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ipo

Advantages and disadvantages of an IPO

The closing concludes and a company suddenly has $50 million cash in its bank account from the sale of its stock.  Champagne corks are popped and celebration ensues―for a brief period.  “Going public” is an exciting event for all involved and may provide many advantages to the company’s operations.  However, being a public company has certain disadvantages that should also be considered.

“Going public” refers to a sale of stock or debt in an initial public offering or IPO registered with the Securities and Exchange Commission (SEC).  A “public company” refers to a company that has undertaken an IPO or is otherwise required to be a reporting company under the Securities and Exchange Act.  A “private company” typically has a limited number of owners or investors and is not required to file reports with the SEC.  This article discusses some of the advantages and disadvantages of “going public.”

Advantages of an IPO

An IPO and the result of being a public company may provide significant advantages to the company and its stockholders.  These include cash infusion, ability to “mint coin,” easier future access to equity and debt markets, liquidity for pre-IPO stockholders and institutionalization of the company.  The common theme of these advantages is that a liquid market for its stock “unlocks” value that the company could not otherwise access.  By having publicly traded stock, the discount that is attached to stock of private companies no longer applies.

Cash Infusion The result of an IPO is a significant and immediate infusion of cash into the company.  This cash is typically “earmarked” for specific items described in the IPO disclosure documents, which can be for a variety of purposes.  For example, the company may use the proceeds of the IPO to expand its inventory, property and equipment base, reduce debt, further research and development or expand its services.

Minting of Coin. Having an established value and liquid market for its stock creates additional “coin” for the company through issuance of additional stock.  This “coin” may be used as consideration to acquire other business and to compensate both current and future employees.

The ability to utilize the company’s stock for an acquisition significantly decreases its cash needs and allows it to engage in transactions without tapping into its “war chest” of IPO proceeds, which can be put to use to fund future growth.  In addition, acquisitions using the company’s stock as consideration may be structured as a “tax-free” reorganization, which can allow the sellers to defer taxes on gains associated with the sale of their business.  Using stock as consideration for acquisitions also provides sellers an opportunity to participate in the future growth of the combined organization.

Another benefit of a liquid market for a public company’s shares is that its stock may be used to compensate both its existing and future employees through the grant of options or direct issuance of shares.  Grants of options or stock provide a means to share the company’s success and are a great tool for attracting talented management and employees.

Access to Capital Markets.  Being a public company enhances access to both equity and debt markets.  After the company has been a reporting company for 12 months, it may engage in follow-on offerings using a “short form” registration process.  The ability to use this process reduces both the time and expense of future equity financings.

As a reporting company, the transparency of its financial position and operations makes it better suited to obtain debt financings.  The infusion of cash from an IPO also enhances the balance sheet and makes the company a much stronger candidate for debt financings.

Liquidity An IPO provides liquidity to the company’s founders, employees and pre-IPO investors holding the company’s stock.  While the liquidity may not be immediately realized due to “lockup” requirements imposed by underwriters and other SEC rules, being a public company provides a means for the pre-IPO stockholders to monetize the value of their stock at some point in the future.

Institutionalization.  Being  publicly traded  adds to a company’s stature as an institution, which can enhance its competitive position.  The IPO process itself generates publicity that may enhance the company’s recognition in the marketplace.  As a result, suppliers, vendors and lenders often perceive the company as a better credit risk and customers may perceive it as a better source of products or services.  The stature of a public company can also enhance its ability to attract top level executives and employees.

Disadvantages of an IPO

While going public provides significant advantages to a company and its stockholders, the requirements imposed by securities laws produce disadvantages to the company and its operations.  These include increased costs, securities law compliance, changes in corporate governance structure and becoming a “slave to the stock price.”

Costs.  The costs of an IPO include both the costs of engaging in the offering process and the future costs of being a reporting company.  Typical costs of raising $50 million through the IPO process can range from $3.5 million to $5 million.  Raising less money can increase the percentage of offering costs significantly.  These costs include underwriting commissions, legal and accounting fees, SEC and National Association of Securities Dealers (NASD) filing fees, exchange fees, financial printing, travel and other miscellaneous costs related to the offering.  In addition to these initial costs, as a reporting company subject to securities laws, including Sarbanes-Oxley, and exchange listing requirements, the company will have significant ongoing costs associated with its operations.  These costs include outside directors’ fees and expenses, directors’ and officers’ liability insurance, accounting and legal costs, internal control costs, printing costs for stockholder reports and proxies and costs of investor relations.  According to a survey published by Foley & Lardner LLP, these costs average approximately $2.37 million per year, not including lost productivity costs, for public companies with revenue under $1 billion.

