By Clemens Mayr of McCarthy Tétrault LLP
Going public is among the most critical decisions a corporation can make. It is an intensive and complex process that affects virtually every facet of the corporation’s operations. Before proceeding with an initial public offering, a corporation must reflect upon whether it is in a position to make a successful public issue of securities, and it must consider very seriously the implications and realities of being a public corporation.
The success or failure of a public offering depends on the state of the financial markets, domestic and abroad. Market conditions can change in a matter of days, sometimes even hours. Adequate preparation allowing for quick decision-making can prove critical in this process.
The purpose of this article is to provide an overview of the factors that should be taken into account when deciding whether to go public. While it discusses most of the material aspects of the topic at hand, it is only a brief outline of some of the issues involved.
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1. Corporation suitability
In deciding whether to go public, a corporation must determine whether it is realistically in a position to support a successful public offering. The following are some of the factors that should be considered in the decision-making process and are elements that could prove critical to the success of the offering.
While it is clear that ideal candidates for successful public offerings are companies with a consistent record of growth over several years, many development stage companies with innovative products and services (such as in the software, Internet or biotechnology sectors) have successfully raised funds based on the potential of their business and management. Thus, a corporation with a short financial history can attract investor interest by showing a strong momentum in sales and profits and by being able to identify anticipated growth opportunities and competitive advantages.
A corporation must have a market value after the issue that is large enough to attract institutional investors. While public offerings may sometimes be structured for issues as small as a few million dollars, institutional investors and major underwriters usually take interest only in issues of $25,000,000 and up.
A corporation must have either a solid net worth supported by tangible assets or, if technology based, solid proprietary intellectual property with strong business prospects. The quality of a corporation’s patent portfolio and other intellectual property protection is critical.
- Business plan
A corporation must think about its longer-term business goals and whether going public is the best way to finance its growth. Prospective underwriters and investors, as well as securities regulators, will require that a corporation have a clear plan for the use of the proceeds from the issue. On occasion, a two-step process whereby a smaller private placement precedes the initial public offering may be more appropriate and financially advantageous, as it may reduce dilution to the founding shareholders.
The going-public process is typically heavily influenced by precedent. Having a good grasp of a corporation’s industry and market, as well as its competitive strengths and weaknesses, is critical to building a credible “case” with underwriters and potential investors.
- Management and board of directors
A corporation’s management must possess sufficient depth and experience to carry out a successful public offering. Prospective underwriters and investors are particularly interested in the strength of the management team. A corporation must therefore ensure that management is willing and able to assume the responsibilities involved in going public. In addition, changes to the board of directors and the establishment of appropriate committees of the board are very often required. Boards of directors play a significant role in both the management of public companies and in their public image. A corporation will often need to add to its board individuals with experience, expertise or the necessary independence.
- Corporate structure and governance
A corporation must consider whether its existing corporate, capital, management and governance structures are appropriate for a public corporation, as well as whether all of its corporate records and contracts are in order.
- Internal controls
A corporation must have internal controls, systems and procedures that are capable of supporting the demands associated with both the process of going public and the requirements to report reliable financial information to investors following the public issue.
- Share structure issues
A corporation must consider whether its share structure, including recent pre-IPO share issuances, meet the public-interest criteria applied by regulators and addressed in CSA Staff Notice 41-305 – Share Structure Issues – Initial Public Offerings.
A corporation must determine early on whether there are any accounting issues that must be dealt with, and whether it is in a position to meet the financial disclosure requirements of a prospectus.
The choice of underwriters is critical to the success of an initial public offering, for it is the underwriters who will take the issue to the public market. It is important therefore that the underwriters have a solid reputation in both the financial community and in the particular industry of the issuer. A corporation should generally look for underwriters who have a wide distribution network nationally and, if necessary, internationally, underwriters who have or have access to good research facilities and underwriters who have a track record of bringing past issues successfully to market. The quality of an underwriting firm’s research teams and analysts should also be considered as a going-forward concern.
