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Part III Public Markets SOX

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Part III: Corporate Governance after Sarbanes-Oxley and a Word on Alternative Markets

The Going Public Process

In order for a public offering to be successful, several parties must be satisfied. These are an investment banker, the SEC, FINRA, and finally, the prospective purchasers. Almost always, the securities are sold with the assistance of one to four investment bankers who will underwrite the purchase. This underwriting group normally forms a syndicate of other broker/dealers in order to better distribute the securities and to share the risk of the commitment. A selling group, which does not share the liability, may also participate in the distribution. All entities must be members of FINRA and must comply with the regulations of that organization.

In addition, every state has a commissioner whose duty it is to see that state “blue sky” securities laws are observed. Public offerings which are going to be listed on NASDAQ, the New York Stock Exchange, Inc., the American Stock Exchange, Inc., and certain other exchanges, need not “register” with the state blue sky commissioners, and their registrations are not subject to state review. In most states, qualification of issues of companies which are not listed are subject to review for full disclosure. In some states, companies not so registered are subject to a review involving a governmental decision on whether the pricing of the securities is fair to the public, i.e., a merit review. All public companies still remain subject to state blue-sky commission enforcement activity. The going public process will normally take at least five to seven months. It can take even longer.

Selecting an Investment Banker/Underwriter
First, management and the investors must deem the enterprise to be sufficiently mature and able to handle the costs of an IPO, as well as the subsequent costs of being public, which even for small corporations may total $500,000 annually. Then in order for the company, its management, investors, or any combination of them, to offer shares to the public, you will certainly try to find an underwriter, rather than attempt to sell shares to the public directly.

It is important to deal with the best possible underwriting group, given the quality of the company. Underwriters differ markedly in size, ability, and willingness to work with smaller companies. Except in a hot new issues market, the large, well-established investment bankers will look to “fundamentals,” a compelling five-year record of earnings progress, culminating in previous year after-tax earnings of at least $4 million. An offering of less than $20 million is usually rejected outright by the bigger houses. Economies of scale make these impractical for them and a small float can be volatile and difficult to deal with.

In any case, most speculators hoping for short-term capital gains are not attracted to the larger houses, which float large issues at prices above $10 per share, where the market is likely to be less volatile. They prefer small, low denomination issues. Prior to the promulgation of stringent regulations covering underwritings of “penny stocks,” i.e., securities priced under $5 per share, such offerings were a useful, but risky much-abused underwriting tool. Another popular vehicle of the more speculative underwriters was the “unit offering,” in which a combination of stock and warrants was sold to the public at $5 or less per unit. Happily, there are a limited number of reputable, qualified investment bankers willing to underwrite somewhat smaller companies with exciting potential. They can be found by studying announcements of recent successful public offerings as well as compilations of SEC filings. Various Internet sites provide a relatively complete compilation.

In a hot new issues market or when dealing with a company with an exciting story, solid financial statements become less important. In those situations, the larger houses will join the smaller ones in underwriting issues where attractive (high or low tech), managed by people with impressive credentials, promise a bright future. Often these are “development stage” companies, i.e., the company is devoting substantially all of its efforts to establishing a new business and either of the following conditions exists: (1) planned principal operations have not commenced; or (2) planned principal operations have commenced, but no significant revenues have been generated.

The lead investment banker should be capable of providing adequate after-market support through his willingness to buy and sell shares in the subsequent market within the constraints imposed by the SEC’s rule, i.e., to stabilize the market. This is necessary to provide an orderly market in which selling will not push down the offering price excessively. A reputation for good research is also helpful, since continuing research reports on the company will generally be needed in order to retain substantial institutional support. However, since positive analyst recommendations cannot be compelled, you need to determine whether the investment bankers’ analyst who covers your industry is sincerely a believer in your business model. Finally, in volatile securities markets, the viability of the underwriter should be considered. From 1971 through 1976, 1981 to 1982, 1986 to 1989, and 2000 to 2003, many investment bankers left the business or were acquired. When the new issues market becomes hot, new underwriters emerge. Their financial strength and ability to put away an issue and support the after-market will vary, and many new houses disappear when the new issues market recedes.