The costs are not just monetary.  The IPO process can take up to six months or longer.  During this period the company’s executive management team must devote substantial time and energy to the IPO.  This takes away from management’s time and ability to run the company’s business, and operations may suffer during the IPO process.

Securities Law Compliance A myriad of compliance issues results from an IPO.  The IPO process imposes severe restrictions on the company’s marketing and publicity activities during the “quiet period” preceding the filing of a registration statement.  The registration and reporting process involves the disclosure of significant information about the company that is readily available to the company’s competitors.  Following completion of the IPO, the company will be required to file quarterly, annual and current reports detailing its operations and announcing major events.  This disclosure includes detailed information about operations, executive compensation, financial results and significant customers and vendors.  Proxy statements must be filed with the SEC before a stockholders meeting can be called.  The company cannot release information on a selective basis and must be careful to assure that the information it releases is accurate and complete.  Company insiders and major stockholders also must comply with the Exchange Act requirements for reporting their stock ownership and prohibitions on short swing trading.  Finally, the exchanges where the company’s stock is traded have various listing standards that impose additional governance and disclosure requirements.

The changes to the securities laws resulting from the Sarbanes-Oxley Act have greatly increased the compliance issues that a public company must meet (with corresponding cost increases).  These include enhanced auditing and governance standards, additional responsibilities for the company’s independent directors, development and documentation of control procedures and certifications by the CEO and CFO.  The certification requirements are backed up by possible criminal sanctions for violations.

Change in Corporate Governance Structure A listing requirement of the major stock exchanges is that the company’s board be comprised of a majority of independent directors.  Independent directors cannot be officers, employees, major stockholders or outside service providers.  Independent directors must comprise the audit, compensation and corporate governance committees.  This means that the duties of selection and oversight of auditors, setting executive compensation and determining board candidates and litigation issues are taken away from management and given to “strangers” that may have little past experience with the company’s operations.  Another listing requirement is holding annual stockholder meetings.  Matters such as calling meetings and presenting proposals to stockholders must now be accomplished in compliance with SEC rules.

A major change brought about by Sarbanes-Oxley was empowerment of the independent directors.  Previous “best practices” of having a majority of independent directors are now mandated by exchange listing requirements.  The independent directors are charged with oversight of the company’s management and auditors.  For most companies, particularly where the founders are executive management, the change in corporate governance structure resulting from being a public company may take some adjustment.

Becoming a Slave to the Stock Price It is often said that a professional baseball pitcher is only as good as his last outing and that a CEO of a public company is only as good as her company’s last quarter.  While a fluid and liquid market in a company’s stock unlocks value, a public company’s stock price is frequently subject to rapid fluctuation.  The stock price can be affected by a variety of factors, over which management may have little or no control.  Reporting of quarterly earnings can lead to decision making based on the short term result when a longer term perspective would be better for the company.  The close ties between executive compensation and their personal net worth to operating results enhances the dilemma of seeking short-term results at the sacrifice of long-term perspective.  Wall Street can be impatient and, as with baseball pitchers, may have a tendency to look only to immediate past results rather than the big picture.

A loss of stock value can lead to dire consequences, such as stockholder lawsuits, loss of confidence in management and possible hostile takeovers.  Lawsuits can stem from a sudden decline in stock price.  A stockholder lawsuit can be very costly and distract management from running the business.    Recently stockholder activism has been on the rise and dissatisfaction with directors (including executive management on the board) has been evidenced by stockholders withholding approval of directors.  Various proposals, such as mandatory removal of directors that do not win a majority of stockholder approval in elections, are increasing the pressures on management to perform on a quarterly basis.  If a company loses favor with analysts and stockholders, its stock may suffer additional devaluation, which could lead to it becoming attractive to a hostile takeover bid.  A successful takeover, particularly a hostile takeover, could result in the company’s founders being removed from management positions.

