Exiting through the Public Market: Corporate Governance after Sarbanes-Oxley and a Word on Alternative Markets
By Kenneth W. Rind, Ph.D. and Martin Mushkin, Esq.
Prepared for the 33rd Annual Venture Capital Institute
September 30 – October 3, 2007
The public offering of a portfolio holding must be properly anticipated prior to making the investment. The initial private placement agreement should contain carefully negotiated rights to financial information and registration rights. These make possible the sale of private holdings in the public market without complete dependence on Rule 144 or other exemptions from registration. Also, the future ability of the investee to satisfy all the parties involved with a public offering, including various regulatory bodies and the financial community, must be considered from the outset.
When the company is judged ready to make a public offering, it must set about selecting an appropriate underwriter and negotiating with respect to valuation, the type of offering, size, fees and the like. The venture capitalist usually assists in this procedure. Moreover, for Securities and Exchange Commission (“SEC”) purposes the venture capitalist will probably be considered an affiliate or controlling person of the company, with accompanying disclosure responsibility and attendant liabilities.
Finally, all private investors should have general familiarity with the rules of FINRA concerning financial and corporate governance matters in new underwritings, so that they may avoid actions which could hinder a public offering. In order for a company to go public using a U.S. broker-dealer as an underwriter, the terms of the underwriting deal must pass muster under FINRA’s rules. FINRA, the “Financial Industry Regulatory Authority,” is the successor to the NASD Inc. as of July 31, 2007, and thus is the regulatory body to which all U.S. securities brokerage houses must belong. Also, now that the New York Stock Exchange Inc. is a public entity, run for profit, its regulatory function has also been turned over to FINRA. And all brokerage house employees who deal with the investing public or give advice to the public must also be registered with FINRA.
The initial public offering (“IPO”) market is fickle; it is predictable that it will ebb and flow, but when, or what types of companies it will favor. Although merger/acquisition will be the more likely exiting vehicle, the venture firm must position its portfolio companies to take advantage of IPO windows. Historically, the investor has been permitted to sell only a small fraction of its holdings in the IPO, being forced to hold the remainder for 90 to 180 days, and perhaps longer. In years when the IPO market was hot, underwriters have been willing to let the venture capitalists sell some of their shares in the IPO and even encourage an early secondary. Also, Rule 144 will be available for subsequent sales.
At this writing, the IPO market remains well below record levels. In some past periods, such as the bubble of 1999-2000, many companies that had not achieved profitability were able to raise large amounts of money in IPO’s at extraordinarily high valuations. However, currently even profitable growth companies are not able to tap into the public market. Do not bet your portfolio company’s future solely on raising capital through a prospective IPO!
Part II: The Sea Change of 2002
Part III: The Going Public Process
Part IV: The Possibilities of Rule 144A; Rule 144; and Conclusion
Appendices: Typical S-1 Prospectus Format; Underwriter’s Due Diligence Procedures