In a normal climate, companies meeting the fundamentals criteria may have a choice of underwriters. The optimum way to select one is to:

  1. Prepare a short, but compelling description of the company and its prospects with a comparison to successful competitors which have gone public. Be sure to include summary financial statements.
  2. Compile a list of investment banks that have done similar size successful IPOs in the same industry, and find colleagues who can make personal introductions.
  3. Circulate the description of the company and its prospects to perhaps the top ten names on that list.
  4. Follow up and entertain visits from responding investment bankers and provide additional information.
  5. Select finalists by using a questionnaire and checking references.
  6. Hold a “beauty contest” or ”bake-off” where a few underwriters make presentations which include prospective pricing arrangements and present a draft research report to determine “chemistry.”
  7. Select a balanced group of two or three underwriters, guided by the lead underwriter, based on the size of the IPO in which you try to balance Wall Street vs. West Coast vs. local interests vs. international interests, and institutional vs. retail clientele.

There is a caveat. Once the lead underwriter is selected, it runs the show on the sales side. The lead underwriter may object to certain co-underwriters the company suggests. Counsel may well advise you not to press too far. The legal structure assumes an issuer on one side and underwriters on the other. That balance is important when issues of responsibility for due diligence arise in a legal context. If you actually select the co-underwriters and members of the selling group that balance may be lost. However, the lead underwriter will certainly value your suggestions, and it may well be glad to find out which houses have expressed an interest in the offering and may be willing to join it in the effort.

What the Underwriter Looks For
The underwriter is vitally interested in several factors.

  1. Do the company executives have good credentials and will they make a good impression on the public and the institutions which will normally account for the majority of IPO purchases?
  2. Is the business easy to understand and does it have exciting prospects? Is the company in control of its own destiny?
  3. Are any of the risks so disturbing as to dissuade investors? Will the deal attract substantial after-market interest?
  4. Has the company made satisfactory progress and will it attract substantial after- market interest?
  5. Is the balance sheet clean with no hidden liabilities, overstated assets, potentially costly lawsuits, or complex capital structure?
  6. Can a desirable saleable security be devised which will make money for the underwriter and its customers?

Types of Underwriters
There are two basic types of financial arrangements made with underwriters.

  1. In the more usual “firm commitment” transaction, the underwriter agrees that at the closing it will purchase the issue from the seller for resale to the public.
  2. In the “best efforts” transaction, the underwriter merely agrees that after the effective date of the registration it will use its best efforts to sell the issue to the public.

Variations in small deals include part firm, part best efforts, mini-maxi best efforts, all or nothing best efforts, and over-allotment rights. In the “mini-maxi” situation, the parties agree that unless a certain dollar amount of the entire issue is sold, the underwriting will not close, and any monies collected will be returned. The maxi end of this arrangement is the maximum number of securities (and dollar amount) of the offering to the public. In the all or nothing best efforts deal, the parties agree that unless the entire offering is sold the offering will not close. Virtually all deals over $10 million are firm commitment deals.

Negotiating With an Underwriter
Negotiating with an underwriter is mostly a process of finding the best lead/managing underwriter for the particular issue, since underwriting fees are quite standard. The final price of the shares will largely depend on the underwriter’s feel for the market after the “red herrings” (preliminary prospectuses) have been distributed, taking into account “expressions of interest” it has obtained, and market conditions a few days before the offering becomes effective.