Conclusion

While going public can have many positive effects on a company and its operations, these positive effects must be balanced against the disadvantages.   Going public drastically changes a company’s culture and has an ongoing impact on business operations.  Determining if going public is the right course for a company to pursue is a major decision and must be carefully considered by management before this course is taken.

 

Thomas Morgan is a partner in Lewis and Roca’s (www.lrlaw.com) Phoenix office in Phoenix, Arizona. He practices securities, corporate and tax law with an emphasis in public and private securities offerings, private equity fundings, mergers and acquisitions, regulatory compliance, and general tax planning. He can be reached at 602.262.5712  or TMorgan@LRLaw.com

Investors Need Transparency AZ Business Magazine Sept/Oct 2010

Investors Need Improved Transparency When Dealing With Illiquid Assets

Now more than ever, investors and regulators are demanding greater transparency when it comes to hedge funds that invest in illiquid financial instruments. This should come as no surprise given that so many recent defining business failures were related to illiquid assets.

For example, AIG’s downfall was caused by investments in structured credit derivatives that were difficult to value. Bear Stearns’ and Lehman Brothers’ descents were due in part to the illiquid non-agency mortgage assets they held. Many hedge fund investors suffered significant losses in the recent financial downturn, and consequently want a closer view of portfolio assets and valuation processes.

What are illiquid investments?

Illiquid assets are investments that can be difficult to sell and value due to limited market participants, infrequent transactions, complex structures or highly uncertain future performance. In some cases, it can take years to realize a return on the investment. Illiquid investments are frequently held in portfolios managed by hedge funds, private equity groups or investment banks. Examples may include investments in private equity or venture capital companies, distressed credit, bankruptcy claims, over-the-counter (OTC) derivatives, whole loan pools, convertible bonds, auction rate securities and collateralized debt obligations (CDOs). Because of the lack of observable transaction prices, illiquid investments often are valued using models that may include significant management judgment.

Upfront due diligence

In order to mitigate the risk posed by illiquid investments, institutional investors need to perform increased due diligence relating to a fund’s investment strategy. They need to be able to answer questions such as:

What experience has management had with liquidity shocks?

What informational advantages or specialization do they have in the marketplace?

What else is required in order to implement the fund’s strategy, such as sufficient ability to sell/hedge positions in a dealer market or continued financing terms?

It’s also important to ensure that the fund structure is appropriate to meet the cash flow needs of investors and the investment strategy, as well as the financing requirements of asset managers. Is the fund’s structure appropriate given the liquidity profile of its investments? Consider issues of leverage, redemptions and side-pocket accounts that have been used to separate illiquid assets from other, more liquid investments. Is the financing or leverage of the fund appropriate given the composition of its assets? For example, a highly leveraged capital structure with short-term financing is not advisable when combined with illiquid investments.

Lock-up periods, which may restrict an investor’s ability to exit a fund investment, are another area of growing attention due to the recent liquidity crisis. While many funds that specialized in illiquid assets were able to negotiate long lock-up periods for redemptions, other firms were forced to sell in order to satisfy investors’ requests for cash. Funds with long lock-up periods were well-positioned to buy assets at favorable valuations when their competitors had insufficient capital available to make investments. For funds with large concentrations of less liquid investments, a long lock-up period is an appropriate structure.

Hedge funds with long lock-ups need to be able to instill investor trust in their managers’ investment approaches and their funds’ interim values. If investors are restricted in redeeming their fund investments, they should have sufficient information to assess the value and report to internal constituents.

Valuation policies and procedures with an independent third-party review

Hedge funds need to establish and follow clear policies and procedures for the valuation of all assets, but this is particularly true with regard to illiquid investments. During due diligence, investors should review the fund’s written valuation methodologies to ensure management is adhering to industry best practices.

Hedge fund management can ease investor uncertainty by engaging an independent third party to review the fund’s valuation policy, process and the resulting asset prices used for investor reporting. The third party may be hired to review the valuation process and inputs for reasonableness, or alternatively, to provide an independent value of the defined assets.

Additional disclosures to investors

In response to market dislocation, many hedge funds have made disclosures above and beyond what may be required by generally accepted accounting principles (GAAP) in their financial statements to investors. Currently, these disclosures are not part of the regular financial statements, but are provided in an investor letter or as part of a supplemental investor reporting package. However, we may also see additional disclosures required related to fair value measurement, as well as structural or contractual risks.

