As a company speeds toward the market for a public offering, the advantages may seem almost self-evident: The public trading markets are the most efficient venue for accessing capital, and they can allow profound future growth for an enterprise.
Yet companies should be prepared for significant challenges when they go public. Stock exchange rules and government regulation will dramatically change the way the company operates and governs itself. Plenty of companies have crashed because they didn’t have a fundamental understanding of the rules of the road before they went to the markets.
With that in mind, here are a few fundamentals for companies—especially smaller and emerging growth players—to remember as they prepare to jump into the public markets.
- Compliance is key. In the wake of a flurry of corporate accounting scandals, Congress passed the Sarbanes-Oxley Act in 2002. The new law set strict rules to prevent accounting fraud and revamped the way companies handled internal controls, corporate governance, auditor independence, and financial disclosure. Eight years later, on the heels of the global economic meltdown, the Dodd-Frank Act revamped banking and consumer protection laws and set new limits on Wall Street.
Together, the two new laws were the most extensive reforms since the 1930s, and they have dramatically increased the compliance and reporting responsibilities of public companies. Before entering the markets, companies must be fully prepared for the increased costs and workload associated with operating a company that trades shares.
- Emerging growth status helps—to a degree. Under the Securities Act of 1933, as revised by the JOBS Act of 2012, your company may qualify as an “emerging growth company” if it meets several conditions outlined in the law. In essence, the law gives companies with revenues of less than $1.07 billion the option of “following disclosure requirements that are scaled for newly public companies,” according to the U.S. Securities and Exchange Commission.
Emerging growth status does alleviate some very burdensome requirements for smaller issuers. This includes composing a less extensive narrative disclosure than other companies; providing audited financial statements for two, rather than three fiscal years; and relief from some internal control and accounting standards requirements, among others.
As advantageous as this may be, companies shouldn’t get too comfortable. Even with the reduced burden, the number of new requirements will forever change your business. Also, emerging growth status sunsets after five years, meaning the full burden of reporting is still on the horizon. And if the company grows quickly, surpassing $1.07 billion in revenue during any of the first five years, it also loses emerging growth status.
- Governance will change dramatically. Under SEC regulations and many stock exchanges’ rules, public companies are required to have a board of directors with a majority of independent directors. In basic terms, this means directors who are from outside the company and who will act independently on behalf of shareholders.
For many emerging growth enterprises, this may be a complete turnaround from the existing board. As an article from the Harvard Law School Forum on Corporate Governance and Financial Regulation recently noted: At founding, the [pre-IPO] board of directors of a typical private company “is composed primarily of insiders—founders, investors, managers—and usually has no directors who meet the independence standards of the New York Stock Exchange and NASDAQ.”
For a closely held private enterprise, the introduction of independent directors will likely mean a sharp adjustment in corporate culture. The board is now focused primarily on providing value for external shareholders—and key executives, founders and other insiders will need to adapt to this reality.
Not only must the board change its makeup, but the company itself may need to reorganize. A company founded as a limited liability company (LLC) or a limited partnership (LP) may need to change to a corporation – an entity strongly preferred by the SEC and exchanges because it creates uniformity in governance.
- Committees must be established. With a reconstituted board, a company issuing shares must also establish board committees that will be controlled by the independent directors. Generally, three committees are required: audit, compensation, and corporate governance/nominating.
In basic terms, the audit committee oversees the financial reporting process and is populated by independent directors who have at least some familiarity with financial reporting methods. The compensation committee oversees pay policies for top executives, sets bonus targets for them, and administers the company’s equity plans. The corporate governance/nominating committee is charged with developing corporate governance standards for the company, nominating future board members, and overseeing evaluations of the board and management.
- Get ready for Regulation FD. When a company issues shares, it is subject to the SEC’s fair disclosure rules, or Regulation FD. According to the SEC, Regulation FD provides that “when an issuer discloses material nonpublic information to certain individuals or entities—generally, securities market professionals, such as stock analysts, or holders of the issuer’s securities who may well trade on the basis of the information—the issuer must make public disclosure of that information.”
The rules are designed to level the playing field between company insiders and the shareholding public. What it also does is create a major new focus for most company management teams. They now must be concerned about all of their company’s communications, how they are disseminated, and to whom.
- Prepare to “float.” Exchanges like the New York Stock Exchange and NASDAQ have specific requirements for trade volumes and “float,” or the number of shares a company has issued for trading. NASDAQ, for example, typically requires that a company have 1.25 million publicly traded shares when it is listed and a 1.1 million average trading volume during the course of a year.
Failing to meet the exchange’s rules can result in delisting. If your company is a smaller or emerging growth business, you will need to work closely with your investment bankers and market makers to ensure you meet these requirements at your offering – and beyond.
- Keep an eye on insiders. Obviously, illegal insider trading should be avoided at all costs. But what about legal trades by company executives, employees, officers and directors?
A company going public needs to create controls and closely monitor trading by its insiders. Insider transactions have their own reporting requirements to the SEC, and as publicly available information, can be interpreted by current or potential investors and regulators about the overall health of the enterprise.
Experienced counsel is crucial for enterprises considering a public offering. Kaplan Voekler Cunningham & Frank has worked closely with a host of companies looking to access the markets. To learn more about how we can help, contact us for a consultation.