During 2013, the IPO market remained incredibly vibrant. Nearly half of the 200 IPOs completed during 2013 by gross proceeds involved private equity portfolio companies, and the trends that drove private equity-backed IPOs in 2013 show no signs of abating. We have found that one of the keys to an efficient private equity-backed IPO is advance planning, preparation and coordination. Accordingly, if a potential public exit is on the menu, now may be a good time to begin working through IPO-related issues. We highlight below a handful of the most important matters that should be considered.
The JOBS Act IPO “On-Ramp”
The JOBS Act, adopted in 2012, has proven to be a hit with the IPO issuer community. Under the JOBS Act, IPO issuers that qualify as Emerging Growth Companies (EGCs) can utilize a number of accommodations to smooth the transition from private to public company. The most widely utilized JOBS Act accommodation for EGCs is the ability to confidentially submit the IPO registration statement for SEC review. Other JOBS Act accommodations available to EGCs include:
- the ability to conduct pre-IPO pricing discovery by “testing the waters” with qualified institutional buyers and other institutional accredited investors;
- the ability to include two years of audited financials (rather than three) and as few as two years of selected financial data (rather than five) in the S-1;
- an exemption from the internal controls audit required by Section 404(b) of the Sarbanes-Oxley Act of 2002 (“SOX”); and
- the ability to include streamlined executive compensation disclosure in the S-1 and post-IPO public reports.
Generally speaking, EGCs are companies with less than $1 billion in annual gross revenues during their most recently completed fiscal year. EGCs remain EGCs until the earliest of:
- the last day of the fiscal year during which their annual gross revenues equal or exceed $1 billion;
- the last day of the fiscal year following the fifth anniversary of their IPOs,
- the date on which they have, during the prior three years, issued more than $1 billion in non-convertible debt securities; and
- the date on which they are deemed to be a “large accelerated filer” (i.e., a company with an unaffiliated float of at least $700 million).
Auditor independence rules can be a harrowing trap for the unwary. A registrant’s audit firm must be currently “independent” and must have been independent during the audit engagement period (generally, the three-year period beginning with the first income statement required to be included in the registration statement). An IPO issuer’s audit firm may not be independent within SEC rules if it performed prohibited non-audit services, such as consulting services, for an “affiliate” of the registrant, such as another portfolio company of the private equity sponsor.
Publicity and Communication Considerations
Public communications by IPO issuers and their affiliates before and during the IPO process are severely limited by U.S. federal securities laws. Offers of securities to be sold in the IPO may, as a general rule, be made only via a compliant prospectus. Any non-compliant offer can run afoul of the securities laws (as noted above, EGCs may “test the waters” with QIBs and IAIs), and can:
- delay the offering;
- give IPO investors the right to put the IPO shares back to the issuer for cost; or
- result in civil and criminal sanctions.
The SEC’s view of what constitutes an offer is very broad and could include many seemingly innocuous written or oral communications. With this in mind, sponsors and IPO candidates should develop tailored IPO communication guidelines with outside counsel.
Internal Control over Financial Reporting and Disclosure Controls and Procedures
An annual assessment of internal controls over financial reporting, beginning with the registrant’s annual report for its first full post-IPO fiscal year, is required to be made by the registrant’s management under SEC rules implementing Section 404 of SOX. In addition, public companies (other than EGCs that utilize the JOBS Act exception from Section 404(b) of SOX and those issuers with a market capitalization of $75 million or less) must also provide an attestation report of their audit firm on their internal controls over financial reporting. Internal controls over financial reporting are designed to provide reasonable assurance regarding reliability of financial reporting and the preparation of GAAP financials.
SOX and related SEC rules also require public companies to maintain and evaluate the effectiveness of the design and operation of their “disclosure controls and procedures.” An issuer’s disclosure controls and procedures are designed to ensure that information required to be disclosed in SEC reports is recorded, processed, summarized and reported in a timely manner. Disclosure controls and procedures overlap substantially with internal controls over financial reporting, with disclosure controls and procedures likely subsuming those aspects of internal controls over financial reporting that relate to the accuracy of financial reporting. Given the scope of work necessary to implement effective controls, advance work on internal controls over financial reporting and disclosure controls and procedures is critical.
Private equity-sponsored companies often embark on the IPO process with a myriad of voting, tag-along, drag-along and registration rights provisions contained in a stockholders agreement and registration rights agreement entered into at the time of the initial acquisition. It is critical to vet these provisions well in advance of the filing date of the IPO registration statement to eliminate any undue delay or complications. Further, if due care is not exercised when restructuring these arrangements for a company’s post-IPO existence, parties to a stockholders agreement may find themselves with unwanted reporting obligations under the Securities Exchange Act of 1934 (the “Exchange Act”) by virtue of being part of a “group” for purposes of Section 13(d) of the Exchange Act. Alternatively, if improperly structured, parties to a stockholders agreement may be unable to claim group status and take advantage of the “controlled company” exceptions discussed below under “Corporate Governance.”
