A Primer on Initial Public Offerings (IPOs)

I’ve been thinking…Just what is an Initial Public Offering (IPO)?

There are four principal methods for a private company’s equity shares to trade in the public markets: (1) sell shares to the public by undergoing an IPO, (2) sell shares to the public through a direct listing process, (3) be acquired by a SPAC, and (4) enter into a so-called reverse merger transaction with an already public company.   This blogs deals with IPOs.  Existing blogs dealt with direct listings and SPACs.  A future blog will cover reverse mergers.

Background

Some basic definitions are going to be helpful for this blog.  A direct listing is a formal process whereby a company facilitates the sale to new investors of registered shares of the company held by existing investors.  Such a sale of outstanding shares is also commonly called a secondary offering.  In a secondary offering, the company does not sell newly created shares and, therefore, does not raise capital for itself.  In contrast, when a company sells newly created registered shares into the market, this is called a primary offering.  In a primary offering, the company raises capital for itself.  An initial public offering, or IPO, refers to the first time a company issues newly created registered shares and sells those shares to a syndicate of underwriters, who in turn sell the same shares to pre-selected investors.  All subsequent offerings of newly created shares are called follow on offerings.

There are many similarities between the IPO process and the direct listing process.  The end result of each process is the creation of a public company with registered shares that are freely traded in the market.  However, becoming a public company also brings with it a host of responsibilities, including being subject to ongoing SEC regulations and reporting requirements.

The IPO Process from the Following Points of View: Issuers, Underwriters, Investors, Regulators and Markets

Issuers

It all starts with the decision at the board level of a private company to sell new shares in the public markets to, among other things, raise cash to facilitate faster organic growth, increase liquidity for either the firm and/or the original investors, and/or to use the marketable shares as a transaction vehicle for either growth by acquisitions or to diversify.

Among the first actions for a firm contemplating an IPO is to assemble the set of professional advisors needed, including the firm’s existing auditors and experienced legal counsel.  It is fact specific whether the firm’s existing law firm can act as so-called issuer’s counsel to guide the issuer through the legal aspects of an IPO, including the requirements of the Securities Act of 1933.  The key deliverable in an IPO is the issuer’s S-1 Registration Statement and Prospectus, which functions as both a disclosure and a marketing document.  By law, the content of the S-1 is required to be accurate and complete in all material respects, and the issuer is fully liable to IPO investors for material misstatements or omissions in the S-1, no matter what the reason.  It is customary for issuer’s counsel to tightly control the drafting process and content in the S-1, to coordinate the input of other professionals and to respond to SEC comments on the submitted S-1 drafts.

While issuer’s counsel can generally escape liability by reasonably relying on written assurances from the issuer’s executives that the final S-1 contains no material misrepresentations, the same issuer’s executives can only escape liability for material misstatements or omissions by having a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  However, from a practical standpoint, if material misstatements or omissions do exist in the S-1, it is a heavy lift for issuer’s executives to escape liability.

The issuer’s auditors are solely responsible for the accuracy of the audited financial statements contained in the S-1.  On the other hand, unaudited statements are often included in the S-1, and these financial statements are clearly marked as unaudited.  Special auditing procedures are used for disclosing unaudited data, and auditors can generally escape liability by, among other things, reasonably relying on written assurances from the issuer’s executives that the unaudited portions of the final S-1 contain no material misrepresentations.

In my experience, the issuer’s board interviews a small handful of investment banks and, based on their individual presentations to the board, selects the lead manager (or co-lead managers) as underwriters of the proposed IPO.  Among the key selection criteria are knowledge and experience with the issuer and/or the issuer’s business, relevant IPO underwriter experience and relevant industry research analyst experience.

While the issuer selects the investment bank as lead underwriter to manage the IPO, the interests of the underwriters are not totally aligned with the interests of the issuer.  To protect their interests, the underwriters not only engage so-called underwriters’ counsel to provide legal advice but also task a team of internal corporate finance professionals to perform a reasonable due diligence investigation to assure compliance with securities laws.  In addition, it is customary that written assurances are obtained by underwriters from issuer’s executives that the final S-1 contains no material misrepresentations.  Furthermore, the issuer’s auditors are often called on to provide underwriters so-called comfort letters on various financial matters.