Maximum underwriting fees are controlled by FINRA, and in the typical IPO the underwriter will ask for a fee based on an average of fees for similar-sized deals completed recently. Fees will generally be 5 to 10% of the funds raised, depending on the size of the offering. The underwriter will also want the right to take a maximum of 15% additional securities to cover over-allotments to the syndicate (“green shoe”) if the deal is hot. The underwriter may also request warrants in order to give it an additional incentive to assist the company after the offering. It may also ask for a right of first refusal on later offerings, the right to designate a person to be appointed to the audit committee, a financial consulting fee for several years, and a non-accountable expense allowance. In smaller, riskier underwritings, the FINRA’s ceilings and controls (discussed below) become more important.

Additional costs must be considered. Even if the IPO is not consummated, the smaller underwriter will attempt to get the company to assume its legal expenses ($50,000-$100,000) and other expenses, such as travel (maybe $25,000). Smaller underwriters may ask for an up-front fee. The letter of intent (discussed below) should cover all of these arrangements so that the company and underwriter clearly understand each other. The company will always directly bear certain costs. These costs and their typical size in smaller deals are: printing ($40,000-$80,000), costs of Edgarizing the issue ($40,000 to $60,000) accountants ($30,000 to $80,000), and attorneys ($100,000 to $250,000). Where the deal is for more than $10 million, these costs will rise and may well double or triple, but become less as a percentage of the deal. For a $25 million IPO, total costs average about 10%, and for a $50 million IPO about 8%.

The size of the underwriter’s compensation depends upon the type of underwriting commitment, the size of the offering, whether or not it is an IPO, or secondary offering, and other factors. As a rule of thumb, on a firm commitment underwriting of $10 million or less, about 18% will be allowed. The 18% includes a pegged value for warrants, the underwriter’s non-accountable expense allowance, legal fees of the issuer, printing expense, and a 15% over-allotment option (i.e., the green shoe). The over-allotment option brings additional proceeds to the issuer and is also highly profitable to the underwriter. All figures here are before the over-allotment. As the offering increases in size, the allowable compensation is reduced proportionately, e.g., maximum compensation will be approximately 12% of the gross dollar amount of a $20 million best-efforts offering. As the deal goes beyond the $20 million level, the non-accountable expense allowance and warrants will diminish and finally disappear.

The preliminary valuation and the size of the offering are generally set by reference to the valuations of comparable companies in the public securities markets and by what the lead underwriter thinks can be sold. It is essential to all concerned that the offering be well received and that the after-market be stabilized within the limits permitted by the law. Therefore, in a well-managed underwriting the shares are priced with the hope that in the after-market they will go to a desirable 10 to 15% premium over the offering price. To keep investors’ and management’s shares from destabilizing the market, the underwriter will usually require by contract that their shares be held off the market for 90 to 180 days or more, regardless of contractual rights to sell. Immediately after the registration is filed with the SEC, (simultaneously filing a listing application with NASDAQ or an exchange), the underwriter will distribute the red herrings to the anticipated members of his syndicate. The red herring discloses the number of shares to be offered, but usually does not include a firm selling price, though an expected range may be given. While the SEC and FINRA are examining the registration, the syndicate members will be testing the public waters. Sometimes, prior to the effective date of the registration, the investment banker may find that insufficient demand for the shares necessitates a reduction in the originally proposed price, or in the size of the offering. The opposite may be true with a hot issue. If the offering is cool, and the issue is not an initial public offering, the underwriter may avail itself of Rule 415 and sell over a period of time into the existing market.

The Letter of Intent and the Underwriting Agreement
After the negotiations the type of underwriting commitment, type of securities, initial pricing, number of shares, fees and the other principal terms of the underwriting will be set forth by the underwriter in a letter of intent to be countersigned by the company and any selling security holders.

The letter of intent always states that it is not legally binding on the underwriter. Frequent explicit exceptions to the non-binding nature of the letter of intent are made with respect to up-front underwriter’s fees, reimbursement of underwriter’s expenses and a “break-deal” clause. A break-deal clause provides the prospective underwriter with liquidated damages if the issuer switches to a different underwriter or decides not to go public at all. However, although it is non-binding, carrying out the letter of intent is a matter of reputation in the Wall Street community for the established underwriter. Moreover, underwriters sometimes are pressured by the need for product to sell, though conversely, volatile markets sometimes make it impossible to do the deal sensibly.