- Other experts
The involvement of experienced legal counsel and auditors early on in the process is also critical to the success of an initial public offering. When selecting these experts, a corporation must consider their familiarity with the complex securities law and stock exchange requirements both in Canada and abroad. The legal counsel, the auditors and the underwriters each play equally important roles and the whole offering process can grind to a halt if any one of these links is too weak.
2. Advantages of going public
- Financing growth
The principal motivation for going public is to raise cost-efficient funds with which to finance operating and growth objectives without the restrictions associated with bank or other debt financing. Such financing objectives may include the financing of research projects, new product development, expansion into new markets, acquisition of other businesses, plant construction or modernization, restructuring of capital, repayment of debt and working-capital requirements.
- Access to capital
Going public can help a corporation obtain future capital. As a public issuer, a corporation’s current financial results, as well as its future prospects, are disclosed to the public on an ongoing basis. If the corporation is well-run and makes good use of its skills and resources, the market will likely respond favourably to its business success through upward pricing and acceptance of future share issuances.
Shares that are publicly traded generally command higher prices because they are more marketable, because public companies are seen as more sophisticated, and because a great deal of information about public companies is made available to investors. Being public provides a corporation’s shareholders with access to an active market, thus enhancing the liquidity and value of their investment.
- Exit strategy
An initial public offering provides founding shareholders and venture capitalists with access to an organized market in which to eventually dispose of their investment. It is also possible in certain circumstances to combine an initial public offering of new treasury shares with a simultaneous sale of shares held by existing shareholders. However, such sales are subject to certain restrictions.
Being public also brings a certain degree of flexibility for the founding shareholders in the medium- and long-term by helping them to diversify their investment portfolio and to simplify their financial, fiscal and estate planning.
- Access to financing alternatives
A public corporation has access to a wider range of financing alternatives, including the issue of additional common shares and the issue of convertible debt obligations, convertible preferred shares or subscription rights. Also, by acquiring an expanded equity base, going public may lead to an improved debt/equity ratio, which in turn may make it possible to obtain additional debt on more favourable terms.
- Mergers and acquisitions
Going public facilitates subsequent mergers and acquisitions through the sale and exchange of shares. Subject to certain statutory restrictions, public companies have the advantage of being able to issue shares with a publicly quoted value (instead of paying a negotiated cash or share value) to acquire other businesses.
- Employee share incentives
Being public makes it easier for a corporation to offer to its executives, directors and employees certain share incentives, such as stock option and share purchase plans, stock bonuses or other profit-sharing schemes. In general, the share incentives of public companies are more attractive because the public market values shares independently, and thus enhances their marketability. Such share incentives can therefore help a public corporation attract and retain key management personnel and develop a stronger sense of loyalty among employees.
- Prestige and visibility
Going public may help increase a corporation’s prestige and visibility in the business and financial community. Through press releases and other types of continuous disclosure, the corporation’s name and products or services become better known to investors, the press, the public and, invariably, its customers and suppliers.
3. Other considerations
Going public is a costly undertaking. A corporation must take into consideration both the initial costs of going public, as well as the annual costs that come with being a reporting issuer.
The direct expenses of an initial public offering will vary depending on the capital market selected and the size and complexity of the offering. The costs involved typically include legal and accounting fees, filing fees with the applicable provincial securities commissions, promotional expenses such as information meetings, translation costs for offerings in Québec, transfer agents’ fees, printing costs for the prospectus, and stock exchange listing fees. In addition, the underwriters’ commission generally accounts for five per cent or more of the proceeds from the offering and may range upward of 10 per cent for smaller, more speculative issues.
A corporation must also consider the time and effort required of management to assist in the preparation and realization of the public offering. The going-public process may take up to three or four months depending upon the amount of advance preparation undertaken, the complexity of the corporation’s business and the offering, the state of the financial markets and the responsiveness of the securities regulators. Even after the offering is completed, management will be involved in meetings of the boards of directors and the audit committee, shareholders’ meetings, meetings with analysts and meetings with journalists.