Underwriters

It is fact specific as to what criteria the issuer uses to choose the lead underwriter, but the selected underwriter works off of a so-called IPO mandate versus a formal underwriter agreement.  It is customary that the binding underwriter agreement will only be signed by the issuer and the syndicate of underwriters on the eve of the actual IPO date.  However, once the IPO mandate is received from the issuer, the lead underwriter and underwriters’ counsel immediately convene the so-called all hands meeting, which in part includes finalizing the initial IPO timeline, including agreeing upon the required actions, due dates and the responsible parties for each required action in the IPO process.  It is fact specific as to the list of attendees in the all hands meeting, but the usual parties include the issuer’s executives (and often selected board members), issuer counsel, the issuer’s auditors and other advisors to the issuer as well as the lead underwriter, underwriter counsel and representatives of the other members of the underwriter syndicate.

The most important action of the lead underwriter, acting on behalf of the underwriter syndicate, is the performance of a reasonable due diligence investigation of the issuer and the securities being issued.  The Securities Act of 1933 requires IPO underwriters to act as gatekeepers for potential investors and to perform a reasonable due diligence investigation of material statements in the S-1.  Such a reasonable due diligence investigation would serve as a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  Legally, underwriters can only escape liability for material misstatements or omissions in the final S-1 by having a reasonable basis to believe in the accuracy and completeness of material statements in the S-1.  This is known as the due diligence defense and requires strict compliance with the underwriter standard of care and custom and practice for (i) accounting due diligence, (ii) financial due diligence, (iii) business due diligence, and (iv) legal due diligence.

Standard of Care and Custom and Practice in Underwriter Due Diligence

Standard of Care: The applicable standard of care in underwriter due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of material information in the offering documents.  The reasonableness standard is that applied by the prudent person in the management of his/her affairs.  The materiality standard is that information is required to be reasonably investigated if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.

Custom and Practice: The custom and practice performing a reasonable  due diligence investigation is as follows: (1) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate); (2) to follow up and reasonably understand and resolve material red flags (that is, information encountered in the course of a due diligence investigation that is inconsistent with the underwriter’s understanding of the issuer’s businesses, executives, operations, accounting or finances or that is potentially indicative of wrongdoing and, therefore, requires the underwriter to investigate further in order to arrive at a reasonably informed understanding or resolution) and to investigate and reasonably resolve issues encountered during due diligence that may not rise to the level of red flags but which warrant reasonable investigation under the circumstances; if the results of the follow up investigation are not satisfactory to the underwriter, the alternatives faced are either withdrawing from the offering transaction or accepting the risks of not conducting due diligence with reasonable care; and (3) to independently verify material information supplied by executives and advisors of the issuer (or other parties with potential conflicts of interest) on which the underwriter intends to rely.

Other services provided by the underwriters are, among other things, (i) arranging for a so-called teach-in by the research analyst of the lead investment bank (to an audience of sales executives from the lead underwriter) to present the research analyst’s opinion on the issuer, including the research analyst’s detailed financial model of the issuer; (ii) arranging for the issuer’s executives to present the preliminary road show slides (to an audience of sales executives from the lead underwriter) covering in part the issuer’s history and strengths but not the actual financial projections prepared by the issuer; (iii) conducting the road show, which is an orchestrated event in front of potential investors showcasing the issuer and its executive management in meetings (physical and/or virtual) with invited prospective investors; the road show takes place in a so-called quiet period, which prohibits the issuer from discussing its projected financial results; (iv) beginning the process of book building by tallying the so-called indications of interest from road show investors at various prices and quantities; (v) negotiating the over-allotment option (also called the green shoe), which is used for share price stabilization, if necessary, in the 30 day period immediately after the opening of share trading; (vi) committing to making a market in the issuer’s shares; (vii) negotiating and administrating the so-called lock-up of the shares of insiders and other investors owning large numbers of shares; a lock up for up to six months is often employed in order to modulate the supply of shares available for sale; (viii) conducting bring-down due diligence just before final pricing meeting to be assured that there are no recent developments that materially affect the accuracy and completeness of the offering documents; and (ix) agreeing on the final IPO share price and the number of IPO shares offered with the so-called pricing committee of the issuer, signing the underwriter agreement and requesting the SEC to accelerate its review process of the now final S-1.

Besides performing the reasonable due diligence investigation discussed above, other typical underwriter services include helping the issuer executives with (i) positioning the company’s story to new investors; (ii) drafting accurate and complete S-1 disclosures; (iii) educating company insiders and other advisors on the IPO process; (iv) outreaching to prospective investors, including orchestrating attendance at the IPO road show presentation; and (v) managing the liquidity of share trading post offering.