The legally binding underwriting arrangement will not be signed until the underwriter, the issuer and their attorneys are informed by the SEC that the registration is ready to become effective. The underwriting agreement is usually a very lengthy document.

If the deal falls apart, it may be alleged that the oral representations made by the company turned out to be materially misleading or market conditions have changed. Since most expenses are incurred regardless of whether the offering finally takes place, the company should carefully consider the likelihood of success prior to authorizing the underwriting attempt. The venture capitalist may be the most qualified individual to make this decision.

The Registration, Listing and Selling Process
After the company has received a letter of intent, the actual work of registration is performed. The lawyers and accountants begin their preparation of the registration statement and the prospectus it includes. Typically, for an IPO, that will take four to six weeks. This is assuming that the company, its outside counsel and its accountants, will have sufficient staff it can devote to the deal to get the job done quickly. When doing its due diligence, company counsel may suddenly appear to the principals of the company he has represented for years to have become paranoid; thoroughness is the touchstone of preparation of a registration statement. The printer, transfer agent, and registrar are chosen, and the registration statement, including a preliminary prospectus, is filed with the SEC, and sent to FINRA and desired state commissioners. Filings will be done electronically.

Usually, the underwriter forms a syndicate of other broker/dealers in order to better distribute the securities and to share the risk of the commitment. A selling group, which does not share the liability, may also participate in the distribution. The underwriter and the members of the syndicate and selling group will be members of FINRA and must comply with various regulations of that organization. These rules concern the due diligence investigation which must be performed, regulate the compensation of the underwriter and ensure that a bona-fide public offering will be made.

The securities being issued will likely be listed; that is, registered for sale on the NASDAQ National Market System, the NASDAQ National Capital Market, or on a securities exchange such as the New York Stock Exchange, Inc., or the American Stock Exchange, Inc. Listing is important, not only for the marketing of the issue, but because it also simplifies the regulatory scheme. See Blue Sky and FINRA issues below.

After a letter of comment is received from the SEC, the registration statement is updated and refiled, and due diligence meetings are held with syndicate members. In the meantime, the preliminary prospectus is circulated to prospective investors, a road show is organized and indications of interest are collected. Finally, SEC clearance is given, and the registration goes effective.

Just prior to the effective date, a final pricing meeting is held, the underwriting agreement is signed, and (usually within 48 hours) the company goes public. It is important that the management and investors focus on the fact that their interests are best served by an offering which develops a following for the company, one which will result in the subsequent sale of their securities at a maximum price. Thus, they should not strive for a maximum price in the initial offering. Indeed, with a hot issue, or in a hot issues market, the underwriter may work hard to keep the lid on, lest the after-market zoom up only to plummet, leaving disgruntled stockholders strewn about.

Legal Types of U.S. Public Offerings: SEC Registration Forms
The prospectus, which may be offered to a purchaser, is the major part of the two-part registration statement filed with the SEC. Although it is of little concern to the investing public, the venture capitalist should be aware that the SEC has promulgated several different forms upon which registrations can be filed. The availability of a particular form will depend on the industry, the financial maturity of the company, the size of the issue, the nature of the seller of the securities being offered, whether the issuer’s securities are listed on a stock exchange or otherwise are subject to, and have complied with, the periodic reporting requirements of the Securities Act of 1934.

The various registration and periodic report forms are not all inclusive. They make reference to Regulation S-K, a compendium of disclosure criteria for various situations which must be complied with through registration forms, and in periodic reports to be filed with the SEC, and the stock exchanges. ”Small Businesses ” may use forms requiring less information. A “ Small Business ” is a domestic or Canadian issuer with revenues of less than $25 million and a public float of less than $25 million (as defined in the regulations). The centerpiece of simpler forms are Forms SB-1 and SB-2. The SEC’s ‘33 and ‘34 Act rules contain parallel Small Business provisions. Among the adjustments are Regulation S-B, the equivalent of Regulation S-K for small companies.

