Taking Your Company Public

by Vanessa Grant, W. Ian Palm, and George S. Takach of McCarthy Tétrault LLP

Part I

In the past four months, the North American tech IPO market has shown some signs of a resurgence, at least in relation to the two years that came before. Given the potential rebound, this edition and the next couple of editions focus on the IPO legal process, together with certain legal aspects related to running a company after its shares are listed on a stock exchange. And while the focus will be on entrepreneurial businesses, much of this commentary applies equally to any type of business looking to go public. But before delving into legalities, first some thoughts on the all-important decision by the controlling shareholder(s): “Do you even want your company to go public?”

Why Go Public?

When a company “goes public” through an “initial public offering” (or IPO), it essentially sells some of its shares to retail and institutional investors, and those shares are then invariably listed on a public stock exchange, where the price for the shares floats up or down depending on a range of factors related both to the financial performance of the company and the state of the capital markets (and the broader economy) more generally. In order to become public, the company must go through a rigorous process of information disclosure centred around an extensive, written prospectus. Then, once public, it must adhere to a range of rules on timely legal and financial disclosure. Why would a business owner agree to jump through all these hoops?

Well, many do not! Particularly in the Canadian tech sector, many owners and managers of entrepreneurial businesses have a good long look at the costs and benefits of going public or staying private, and choose the latter. For example in the US, there are some significant private tech companies, such as SAS.

Moreover, if the owners of a private company want liquidity (that is, they want to turn the shares they hold in their private tech company into money), they can always sell the company outright to an interested buyer rather than sell a part of the company to public investors. And this is still the most common way shareholders of, for example, private Canadian tech companies achieve liquidity — by selling to typically non-Canadian-based larger public tech companies, such as IBM (though, usefully, companies like Constellation Software and Aastra Technologies are now acquirors as well). Indeed, there is by no means any shame in such an exit, particularly given that the founding entrepreneur of the sold company (and often several of his or her senior management), tends to reinvest much of the proceeds of their sale into new, start-up ventures (and the virtuous company cycle of establish, build, grow and sell will begin again).

Accessing Growth Capital

Often, however, Canadian entrepreneurs do not want to sell their companies, but rather want to stick around and build them. Moreover, they want to grow their companies, either by hiring additional staff with which to undertake the development or selling of new products or services, or by acquiring other companies with complementary or related products (in the tech industry, for example, the Constellation and Aastra Technologies models).

For an entrepreneurial business to either expand its current capabilities or buy a competitor, it requires serious investment dollars. Which brings us to perhaps the leading reason for a company going public — namely, to increase its access to capital. In a 2007 American survey of CEOs and CFOs of US companies (both tech and other) that had recently gone public, more than two-thirds (69 per cent) said their prime rationale for the IPO was to access capital (presumably at rates that were more favourable than the alternatives).

Minting Your Own Currency

This same survey found that 15 per cent of those questioned indicated that their main reason for going public was to be able to use the resulting public stock as a “currency” for acquisitions. That is, as a public company, you can buy other companies and exchange their shares for shares of your own company (or you can make it a combination of shares and cash — or, for that matter, all cash).

Accordingly, if you put together these two categories of respondents to the survey, fully 84 per cent of companies going public in 2007 (at least in the US), did so for financial reasons, and indirectly in order to grow the business. The same dynamics should hold true in Canada (and perhaps even more so in light of the recent credit crisis when access to private capital has been limited).

A Delayed Payday

There are several other good reasons companies go public. The survey noted above found that 31 per cent of senior executives wanted to do so in order that they, other managers who hold shares, and principal shareholders would be able to make some money by selling some (but not all) of their shares upon or soon after the IPO.

This is not surprising. A founder of a company, for instance, may have the bulk of his or her net worth tied up in the shares of his or her company. As a private company, there is no ready market for these shares. Now, of course, the founder could sell the whole company outright (as noted above). But the founder may believe that the company is unfairly undervalued, given the rather early state of development of the company (that is, it’s not a bad business, but “the best has yet to come”). The founder would be well-advised not to sell all of his or her shares at this premature juncture.