Investors

There are two types of investors in IPOs: institutional and retail.  It is fact specific as to (i) the percentage of new registered shares being sold compared to existing shares, and (i) the share allocation between institutional and retail investors.  In my experience, the issuer determines the specific number of shares for each specific retail investor in the so-called friends and family initial allocation.   For the balance of shares sold to investors, the issuer largely defers to the lead underwriter’s recommended allocation.   There are technical reasons these practices.  For example, the actual mechanics of an IPO are that the issuer sells the registered shares to the underwriter syndicate, who in turn resells the very same shares to the investors at a standard markup of 7%.  Further, it is customary that the underwriter has negotiated the so-called over allotment option totaling 15% of the shares, and that the full 15% is sold at the IPO date.   Moreover, during the road show, certain institutional investors have individually submitted so-called indications of interest for set numbers of shares at set prices.  This road show information is used by the syndicate manager to build the so-called book and, ultimately, to inform the setting of the recommended IPO share price to the pricing committee of the issuer.   The price discovery process is called the book building process.  In a typical IPO, the offering is oversubscribed, meaning that the number of shares sold in the IPO is less than the total indications of interest received.

Once the pricing committee of the issuer accepts the recommended final IPO share price and the number of shares to be issued, the SEC is asked to accelerate its review process of the now final S-1.  If the SEC complies, the registered IPO shares are sold to the pre-selected investors the next morning at the IPO price; and the new shareholders can immediately begin trading their shares at an opening price that is determined by supply and demand, which is almost always different from the set IPO price.

Regulators

The federal government dominates the regulation of the US public and private securities markets, with the states having minor roles in regulating the sale of securities to investors in the respective jurisdictions.  For firms contemplating an IPO, intimate knowledge of the following two federal laws is fundamental: (1) the Securities Act of 1933 (Securities Act), which deals with firms going public for the first time; and (2) the Securities Exchange Act of 1934 (Exchange Act), which established the SEC and deals with the continuing responsibilities of firms that are already public.

The Securities Act requires IPO candidate firms to file a registration statement on form S-1 before the registered shares can be sold to the investing public.  The requirements of the original Securities Act have morphed through amendments, case law interpretations and SEC directives.  In my experience, the SEC stands ready to timely review S-1 drafts submitted and to make comments consistent with the SEC’s goal of investor protection through full and fair disclosure.  Importantly, the SEC does not comment on the investment merits of a proposed offering.   Rather, the SEC’s review focuses on the accuracy and completeness of material information in the final S-1, which is fully consistent with the SEC’s mandate of investor protection.  Along with investor protection, another key goal of the SEC’s disclosure philosophy is market efficiency.  The SEC’s disclosure system is based on the notion that timely, accurate and complete disclosure of material information would not only help investors make informed investment decisions but also help inform independent investment analysis undertaken by key market participants, such as the sell-side investment banks and the so-called buy-side institutional investors, and thus help promote market efficiency.

Markets

As the principal regulator of the US public capital markets, the SEC’s unifying principle of regulation (to promote its mandates of investor protection and market efficiency) is through the requirement of full and fair disclosure.  To that end, so-called reporting companies are required to, among other things, (i) make accurate and complete disclosures of the SEC required information on a timely basis, and (ii) receive a clean audit opinion on an annual basis.  Domestic issuers, for example, are required by the Exchange Act to file with the SEC timely quarterly (10-Qs) and annual reports (10-Ks) as well as timely interim reports on material developments (8-Ks).   Each of the reports has proscribed content areas and is posted on the SEC’s public website, freely available to all market participants.

In my experience, investors and Issuers alike benefit from the SEC’s requirement of full and fair disclosure of material information.  For example, investors benefit by having access to timely, accurate and complete material information on which to base their investment decisions, including potential access to informed investment analysis and research from sell-side and/or buy-side analysts.  Issuers also benefit from receiving higher prices for their securities, resulting in less ownership dilution and lower cost of capital.  In addition, the policy of full and fair disclosure in the US securities markets has also attracted not only foreign investors but also foreign issuers.

Since its establishment in 1934, the SEC has continued to introduce new regulations to help meet its mandates of investor protection and market efficiency.  For example, in 1980, the SEC addressed the disclosure burden on issuers by adopting integration of the 1933 Securities Act disclosures with the 1934 Securities and Exchange Act disclosures and allowing previously filed information to be incorporated by reference in new filings.  In 1981, the SEC adopted the Management’s Discussion and Analysis (MD&A), which provides securities holders and the market a narrative discussion and analysis of the financial condition and results of operations of the issuer, from management’s point of view.  Beginning in 1984, the SEC sought to make access to disclosed information easier with the development of the Electronic Data Gathering, Analysis and Retrieval system (“EDGAR”), an online system that provides digital access to the filings of issuers.  In 1998, the SEC sought to make disclosures more comprehensible with its Plain English Disclosure rules.