All these forms and regulations are in flux. Proposed regulations would abolish the present hard distinction between large companies and “Small Businesses” and redefine them as Larger Companies and Smaller Companies. The disclosure requirements would also be scaled so that the disclosure requirements of really small companies would be less than of their larger Smaller Company brethren. To that end Regulation S-B, the set of rules which govern Small Business disclosure would be abolished and replaced with appropriate references in Regulation S-K, the regulation which governs disclosure of companies which are not “Small Businesses.” The dollar amounts providing the borders between all these companies would also automatically adjust every five years depending on criteria set out in the regulations. These changes, if promulgated, redefine what is material for disclosure purposes, much to the benefit of the market and the investor. However, the ultimate criterion is always disclosure of all “material facts” and unfortunately, that is tested with 20-20 hindsight, in a regulatory proceeding or litigation. These changes are discussed in greater detail below.

Regulation A and Testing the Waters: Regulation A was revised and modernized in 1992; up to $5 million can be sold through Regulation A. Audited financial statements are not mandatory unless required of the issuer by some other SEC rule. However, Regulation A offerings are reviewed by state blue sky authorities, and if the offering is in excess of $1 million, most states will require audited GAAP financials covering one or two years. A Regulation A offering allows a public market to develop for the issuer’s securities. Regulation A allows affiliates, such as venture capitalists, to sell a maximum of $1.5 million as part of the $5 million maximum, so long as the issuer has net income in each of the two most recent fiscal years. Regulation A allows the offerors to test the waters for potential interest in the company so long as the “solicitation of interest documents” is filed with the SEC.

These litmus test preliminary documents can be used even before filing of Regulation A forms. There are several ways to comply with the disclosure requirements of Regulation A. One is to respond in a question and answer format. This document becomes the offering circular, the equivalent of a prospectus. The problem is that the questions are long and complicated, and since the federal securities laws’ anti-fraud provisions apply, counsel is likely to worry lest something material – again with 20-20 hindsight, be left out. Since audited financial statements are not needed for a Regulation A offering, the cost and time needed to audit a small concern is dispensed with.

Going public by use of Regulation A is not very popular. People who buy shares sold pursuant to a Regulation A filing expect their shares to be saleable on a public market. However, because of the small size of a Regulation A offering, the float is small, good market makers are hard to attract, and the market, if any, will tend to be volatile.

Small Business Registration Forms: Form SB-2 may be used by any Small Business Company and its affiliates for any offering for cash without regard to the size of the offering. Form SB-1 is a simpler version of Form SB-2 and may be used by Small Business Companies for issues up to $10 million per annum in cash under limited circumstances. These forms refer to Regulation S-B. The financial statements needed for Form SB-2 are an audited balance sheet for the most recent fiscal year, and income statements for the two most recent fiscal years. Unaudited interim statements are also required. However, if the proposed revised disclosure provisions are promulgated these forms will disappear and the scaled disclosure rules will apply.

Periodic Reporting Requirements: For the first year after an offering, an issuer must comply with the periodic filing requirements under the ‘34 Act. Thereafter, if a company has more than $10 million in gross assets and 500 stockholders, it will become subject to the periodic reporting requirements of the ‘34 Act. This is true whether or not the company has ever sold securities pursuant to a ‘33 Act registration. However, it is more likely that a company with that many stockholders will have previously gone public through the ‘33 Act registration process. The rules provide that smaller companies may register if they desire to do so. This will be necessary to get listed on NASDAQ or an exchange or should be insisted upon by the investors.