Such disclosures can help clarify the risks to investors, such as an estimate of transaction and search costs required to liquidate assets, a discussion of market participants and exit strategy, or an estimate of the time necessary to sell or unwind a position — especially a large position. Hedge fund disclosures may also include the liquidation or quick-sale value, i.e., the price if the manager is compelled to sell.

Types of illiquid assets

  • Private equity or venture capital companies
  • Distressed credit
  • Bankruptcy claims
  • Over-the-counter derivatives
  • Whole loan pools
  • Convertible bonds
  • Auction rate securities
  • Collateralized debt obligations

Arizona Business Magazine Sept/Oct 2010

Valuations For Financial Institutions Are Falling — And Presenting New Opportunities For Estate Planning

“Strange,” “Nothing like it before,” “Astonishing” are a few ways to describe what has transpired in the financial institution industry over the last several months. As liquidity and asset concerns for financial institutions have become magnified, national economic trends have exacerbated the situation.

Despite all of this gloomy news there is at least one silver lining: If you own stock in a financial institution and need to do some estate planning, now is a great time to consider gifting some of those shares to family members or other beneficiaries. While gifting has many advantages, one of the most important benefits is the removal of assets from your estate and lowering your future estate tax.

Valuations of shares in financial institutions (and many other privately held businesses) are likely to be lower than in recent years due to many factors.

Some of the external factors include the uncertainty and volatility of the public stock markets, the effects and duration of the current economic downturn, the potential estate tax law changes that will occur with a new administration in the White House, and U.S. Treasury programs that are still being finalized from the financial-system bailout.

Each financial institution is unique and specific facts will dictate whether a substantial decline in value exists for each institution. The following are some noteworthy items that should apply when determining the value of any financial institution in today’s environment.

Liquidity and capital concerns may lead to financial institutions tightening their distribution policies to ensure capital levels are maintained.

Distribution policies can significantly impact the value of an entity. If lower distribution levels are expected to be maintained for a significant period of time, lower values for an entity can be substantiated.

There have been 139 bank failures since July 1, 2008, according to the FDIC’s Web site. As many as 115 of those bank failures have occurred in 2009. To put this in perspective, from 2001 through 2007, there were only 24 bank failures. This trend suggests that problems are more prevalent with financial institutions than in the past and that earnings expectations for future years may be lower than in recent years. Lower future earnings generally equate to lower valuations of stock prices.

The ability to achieve recent historical earning levels for financial institutions may prove to be difficult. According to the FDIC’s quarterly banking profile for the fourth quarter of 2008, annual net income for all financial institutions was at its lowest level since 1989, and return on assets for the industry (0.08 percent) has not been this low since 1987. During the second quarter of 2009, the FDIC noted that more than one in four institutions was unprofitable and industry assets declined by $238 billion. With future earnings unlikely to mirror recent historical earnings (prior to 2008), valuations for shares in financial institutions should be lower.

Many valuations of privately held financial institutions rely on publicly traded information as benchmarks for establishing values. While the markets have rebounded since early 2009, the publicly held banks are still trading at considerably lower levels. Specifically, a review of publicly traded banks in Yahoo! Finance’s Pacific and Southwest Regional Banks category indicates the average price-to-book value for the 184 publicly traded banks was 0.70 as of October 31, 2009. This is considerably lower than price-to-book ratios prior to 2008, and will likely impact buyers of private financial institutions leading to lower valuations.

The private marketplace is another source of information that appraisers rely upon when determining the value of financial institutions. The amount of activity in mergers and acquisitions of private financial institutions in the Southwestern U.S. significantly dropped during 2008 and 2009. Of the 20 transactions in 2008, only five were announced in the second half of 2008. Like the publicly traded banks, private banks in the Southwest also have seen a decline in the average price-to-book multiple above 30 percent from 2007.

Moving shares at lower values seems counter intuitive, but the tax advantages may be beneficial in planning your estate. With the current potential for lower stock valuations of financial institutions, owners may be able to gift more shares for the same dollar amount than they would have been able to gift in the past. These conditions should reduce the applicable gift tax and/or unified credit that would be used in connection with a gift. While the timing may be right for gifting shares of stock in your financial institution, be sure to visit with your financial advisers to determine when gifting is the best option for you.


Arizona Business Magazine

February 2010