This is where an IPO might make good sense. Upon the IPO, the founder either sells very few — or none at all — of the founder’s shares, but waits until a market has truly evolved in the now-public company shares. Presumably the valuation of the company increases as the true potential of the company is realized. Then, from time to time, the founder can sell some shares, all the while working hard to increase the value of his or her remaining shares (the founder may also be subject to restricts on the sale of shares post-IPO imposed by either investment bankers or regulatory authorities, who will want to give the founder an incentive to unlock value).

In a similar vein, other employees of the public company can begin to cash out some of their shares once the company is public and there is a liquid market for the shares. Equally, the company can better recruit staff as a public company assuming they have a stock option plan or other equity based compensation plan of some sort that allows employees to purchase shares of the public company on some favourable basis.

Prestigious Public Companies

One reason popularly perceived as a very important one for going public is “publicity and prestige”; it is often thought, for example, that people would much rather work for a widely known public tech company, than for a relatively (or completely unknown) small, private one. In the event, however, the survey noted above found that only nine per cent of respondents cited publicity and prestige as the main drivers behind going public.

This is an extremely interesting insight (if indeed it is accurate). It tells us that, actually, fairly few founders and other shareholders are motivated principally by what others think, when it comes to the all-important “Go — No Go” decision on the IPO. Rather, the urge to build good companies through growth is the prime driver behind taking tech (and other) companies public. And this is how it should be.

So, assuming you are ready to go public (for all the right reasons), we will look at the legal process involved in doing so in the next Part.

Part II

Having previously discussed some reasons that private entrepreneurial companies might want to go public, we turn to consider some of the downsides of being a public company. Founders and shareholders of private companies should consider the cons as well as the pros of being a public company, before deciding whether to proceed with an initial public offering (IPO) or other transaction that results in the company being public.

Losing Control

In many private companies, the founder (or founders) of the company is still the principal shareholder. As such, the founder more or less runs the company however he or she likes. For instance, the founder may choose to focus on long-term prospects and make investments that depress cash flow and earnings in the short term, but that increase the chances for longer-term growth and profitability.

By contrast, the management of a public company must maintain close attention on fairly short quarterly time horizons (in addition to meeting long-term expectations). Most public company investors focus on quarterly earnings. For public companies, closing business at the end of each quarter (and at fiscal year-ends) then becomes an extremely important exercise so earnings estimates can be met or exceeded. If quarterly results do not match expectations, many investors will often sell the stock, putting downward pressure on a public company’s share price.

Thus, a founder who takes public a previously private company may well come to feel that he or she has lost control of its destiny, and that as a public company, the requirements of the stock market have taken over. Some founders believe this is a trade-off worth making. Other founders, particularly in knowledge-based industries, leave the public company and start over again with another startup.

Another dynamic of the public company that can give a sense of a loss of control is, as the name suggests, the lack of confidentiality for public companies. In the next article, we’ll see just how revealing the company’s prospectus is (as it should be, in a securities law context). And then all the material information in the prospectus and other disclosure documents is periodically updated so that the investing public can keep tabs on the company. This all makes perfect sense. It’s just that some entrepreneurs are not ready for it, and their expectations around loss of control have to be managed.

A founder’s sense of loss of control can be mitigated somewhat if the company has obtained private equity financing while it was still a private company. In that case, the founder will have had representatives of the investors on the company’s board of directors, and would have provided investors with regular financial information. As a result, founders who have gone through one or two rounds of private equity or other institutional investment tend to find the transition to a public company easier than those who have not done so.

Toward Board Independence

Another way a founder can lose control of a previously private company after it has gone public is through the board of directors. In a private company controlled by the founder, he or she essentially appoints all the members of the board, who serve at his or her pleasure (unless the private company had some private equity or institutional investors, as noted).

