed, the rule is that the prospectus must reveal the compensation of the CEO, CFO and next three highest-paid executives of your company.
Again, this rule will result in some operational downsides to you. For example, recruiters looking to entice away some of your top people will now know precisely what compensation package they have to match or exceed. On the other hand, in this day and age of websites, Internet search engines and blogs, much personal information is already available to the public, so perhaps this is not as serious a factor for you as it might have been 10 or so years ago.
The Risks of Investing
One very interesting section of the prospectus is called "Risk Factors." Life and business are full of risks. As noted above, it’s so difficult to predict the future because of various different risk factors and our inability to foresee exactly which risks will come to pass. Nevertheless, securities law requires that companies list in their prospectus the various risks that are relevant to the business and the industry in which it operates.
The result is a fairly extensive list of items that, if they came to pass, would adversely impact your company. Some of these risks will be generic and apply to all players in your segment of the market (e.g., "if the economy slows down, there will be fewer purchases of our type of product.") Key risks are typically those that are more specific to your company (e.g., "our product depends on one major supplier; thus, if that supplier terminates our agreement, we may not be able to continue in our business.") Again, the touchstone is "full, true and plain" disclosure.
Meaningful Due Diligence
The prospectus document is not created or written in a vacuum. Rather, it must be firmly anchored in an extensive and meaningful due diligence process. In effect, your lawyer and investment banker and the banker's lawyers will want to be sure that each and every factual statement in the prospectus is supported by a document (e.g., an industry report, a contract of your company, etc.) that they have reviewed, and have satisfied themselves does indeed support the relevant proposition in the prospectus. The same will hold true with respect to any financial details or other numbers that appear in the prospectus. Your investment bankers will call upon your auditor to provide written comfort as to their accuracy.
Conducting proper and thorough due diligence takes time. You must assign adequate staff to the job of compiling the materials. Increasingly, the materials are uploaded to a restricted website so that all relevant parties can access them quickly and simultaneously. But even if presented electronically, there is still the time-consuming job of compiling all the raw documents as the first step. Make sure you have enough staff on this project. Don’t forget to keep the material on the diligence website up-to-date over the course of the IPO process. And make sure you advise your banker and the lawyers of any changes that occur during the process, no matter how small you may think it is.
Filing and Finale
The prospectus is such an important document that before you "go final" with it, the securities regulatory authorities must review it. Thus, you will have to file a "preliminary prospectus" with the regulators, who will then typically take 10 business days to go over it, at the end of which they will send you a comment letter that contains suggestions for improving the document. You will not be able to receive a "final receipt" from the regulators for the prospectus (and close your IPO) until the issues in their comment letter and any subsequent comment letters are all addressed to their satisfaction.
Around this time, your investment banker will start to build the order book for the shares you will be selling through the IPO, but they can't confirm orders at this point. To support this effort, you will go on a "road show," where your company’s CEO, CFO and perhaps one or two other senior officers will meet with prospective investors and answer any questions they may have. The six to nine months of laborious IPO process will come down to this moment of truth — are investors willing to buy your shares, and most importantly, at what price?
Then follows an intricate negotiation between you and your investment banker about the final public issue price for your shares. If you price them too low and their price rises rapidly on the stock exchange after the IPO, perhaps you will have "left some money on the table" that investors will now pocket, instead of it going into your company. On the other hand, if the price is too high, and you meet significant resistance to buying your shares at all, you might not raise the amount of money you need.
In determining the final price for your shares, ideally you will have some wise members of your board of directors help you negotiate a sensible compromise with the investment banker (and then you can close the IPO, and behold, you are a public company). This illustrates but one useful role of the board — more on them, and other issues relevant to the now public company, in the next issue.