The composition of the IPO issuer’s board of directors and board committees after the offering is of key importance and requires attention to applicable stockholder arrangements and relevant stock exchange and Exchange Act rules. For example, stock exchange rules will require the establishment of an audit, compensation and nominating/corporate governance committee, with each of these committees and a majority of the IPO issuer’s board comprised of “independent” directors (subject to applicable transition rules for newly public companies). Stock exchange rules provide one notable exception to this rule that is particularly useful to private equity sponsor companies: if the registrant will be a controlled company for purposes of stock exchange rules (i.e., more than 50% of the voting power for the election of directors is held by an individual, a group or another company), then only the audit committee is required to comply with these independence requirements.
However, there are other implications related to compensation committee composition that should be considered carefully. First, in order to maintain the deductibility of performance-based compensation for named executive officers that exceeds $1 million, this compensation must be approved by a committee comprised of at least two “outside directors” or by the full board of directors. Second, all Section 16 individuals are subject to the “short swing profit rules” pursuant to which such insiders must disgorge profits from any matchable purchase and sale transactions that occurred within any six-month period. Importantly, transactions involving an acquisition of equity securities from the issuer are not subject to the rules if approved by a committee of the board of directors composed solely of two or more “non-employee directors” or by the full board of directors.
Cheap Stock. One accounting issue that frequently causes problems for sponsors and their portfolio companies is the so-called “cheap stock” issue. This issue arises when there is a large discrepancy between option exercise prices and the IPO price, and the option has been granted with an exercise price of less than the underlying common stock’s fair value on the grant date. To help steer clear of cheap stock issues consider (1) having an independent valuation firm contemporaneously value the equity awards at the time of grant (which may also help to reduce the risk of adverse tax consequences associated with equity award grant date value), (2) disclosing the process and substance related to the registrant’s equity awards in the registration statement and (3) maintaining a file of valuation materials and information regarding the grants themselves (which may be helpful in responding to any related SEC comments).
Pro Forma Financial Information. Most private equity-backed IPO issuers will be familiar with pro forma financial statements from their debt financing transactions, add-on acquisitions or the initial private equity acquisition itself. Often there is a new set of pro forma financial statements required or desired to be included in the IPO registration statement. Accordingly, management teams and private equity sponsors should carefully consider whether any transactions or events have occurred or will occur in connection with the IPO that argue for pro forma presentation, including significant acquisitions or refinancings, conversion of securities upon the IPO or a significant pre-IPO dividend.
Financials of Acquired Companies. One gating item that frequently comes up in private equity-backed IPOs is the requirement to file with the SEC the audited financial statements of significant acquired businesses and related auditor consents. To the extent significant acquisitions have been completed or become probable prior to consummation of the IPO, the private equity sponsor, the management team and the auditor should consider whether separate financial statements for the acquired companies or acquisition targets will be required in the registration statement and confirm that the relevant auditor will consent to including these statements in the registration and provide any required comfort letter.
Non-GAAP Financial Measures
While not quite as controversial as they once were, non-GAAP financial measures included in IPO prospectuses and other public disclosure are still a focus for the SEC. In fact, in July 2013 the SEC established an accounting-fraud task force to review, among other things, the use of non-GAAP financial measures. SEC enforcement actions could be the next step. IPO companies and sponsors, in consultation with underwriters and counsel, should carefully consider what non-GAAP financial measures the company intends to disclose, ensure that the measures are adequately defined so that that they will remain useful to the company and investors going forward and anticipate SEC comments by including fulsome disclosure to address potential concerns.
Management/Consulting Agreement Arrangements
Private equity portfolio companies typically enter into a management or consulting agreement with the sponsor at the time of the initial acquisition. These arrangements and the related fees may terminate by their terms, or may be terminable by the company at its option, at the time of the IPO. Even if the IPO does not constitute a termination event under the management agreement, these agreements are commonly terminated in connection with an IPO. Often the termination involves the payment of a fee. Termination and other fees paid under these arrangements may:
- affect the independence of the sponsor’s board designees under applicable stock exchange rules; and
- have regulatory implications for the private equity sponsor – an issue the SEC has been focused on for the last year.
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The IPO process is a long one, and is often complicated by foreseeable issues that create speed-bumps. Getting a head-start on IPO preparation can shorten the timeline and facilitate a smooth transition from private to public company.