With a public company, best practices (and, in some jurisdictions, the law) dictate that a certain percentage of the board members must be independent; that is, connections to the company or the founder that would compromise members’ independence must be limited. Moreover, the agencies that regulate public companies (securities regulators and stock exchanges) are advocating corporate governance practices that include ensuring the majority of directors on a public company board are independent. This allows the board to oversee the management team, and often, to challenge management on fundamental strategies and tactical issues confronting the company.

Independent Board Committees

If most public company boards comprise a majority of independent directors, the audit committee of the board must, by law, solely comprise independent directors. The audit committee members of the board oversee the company’s interactions with its external auditors. They also oversee the internal financial controls of the company, as well as its risk-management procedures. Similarly, the board’s compensation committee comprises either entirely independent directors, or at least a majority of them.

Again, the upshot for the founder is that his or her discretion in both the longer-term strategic and shorter-term tactical decisions for the company will be increasingly narrowed as a result of this additional layer of regulation. The objective is now to achieve better corporate decisions through independent analysis and input. Nonetheless, the result for the founder is less room to manoeuvre.

Unwanted Sale of the Company

In many cases, subject to any statutorily or contractually imposed escrow requirements, within a year or two of going public, the founder will want to sell some shares of the company. This typically means the founder has done well financially by virtue of the IPO, but it does raise the spectre of the founder eventually losing ownership control of the company altogether.

This is so because once the shareholdings of the founder fall below a certain percentage, the company is susceptible to a take-over bid from another company or one or more investors. In such cases, the buyers usually only have to convince the holders of a majority of the company’s shares to sell into their offer, and they can then become the new owners. Many founders have been ousted from the companies they founded and took public, much to their dismay. But that possibility goes with the territory when the founder takes the company public.

A Public Company Candidate?

Even before considering the issues surrounding control — and the concerns the founder might have about losing it — one must ask if the company is even a good candidate for the public markets. As noted, steady quarter-to-quarter earnings performance is vastly important in the public securities markets. Therefore, companies with healthy sales and even robust growth — two requirements for public company success — might still be problematic if their sales, on a quarterly basis, are lumpy or cyclical. A couple of bad quarters can greatly devalue the company’s share price and cause a significant decline in the net worth of the founder (assuming much of it is tied up in shares of the company). And it can take years for the share price to recover.

Another issue revolves around the senior management team required for a public company. In a private entrepreneurial company, the founder may have superior skills and may be the enterprise’s knowledge guru. And as a private company, this may still be the critical skill set of the management team. But in a public company, a CEO’s ability to generate and hold the confidence of the investor community is probably of paramount importance. Thus, many sensible founders change their public titles following the IPO and bring in seasoned senior management — such as a new CEO and CFO — to take the public company to the next level. Many founders that have not followed this path have not done so well — and have devalued their companies as a result.

Once the founder has thought through the various issues noted above, and the decision is made to go public, then the exercise turns to the nuts and bolts of the public offering process. We will discuss this topic in the next Part.

Part III

In the last two Parts, we outlined why some private entrepreneurial businesses go public — and why many do not. If you have worked through the pros and cons of becoming a public company, and you do want to sell shares in the public market, we now turn to the process of the initial public offering (or IPO, as it is colloquially known).

The Internal IPO Team

The first process step is to organize the team that will stickhandle the complicated legal, regulatory and financial exercise that is an IPO. Internally, your CFO and CMO (Chief Marketing Officer, often a VP Marketing) will be two key people, usually with important input from the CEO and various other senior officers of the company.

One challenge you have is that the IPO process will suck up a large amount of the CFO’s and CMO’s time (up to six to nine months, the typical length of an IPO process). It will mean that these two important people will have much less time for their “daily jobs.” So, ideally your company has planned for this and is able to shift some of their usual duties to others.

However, it is not uncommon, particularly with smaller, growing, entrepreneurial companies that go public, that several others from the senior management team (in particular, the VP Sales) get too involved in the IPO process, such that the company takes its eye off the ball for a couple of quarters (especially in terms of pursuing and closing sales). The result can be, for example, that sales suffer in the quarter or two following the IPO. This can then lead to a drop in the (now publicly traded) share price of the company to below the IPO issue price, a situation that can be discouraging to investors and employees alike (employees because they typically have options to buy shares of the company).

