Running a Public Company

From IPO to SEC Reporting

Steven M. Bragg

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470446362
• eBook ISBN: 9780470527283
• Edition: 1
• Topic: Business
• Subtopic: Management
• Index: Business

Praise for Running a Public Company: From IPO to SEC Reporting

"Steve Bragg's book is an essential read for anyone contemplating a public offering or taking on leadership responsibility in a public company. Not only does he explain the complicated aspects of registration and reporting, he provides practical examples of policies, procedures, and controls to keep a public company on the right track. This book is easy to follow and will continue to be a resource for the reader."—Tom Wilkinson, PMB Helin Donovan, LLP

"I will recommend Running a Public Company: From IPO to SEC Reporting to my clients and consulting colleagues as an excellent resource. The book provides helpful guidance about the decision to go public, and about managing the requirements once a company is public. Steve Bragg's extensive knowledge stems from actual business experience, and his writing style makes a complex topic easier to follow and understand."—Valerie G. Walling, CPA, CMC, Management and Internal Controls Consultant

"I highly recommend Steve's new book, Running a Public Company: From IPO to SEC Reporting, because it's a reference manual and insider's guide that contains a treasure trove of valuable insights certain to help managers, accountants, and attorneys navigate through the countless challenges that arise when taking (and keeping) a company public."—Matthew Posta, Esq., CPA, Vice President of Finance, Key Air, LLC

"Mr. Bragg has done an excellent job of demystifying what is required to run your company and sell your stock in the public markets. I consider this a must-read for anyone considering a public offering or working with a public company."—Wray Rives, CPA

"Running a Public Company: From IPO to SEC Reporting is an incredibly exhaustive guide to going public, spanning the process from first deciding to take the leap to filing with the SEC and everything in between—so comprehensive that it even includes the SEC's account number for paying filing fees! This is yet another Steven Bragg title for professionals that takes a complicated and oftentimes confusing process and breaks it down into simple, easy-to-follow steps. Should our company ever decide to make that jump, it is reassuring to know that Running a Public Company has laid out the path before us in perfect detail. Whether used as a reference or a guide, Mr. Bragg makes the process simple, clear, and amazingly straightforward."—Adrienne Gonzalez, Project Coordinator, Roger CPA Review, Chief Information Officer, JrDeputyAccountant.com

"The first A to Z guide that I have seen. An excellent reference for management and investors alike."—Brian A. Lebrecht, Esq., President, The Lebrecht Group, APLC

PART I

How to Go Public

CHAPTER 1

The Initial Public Offering

Introduction

The initial public offering (IPO) is considered by many business owners to be the true sign of success—they have grown a business to the point where its revenue volume and profitability are large enough to warrant public ownership. However, the road to an IPO is both expensive and time consuming and requires significant changes to a company. This chapter describes the pluses and minuses of being public, as well as the steps required and costs to be incurred in order to achieve that goal.

Reasons to Go Public

Though a management team may not say it, a major reason for going public is certainly to create a market for the shares they already own. Though these shares may not be available for sale for some time after the IPO, management will eventually be able to cash in its shares and options, potentially generating considerable profits from doing so. This reason is not publicized to the public, since the public would be less likely to invest if investors think the management team is simply cashing in and then leaving the business.

A slight variation on the wealth creation theme is that, by having a broad public market for their shares, original shareholders are likely to see a rise in the value of their shares, even if they have no intention of selling the shares. The reason is that there is no longer a penalty for not having a ready market for the shares, which adds a premium to what the shares would have been worth if the company had remained privately held.

The same logic can be used as a tool for employee retention. A private company can issue options to its employees, but they are worth little to the employees unless there is a market in which they can sell the shares. By going public, a company may experience increased employee retention, since they wish to wait until their options vest so they can cash in the resulting shares for a profit.

Going public is also useful from the estate planning perspective. If the owner of a private company dies, his or her heirs are frequently forced to sell the entire business in order to pay estate taxes (though with proper planning, life insurance payouts can be used instead). By taking the company public, the heirs are only forced to sell a portion of the company to pay estate taxes, at least leaving them some portion of the business as a residual.

From an operating perspective, going public gives a company a large pot of cash, which it can use to increase its competitiveness by increasing its asset base, improving marketing, hiring qualified staff, funding more product research, and so on. This can be such a competitive advantage that other companies in the same market segment may be forced to go public as well, just to raise enough funds to survive against their newly funded competitor.