Once an initial public offering is completed and the shares are trading on the stock markets, a corporation must be aware of the significant ongoing costs that come with being a reporting issuer. These include the costs associated with the filing and distribution of periodic disclosure documents and proxy statements, such as printing costs, the costs of mailing documents to shareholders, legal and auditing fees, and the fees paid to registrars and transfer agents.
- Loss of confidentiality
A corporation will lose a great deal of confidentiality once it becomes public. The disclosure obligations in the prospectus and the continuous disclosure required of public issuers forces companies to sometimes divulge highly sensitive information, such as the compensation paid to their senior executives, special incentives offered to management, special arrangements with key personnel or related parties, and many strategic business plans and operations.
One obvious disadvantage to this increased publicity is that a corporation’s competitors will have access to the information it discloses. Also, with financial disclosure requirements, the successes and failures of a public corporation are made public. This type of information is reflected rapidly in the marketplace and a series of poor quarterly results can have an adverse effect on a corporation’s public image and on the market price of its shares. Increased visibility also leads to the potential for unwanted publicity, particularly in such areas as litigation, potential liabilities and regulatory or environmental matters. Such publicity could be damaging to a corporation’s reputation and its customer, supplier and community relations.
- Restrictions on management decision-making
Compared with that of a privately held corporation, management of a public corporation acts with less freedom. A certain degree of spontaneity is lost when management is required to obtain the prior approval of the board of directors for major decisions and even the approval of the shareholders for certain special matters. Directors’ and shareholders’ meetings must be convened, information regarding the meeting must be sent in advance and a certain amount of time must be given to allow for review of the material.
- Increased pressure for short-term results
Shareholders who trade on public markets put more pressure on the companies in which they invest to increase their short-term return. They tend to focus more on a corporation’s quarterly performance in terms of profits, dividends and stock prices than would certain private investors. As a result, management often feels pressured to present short-term strategies in addition to long-term objectives.
- Restraints on transactions by majority shareholders
While shareholders of public companies generally benefit from increased liquidity of their shares, there are a number of regulatory rules that govern the rights of majority shareholders and corporation insiders to sell or transfer their shareholdings. These restrictive rules may have a significant impact on the size and nature of the founders’ equity positions and their ability to deal freely with their shares both during and after the initial offering.
- Potential loss of controlling interest
If enough shares are issued in the initial public offering and purchased by an investor or group of investors, the founding shareholders risk losing their controlling interest in the corporation. The founding shareholders can sometimes avoid or delay such a result by issuing shares with limited voting rights to the public; however, such shares are less appealing to investors and may sell for less than would fully voting common shares. Also, certain regulators restrict a corporation’s ability to issue subordinate voting shares and thus this option is not always available.
- Escrow requirements
In the past, founding shareholders sometimes abused the public offering process by taking a corporation public only to sell their investment and retire with the proceeds. In response, Canadian regulators adopted a number of escrow requirements that restrict a founding shareholder’s ability to dispose of shares immediately after the corporation has become public. The objective of these restrictions is to guarantee the continued interest and involvement of founding shareholders in the management of the corporation and to increase shareholder value, thus protecting the investing public.
In general, directors, senior officers, promoters and shareholders holding more than 10 or 20 per cent of a corporation’s shares after the offering are subject to such escrow requirements when the corporation goes public. Canadian securities regulators require these shareholders to place a percentage of their shareholdings in escrow with an independent third party upon certain conditions. These shares must remain in escrow after the initial public offering for a period that may last up to 18 months for established issuers and 36 months for emerging issuers. The escrowed shares are released progressively over the escrow period.
Escrow requirements have been relaxed in Canada since 2002, and certain categories of senior or large issuers are entirely exempt from these requirements.