Therefore, it is critical that you have all senior management exercise discipline in terms of the amount of time devoted to the IPO process. The team cannot lose sight of the fact that as exciting — and challenging and important — as the IPO process is, there is still a business to run (if not more so, now that you will soon be a public company, and everyone will see your next quarterly financial results). Through diligent planning and execution, the more successful IPOs will use the process as a springboard to more growth and opportunity.

External Advisors

In addition to your internal team, the IPO process will require you to harness the talents and efforts of at least three different external advisors. First, you will need an investment banker (and their investment bank) to be your underwriter for the going public exercise. The banker will tell you whether the financial markets will want to buy shares of your company, and at what price. They will conduct due diligence (they will have a law firm and other advisors assist them with this process) on your company (more on diligence in next issue), and will help craft the all-important prospectus document (more on this key document below and in the next issue).

Most importantly, the banker will help sell your shares. They will determine with you what mix of retail and institutional public shareholders makes the most sense for your company. Then they will reach out through their distribution channels to build an order book for your shares towards the tail end of the IPO process. Particularly if you are a younger entrepreneurial company without a significant track record, the credibility and reputation of your banker will be important.

The IPO process is an extremely intensive legal exercise. In order to protect the investing public, and generally the integrity of the public stock markets, a host of legal rules and regimes surrounds the prospectus and other aspects of the IPO process. You will need a law firm with two strengths to assist you through the going-public exercise. Of course the law firm must have solid expertise in securities law, and specifically with IPOs. But it should have deep experience in your industry sector as well, so that it fully understands your unique business model. This knowledge will be invaluable in crafting the prospectus and conducting due diligence.

Finally, you will need an accounting firm to help you work through the numerous regulatory requirements surrounding your financial statements, internal controls and other accounting-related requirements. As a threshold matter, your prospectus will have to include audited financial statements for the last three fiscal years as well as unaudited quarterly statements for the current fiscal year. But the accountant will help in other ways as well, including assisting with financially oriented portions of the prospectus, such as the MD&A section (Management Discussion and Analysis), where you have to give a meaningful explanation of your financial results in narrative terms.

Sound Expensive?

Yes, all this hired help is going to be expensive. The banker will typically charge a fee equal to six to eight per cent of the amount of money raised from the new public shareholders through the IPO process plus certain expenses they incur on your behalf as part of the process. The lawyers and accountants typically charge on an hourly-rate basis. Then there are printing costs for the prospectus, as well as French translation costs for the prospectus if you want to see your shares sold in Québec. And if you want to sell some of your shares in the US, there will be additional costs for US legal assistance.

When you are working up the budget for your professional advisors, however, we would suggest you look beyond the raw dollar amount of the fees, and instead consider these costs relative to the total funds raised in the IPO process. Moreover, saving professional fees by cutting corners on items like due diligence is not a good idea, given that significant personal and corporate liability can attach to a faulty prospectus. So, as with all premium legal, accounting and other professional services, the real touchstone ought not to be cost but value.

The All-Important Prospectus

Once you’ve assembled your working group (of internal company people and your external advisors), the focus of the IPO process turns to the crafting of the all-important prospectus. This is the document that the law says you must give to prospective investors in your soon-to-be-public company. The prospectus is a critically important document.

To understand the pivotal role of the prospectus, consider the difference between selling shares of your company to hundreds of retail (i.e., individuals) and perhaps tens of institutional (i.e., mutual funds) investors (which is essentially what the IPO process is about) to selling shares to a venture capital investor (VC), which you likely did a few years ago when you were at an earlier stage of development as an entrepreneurial company.