Along the same lines, having publicly held shares allows a company to more readily include its shares in the purchase price of an acquisition. The acquiree is much more willing to accept this form of compensation, since it can sell the shares for cash to other investors. This is a powerful tool for some companies, which use it as the primary method for consolidating a group of smaller, privately held organizations within an industry.

From a financing perspective, going public lowers a company’s cost of capital. The main reason is that investors are willing to pay a higher price for a company’s stock than if the shares had been privately issued, since they can easily sell the shares. This premium can reduce the cost of capital by several percent. In addition, issuing shares to the public reduces the power that private investors previously may have had over the business, which could have included restrictions on operations, guaranteed dividend payments, or their prior approval of a potential sale of the business. Also, by being publicly held, it is much less time consuming and less expensive to raise funds through subsequent rounds of financing.

Another financing reason to go public is that new equity drastically lowers the proportion of debt to equity that is recorded on the corporate balance sheet, which is looked upon with great favor by lenders. With the new equity in hand, a company can then ask lenders for a larger amount of debt, which they will be likely to lend until the amount handed over results in a significantly higher debt/equity ratio.

Thus, there are excellent wealth-creating, operating, and financing reasons to pursue an IPO. However, there are just as many reasons for not doing so, which are itemized in the next section.

Reasons Not to Go Public

One of the best reasons for not going public is its cost. These costs are detailed in the following section, while the fees for trading on an exchange are listed later in Chapter 3, “Listing on a Stock Exchange.” In brief, a small company will be fortunate indeed to incur less than $1 million in upfront fees as part of an IPO. A large company can expect to pay many times these base level expenses. Also, a company conducting a small offering will find that the proportional cost of obtaining equity funding is extremely high, since the underwriter will charge a higher fee as a percentage of the amount raised in order to cover its costs and still earn a profit on the transaction.

Besides the initial cost of going public, there will be incremental increases in ongoing expenses. Most obviously, additional staff must be hired into the accounting department, whose job will be to keep up with all reports required by the SEC. In addition, the cost of director’s and officer’s insurance (D&O) will skyrocket from what would have been paid when a company was privately held, assuming that the insurance can be obtained at all. The reason for this increase is the vastly increased pool of investors who may be tempted to sue the company on the grounds of material misstatements in its public comments (such as its registration statement for the IPO) in the event that the stock price drops. One can reasonably expect the cost of this insurance to increase by a factor of at least ten. The cost of documenting a control system under the stipulations of the Sarbanes-Oxley Act will also require additional staff time, as well as more review time by outside auditors. There will also be a considerable investment in legal expenses for the construction and review of public filings. For these reasons, even a smaller firm can reasonably expect to incur anywhere from $500,000 to $1,000,000 per year on an ongoing basis in order to remain public.

Another problem is that a smaller company with a modest market capitalization will have difficulty establishing a market for its stock. If it is too small, institutional investors (who like to buy and sell in large blocks of stock) will have minimal interest in making an investment. Because of this small market, a company’s stock will be more likely to be subject to manipulation by a small number of investors, who can short sell it to drive the stock down and then purchase large blocks of stock at a reduced price in order to gain some measure of control over the company.

Loss of control is quite possible, unless the owner has retained a large proportion of corporate stock or unless a separate class of super voting stock has been established that gives the owners additional votes at shareholder meetings. Otherwise, outside investors can either buy up shares to create large voting blocks or band together to create the same result.

Information disclosure is yet another problem. In addition to the expense of having additional accounting staff to organize and report this information, there is the problem of disclosing information to a company’s competitors, who only need to access the SEC’s Web site to access all required reports filed by the company. Although many pundits claim that the types of information disclosed will not harm the competitive posture of a public company, competitors can tell from its financial statements when it has put itself out on a financial limb by obtaining too much debt and can easily start a price war at this point that could cause the company to miss debt payments and therefore possibly go into bankruptcy.

A serious concern is the risk of shareholder class action lawsuits. These arise when there is a drop in the stock price that shareholders claim was the result of material misstatements in the registration statement or in any other information releases thereafter. These lawsuits are the reason for much more expensive D&O insurance. They will be targeted at the company as a whole, the corporate directors, whomever signed the registration statement, any experts who have given statements on behalf of the company, and its underwriters. The threat of lawsuits is one of the main reasons why IPO prices are frequently set somewhat low—there is less chance that the price will drop farther, giving investors no reason to sue.

Another issue is the constant pressure from investors and analysts to show improved results every quarter. If a company had been private, it could easily stand lower profits for a year or so while it ramps up new products and markets, but being public makes this completely practical approach to growing a business more difficult to implement. Investors can attempt to unseat the management team by approving a different board of directors if they feel that growth rates are below their expectations. This issue can only be dealt with by continually informing the investing public of management’s intentions for corporate growth, so that investors will adopt a longer-term perspective.