- Potential liability for disclosure
Directors and officers of companies must be aware of the responsibilities they will be assuming if their corporation goes public. Directors and officers may be subject to both personal liability and penal sanctions for any misrepresentations in the prospectus as well as in certain subsequent public disclosure documents. It is anticipated that legislation will be introduced shortly that will result in directors and officers potentially being liable to investors in respect of misrepresentations contained in any continuous disclosure made by a public corporation.
4. The IPO process
The following is a brief outline of the main steps involved in the initial public offering process. Refined over time, they are quite standard and were designed to comply with the complex regulatory framework created to protect the investing public by providing standardized and complete disclosure about the proposed investment.
- Organizational meeting
Once underwriters have been retained and an engagement letter executed, the process typically begins with an organizational meeting between representatives of the issuer, the issuer’s auditors and legal counsel, and the underwriters and the underwriters’ legal counsel. At that point a timetable is set and initial responsibilities are assigned.
- Due diligence
Both the corporation and the underwriters are required to attest to the fact that the prospectus will contain “full, true and plain disclosure.” Extensive due diligence is therefore required by all parties to discharge this legal obligation. The scope and content of each due diligence investigation will vary, and must be tailored to such determinants as the nature of the offering, the size of the issuer and the availability of information. For example, legal counsel will review the issuer’s minute books and other corporate records to ensure that filings were correctly made and that the issuer’s decisions were properly authorized and documented. Counsel will also review material contracts to which the issuer is a party and documentation relating to various aspects of the issuer’s business, such as employment, property ownership, litigation, environmental matters, insurance, financial and tax issues.
The due diligence process is ongoing and lasts the duration of the public offering. The findings must be regularly updated and confirmed, because the discovery of a material fact not properly disclosed in the prospectus can trigger liability and may require the filing of an amended prospectus before any purchase orders are confirmed.
- Preliminary prospectus
Preparation of the preliminary prospectus for filing is a lengthy process that can take over a month. The form and content of the prospectus are largely governed by securities laws and regulations, although the most pertinent information may vary depending upon the nature of the issuer involved.
The disclosure in the prospectus is open-ended in that it requires full, true and plain disclosure of all “material” facts relating to the securities being offered. The issuer and the underwriters must decide what information is “material,” keeping in mind that they assume responsibility for the accuracy and adequacy of the disclosure.
In short, the purpose of the prospectus is to provide potential investors with a comprehensive, accurate and informative description of all matters an investor might reasonably take into account in reaching a decision on whether to invest in the issuer.
- Prepare financial statements
The preliminary prospectus must contain certain prescribed financial information, which generally includes two years of audited balance sheets and three years of audited statements of income, retained earnings and cash flow. Prospective issuers that do not typically audit their statements should begin to do so well before the public-offering process begins so as to avoid having previous years audited while the process is underway.
- Translate prospectus
For public offerings in Québec, a French-language version of the prospectus must also be prepared. Note that time should be allocated for translating the prospectus to avoid filing delays in Québec.
- Formal due diligence session with management and auditors
Immediately prior to the filing of the preliminary prospectus, the underwriters meet with the issuers’ management and auditors to conduct a formal due diligence session and to carefully review the prospectus to ensure that its disclosure is complete and accurate, and does not contain any misrepresentation.
- File preliminary prospectus with Regulators
When the issuer and the underwriters are satisfied with the disclosure in the preliminary prospectus, and it bas been approved by the board of directors, it is filed electronically via the System for Electronic Document Analysis and Retrieval (SEDAR) with the Canadian regulators in those jurisdictions where the offering will be made. A press release is often issued announcing the filing. Where the offering is to be made in more than one jurisdiction (which is typically the case), the principal regulator will issue the receipt, lead the prospectus review process and coordinate it with the other regulators.
The underwriters will arrange for information meetings with various institutional investors and retail brokers, commonly known as “road shows,” in the principal cities where the offering will be made. These meetings are designed to present the issuer to the investment-dealer community and to create additional investor interest in the public offering of its shares. Commercial copies of the preliminary prospectus are printed after a receipt has been obtained from the principal regulator for use in the marketing of the offering.