The VC was a seasoned investor in entrepreneurial companies, and in particular in your industry space. So the VC thoroughly understood your market, business and your challenges, and then personally conducted due diligence on your management team, your technology and your financials. In short, the VC got to know you really well, and by sitting with you in numerous meetings, the VC had all of its specific questions answered. Then the VC’s lawyer prepared a share-purchase document in which you gave a long list of representations and warranties about your business. Only after all of this information exchange did the VC invest several millions of dollars to purchase your shares.

For practical purposes it is, of course, impossible to repeat this detailed, personalized information exchange process when selling shares to hundreds of public investors. The alternative is the prospectus. This document must give “full, true and plain” disclosure of all material facts relating to your company and its business and the securities to be sold, so that prospective investors can come to understand your circumstances before they decide to buy your shares. This is the core public policy “deal” reflected in the securities legal regulatory system — namely, you can sell your shares to people you have never met before, provided you deliver to them a meaningful prospectus document so that they can make an informed decision.

In the next Part, we look at the various particular requirements of the prospectus, and the due diligence process that needs to underpin the document.

Part IV

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.

Financials

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 Part.

Part V

This final article in our Taking your Company Public series examines the issue of ongoing disclosure once your company is public. In the four previous articles, we discussed the pros and cons of entrepreneurial companies “going public” (essentially, becoming companies that sell their shares into the public market, by having their shares trade on a stock exchange) and the exercise of becoming a public company (focussing largely on the importance of the prospectus as a means of informing the investing public about your company).

Continually Disclosing

Once your company is public, the disclosure does not end — indeed it is ongoing and quite rigorous. First of all, if your shares are listed on the Toronto Stock Exchange, like clockwork, you have to publish your unaudited quarterly financial statements within 45 days after the end of each of your fiscal quarters, and your audited annual financial statements within 90 days after the end of your fiscal year. If your shares are listed on the TSX Venture Exchange, you are known as a “venture issuer” and the timeframes are a little longer: 60 days and 120 days, respectively. Woe betide you if you are late in getting out these financial statements. Investors will lose confidence in your organization very quickly if your regular financial “report card” is not promptly forthcoming when it should be. In addition, you will be required to pay late filing fees to the securities regulators and may be subject to a cease trade order.

In your financial statements, one figure will be of particular interest: your earnings. With some entrepreneurial companies other metrics can be important, at least for a time, such as subscriber growth (or loss) for mobile communications operators. But ultimately, earnings rule, and many a public company stock has been punished because earnings were below the market’s expectations.

To Forecast or Not to Forecast

How the market’s expectations about your earnings are set comprises a fascinating exercise in collective soothsaying. Different analysts at the various brokerage houses opine periodically on your company’s immediate past performance, current situation and most importantly, short- and medium-term prospects. Then a financial information firm aggregates all these analysts’ predictions into one composite expectation for your next quarterly results.

Some companies (especially smaller US companies listed on the NASDAQ exchange south of the border) add fuel to this interesting fire by periodically giving guidance about their own future earnings. This is a dangerous activity, and one fraught with risk. It requires being ever-vigilant about market conditions, and at the earliest signs of softening (or even increasing) sales, announcing further earnings guidance to recalibrate the previous forecast downward (or upward). If the result is a sell-off of your shares, it is not uncommon for a class action lawsuit to follow, alleging on behalf of those who bought your shares just before your latest announcement that, had you given the guidance earlier, these investors could have avoided losses.

Of course this is an invidious situation for your company, because there will always be a group of investors who purchased your shares before your revised earnings guidance. So, why give earnings guidance at all? Why not just stick to publishing your quarterly and annual financials after the fact, and let the market make its own decisions based on actual results, rather than on predictions about the future?

This is indeed sound advice, and many Canadian companies follow it. Those, however, that have their shares listed on the NASDAQ in the US (in addition to the TSX in Canada) often feel compelled to give earnings guidance because their American counterparts do so. And these smaller American companies seemingly have to give earnings guidance because in the large US investment market they often have difficulty getting analyst coverage if they do not.