Finally, the management team must understand that it now exists not to serve itself, but to serve the investing public. This major shift in focus calls for the elimination of unusually high compensation packages to the managers, as well as a commitment to increasing shareholder value over other objectives that may have been in vogue at the company prior to going public. Management may be uncomfortable with this paradigm shift, resulting in investor unhappiness with a perceived lack of attention to their needs by management.

There are so many negative reasons for going public that the managements of many perfectly good private companies have elected to stay away from the public markets. In addition, a great many companies that have gone public find these issues to be so burdensome that they have elected to take themselves private once again.

The Cost of an IPO

Even a small company should expect to pay a minimum of $1 million to complete an IPO. This expense is composed of a number of fees. Accounting and legal fees will consume the largest proportion of the total. Expect to pay at least $250,000 in legal fees. Audit fees will vary, depending on the size and complexity of the company, but certainly expect to pay at least three times the cost of a normal audit. This figure will increase if there are weak internal control systems that require the auditors to conduct more extensive audit tests. Further, printing costs for the prospectus will exceed $100,000 for all but the most “Plain Jane” documents, which will increase if a large number of revisions to the registration statement are required prior to printing. Also, initial filing fees with a number of government and regulatory bodies will likely consume a minimum of another $25,000.

In addition to these professional fees, the underwriter requires a significant payment that is based on the percentage of capital raised. The usual fee is in the range of 6 to 7 percent if an offering exceeds $20 million, with the percentage gradually increasing to as much as 15 percent of the total offering if it is quite small (in the $1 to $3 million range). This cost can be reduced if a company accepts “best efforts” marketing by the underwriter, whereby it does not guarantee a full sale of the entire stock offering. In this case, the percentage fee will drop by 2 to 3 percent.

To make the situation worse, with the exception of the underwriter fee, most of these costs are incurred prior to the sale of any stock, so a company will be charged with the full expense of an IPO even if it is never completed. If the company withdraws from the IPO process, it must pay the fees incurred to that point by its underwriter, though this obligation is not usually required when the underwriter withdraws. Furthermore, if the IPO is merely delayed, many of the costs must be incurred again, since the underlying operational and financial information upon which the original offering was contemplated will have changed and must be re-examined by the lawyers and accountants.

Preparing for the IPO

Preparing for an IPO begins years before the actual event, because the company must “clean up” prior to being presented to the investing public as a quality investment. This house cleaning involves the following steps:

• Increase the competence of the management team. The single greatest driver of corporate value is the quality of the management team. The owners must evaluate each management position and replace anyone who is not a team player, who does not drive efficiency and effectiveness throughout his or her department, and who does not have a tight strategic vision. Obtaining a manager who is well known at a national level can have a startling positive impact on the perceived value of the company as a whole. A key point is that a management team is not a one-person show. Investors need to see a competent supporting team that can readily take over the business in the event that one key manager dies or leaves the company.

• Create a reward system that is tied to strategy. With the assistance of a compensation expert, design a reward system for not only the management team but for the entire company that offers incentives for them to focus their activities on those areas of the business that must be improved prior to the IPO (as described in all the points in this section). A key area is in the use of stock options, which can be issued several years prior to the IPO, when the company’s value is substantially lower, resulting in significant gains for the recipients after the company goes public. To do this, one should set aside a large pool of stock for option conversions, and do so well in advance of the IPO, in order to avoid having the new shareholders vote to create it.

• Obtain audited financials. A reputable audit firm, and preferably one with a national presence, should audit the financial statements for the three years prior to the IPO. A review or compilation is not acceptable—these less-expensive and less-thorough forms of an audit will be rejected by the underwriter and the SEC when the registration statement is filed.

• Obtain a top securities law firm. Although there may be little perceived need for a law firm well in advance of an IPO, it is useful to have such a firm examine the legal structure of the business and recommend changes that will properly position the company for the IPO. The need for this firm will rise dramatically during the IPO filing period, when its lawyers will review the company’s prospectu...

Table of contents

• Title Page
• Copyright Page
• About the Author
• Preface
• PART I - How to Go Public
• PART II - Dealing with Investors
• PART III - Dealing with the Securities and Exchange Commission
• PART IV - Special Accounting Standards for a Public Company
• PART V - Closing the Books of a Public Company
• PART VI - Going Private
• APPENDIX A - Board Questionnaire
• Index