It is important to note that during the period between the issue of the receipt for the preliminary prospectus and the issue of the receipt for the final prospectus (the “waiting period”), securities laws restrict the conduct of the issuer and the underwriters regarding advertising of the issue. As a general rule, the preliminary prospectus is considered to be the primary disclosure vehicle for marketing purposes during the waiting period. The underwriters may only distribute notices or advertisements identifying the security to be issued, its price, the name and address of a person from whom purchases may be made, and the name and address of a person from whom a preliminary prospectus can be obtained. The underwriters will typically also prepare a brief summary of the preliminary prospectus, commonly referred to as a “green sheet,” which is subject to prior review by the securities regulators before it may be used.
Furthermore, while the underwriters may solicit expressions of interest from prospective purchasers and may distribute copies of the preliminary prospectus to them, they are prohibited from taking any purchase orders at this time. Purchase orders can be accepted and confirmed only after a final prospectus has been receipted and circulated.
- Stock exchange listing
Shortly after filing the preliminary prospectus, application is made for listing of the offered securities on one or more stock exchanges. If the issuer meets the minimum-listing requirements under the stock exchange rules, conditional listing approval will be granted.
- Prepare underwriting agreement
The underwriting agreement between the issuer and the underwriters sets out such matters as the obligations of the underwriters, various covenants and representations of the issuer, and the conditions relating to the underwriters’ obligations and rights of termination, including the “market out” clause that outlines the circumstances in which the underwriters can choose to terminate their obligation to purchase shares and proceed with the offering.
- Receive and respond to comment letters of the regulators
The principal regulator usually issues a first comment letter within 10 working days of the filing of the preliminary prospectus.
The corporation will normally deal only with the principal regulator. In cases where the Ontario Securities Commission (OSC) is not the principal regulator, and the prospectus is also filed in Ontario, the OSC will also review the materials and may, in rare circumstances, “opt out” of the dual review under National Policy 11-202, in which case the corporation will deal directly with the OSC and the principal regulator.
Legal counsel to the issuer and underwriters will then contact the staff of the principal regulator to resolve the deficiencies in the preliminary prospectus. The period required to settle the deficiencies normally takes several weeks. When the principal regulator is satisfied that all the comments have been resolved, a draft final prospectus, blacklined to show the changes made, is typically sent to the principal regulator before the filing of the final prospectus.
- Pricing and board meeting
Once all the deficiencies in the preliminary prospectus are cleared and the regulators have indicated that they are “clear for final” (ready to receive the final materials) and the marketing efforts of the underwriters have been successfully completed, the underwriters and the issuer will agree on the issue price of the shares and the number of shares to be issued. The underwriters and the issuer will then execute the formal underwriting agreement, which is submitted to the board of directors of the issuer for approval. Upon approval, a press release must be issued.
- Second formal due diligence session with management and auditors
Immediately prior to the filing of the final prospectus, the underwriters meet with the issuers’ management and auditors to conduct another formal due diligence session and to carefully review the prospectus to ensure that its disclosure is complete and accurate and does not contain any misrepresentation.
- File final prospectus
The issuer must file the final prospectus, together with required supporting documentation, with the regulators in each Canadian jurisdiction in which the issue is to be distributed.
Upon the filing of the final prospectus, the principal regulator will issue a receipt that is deemed to be a receipt issued by each relevant Canadian regulator.
- Confirmation of orders by underwriters
Once the receipt for the final prospectus has been issued, the waiting period ends. At this point the underwriters can distribute the final prospectus, accept orders for the issuer’s shares and collect funds from their customers in payment therefor.
The closing is the final formal step in the transaction, and it typically occurs three to five working days after the receipt for the final prospectus has been issued. It is at the closing that the issuer issues the shares to the underwriters and the underwriters pay the issuer the price of the issue.