Here’s the bottom line: Canadian public companies would do well to avoid giving earnings estimates, especially if they are in a particularly volatile space like semiconductor products, where quarterly swings in revenues, and therefore earnings, can be quite pronounced. On the other hand, a software company with a substantial installed base of customers from which it draws a steady and fairly predictable recurring maintenance revenue stream can more easily predict earnings from quarter to quarter. Nevertheless, even they should avoid the exercise, particularly in Ontario where we have a stricter legal regime for dealing with material misstatements (or material omissions) by companies and their officers.

Disclosing Material Changes

That is not to say Canadian public companies need only disclose quarterly financial results. Far from it. Every material fact relating to your company and every material change experienced by your company needs to be reported promptly. This explains the practice, for example, of issuing a press release whenever you sign an agreement to acquire another company (M&A activity being very common in the entrepreneurial space).

In fact, the Ontario Securities Commission has indicated that a press release and a related material change report may be required even before the signing of the definitive purchase agreement. For example, in certain circumstances, the disclosure may be required at the stage a non-binding letter of intent is executed between the parties if the parties are committed to proceed with a transaction (as evidenced by their actions) and there is a substantial likelihood that the transaction being discussed will be completed.

As a result of this OSC decision, it is important to record, on an ongoing basis, what material issues remain outstanding among the parties in the period leading up to the execution of the definitive agreement, and in particular, whether final senior management and/or board approval has been given by either side. In all likelihood, the widespread practice of only announcing publicly a deal when the definitive merger agreement is signed will continue, but parties will have to remain vigilant for exceptions to this rule.

Moreover, if you are acquiring a company that is large relative to your own size, then you also have to file a “business acquisition report” within 75 days of closing the deal. This report will generally require you to attach audited financial statements for the target for its last two years, as well as pro forma financial statements of your company which give effect to the acquisition. While often this is not a problem (where the target was a stand-alone business and has audited financials), it can be more of a challenge where the target is actually a division of a larger company, and therefore doesn’t have stand-alone audited financial statements. In such a case, you need to address this issue in your purchase agreement for the target.

Disclosing Material Contracts

In addition to disclosing material changes, public companies must disclose certain material contracts even when they are entered into in the ordinary course of business. Most material contracts entered into in the ordinary course of business do not have to be disclosed, but the following types of contracts (in addition to a couple of others) do have to be disclosed:

• a continuing contract to sell the majority of the company’s products or services;
• a licence agreement to use a patent, formula, trade secret, process or trade name;
• certain financing agreements; and
• a contract on which the company’s business is substantially dependent.

It is possible to redact certain provisions of such publicly filed agreements to comply with confidentiality undertakings or if failure to do so would be seriously prejudicial to the interests of the company. However, you cannot black out certain provisions, including those relating to: debt covenants and ratios in financing or credit agreements; events of default or other terms relating to the termination of material contracts; and other terms necessary for understanding the impact of the material contract on the business of your company.

You cannot avoid the application of the material contract disclosure regime merely by putting some provisions in a “side letter.” The rules are quite clear on this, and stipulate that a material contract generally includes a “schedule, side letter or exhibit referred to in the material contract.”

Keep in mind that the above discussion does not cover all the areas of ongoing disclosure for your public company. For example, you will have to prepare proxy circulars for your annual meeting of shareholders, an annual information form (not a requirement, if you are a venture issuer, although many companies do one) and a “management discussion and analysis” which provides more colour and context to your financial statements, to name a few. Also, while strictly speaking not an obligation of your company, certain of your directors, officers and others considered “insiders” will have to report their trades in your company’s shares.

Taken together, these rules stipulating extensive disclosure are important and require not insignificant resources within your company to ensure compliance. And that brings us full circle, to the discussion about the pros and cons of going public canvassed at the beginning of this series of articles. Some entrepreneurs will sell their private company to an already public company in order to avoid the various responsibilities of being a public company; others will find these burdens are outweighed by the advantages of being a public company. Whichever way you decide, it’s important you make the decision in an informed manner.