Other Registration Forms: Other registration forms are intended for use under different circumstances and those dealt with here do not exhaust the list. If a company has been filing periodic reports for three years under the ‘34 Act, it may be able to register securities for sale on Form S-2, a form which is less comprehensive than the more commonly used Form S-1 (see below), and which makes reference to the periodic reports filed by the company under the ’34 Act. Form S-2 has also been modified to accommodate Form SB-2 companies which file full (i.e., not Small Business) periodic reports under the ‘34 Act. Form S-3 is an even simpler form available to companies which have been reporting for more than 12 months. It is useful for offerings where non-affiliates hold voting stock with a market value of at least $75 million market value. One of the beauties of Form S-3 is that the registration is effective immediately upon filing. One of the proposed regulatory revisions would allow S-3 to be used by more companies so long as they were in compliance with the periodic filing requirements for a specified period of time.

Shelf Registrations: Rule 415 provides for shelf registrations, i.e., continuous or delayed offerings of an issue where the issuer (or other sellers) wants to sell at market from time to time. Registrations can provide for sales under Rule 415 in a wide variety of situations. On many registration forms, its use is announced by simply checking a box. It is a highly efficient tool for established public companies to sell to the public at the right price at the right time. It allows for virtually continuous offerings.

Although the revised Regulation A, Form SB-2, and their companions require less stringent disclosure and less formal (audited) financial disclosure, venture capitalists should require by contract at the time they invest that the investee comply with the accounting standards required for SEC Form S-1. That form requires audited balance sheets for each of the company’s two most recent fiscal years and audited income statements for the three most recent fiscal years. Unaudited interim statements are also required. If a registrant can meet the requirements of Form S-1, it can meet any SEC ‘33 Act registration requirements. That way the company going public is less likely to commit the ultimate securities law sin, the failure to disclose a material fact. It also means that the venture capitalist does not have to deal in hindsight with inadequate financial statements. Accordingly, the parties may choose to file a registration on a less demanding form, such as SB-2, but still put in all the material required by Form S-1, just to be on the safe side. More reasonable disclosure standards may soon be adopted for very small companies.

No matter which form is utilized, SEC permission to go effective will be forthcoming more easily if the company utilizes experienced, reliable legal counsel and a recognized accounting firm.

What the SEC Looks At

Before a company is permitted to issue securities to the public, the SEC will carefully consider whether the company’s previous private placements were indeed exempt. The SEC may require a disclosure of possible claims for rescission or damages if they believe that a previous public offering took place even inadvertently. A major problem is the float of a private issue quickly followed by a registered issue. Private issues may suddenly be deemed an illegal testing of the waters, or otherwise an unregistered, non-exempt public issue. Certain no-action letters and Rule 144A transactions are reported to account for about one-third of all offerings. Care must be taken to assiduously follow the applicable no-action letter rulings on 144A and to avoid a regulatory tempest. In any private placement, an investor should carefully investigate all prior securities transactions, and insist on an opinion by counsel to the company that all placements were properly exempt from registration with the SEC under some subsection of Section 3 or 4 of the Securities Act of 1933 or under one of the several SEC rules providing exemption from registration, such as Regulation D, or 144A.

In addition, the venture capitalist should be familiar with the factors the SEC requires that the company to disclose (see Appendix A), since cont rolling persons may be personally liable for any omissions or misstatements of material fact. Note that the SEC does not approve the offering, but reviews the registration so that it is satisfied that material facts and the risks are fully described. The facts and risks may have to be described in such a manner as to prove extremely discouraging to prospective investors. Although some cynics claim that the public ignores the risk factors section of the prospectus, the company will generally have to gain acceptance from sophisticated investors in order for anyone to have the ability to sell a substantial private holding through subsequent transactions. The entire prospectus should be written in the simplest English.

The SEC has been particularly careful in recent years to challenge accounting entries it deems do not state fairly the company’s financial condition. The SEC also monitors the selling process both before and after the effective date of the registration to detect fraud. It has established its Office of Internet Enforcement to surf the Web searching for perpetrators in that arena.

The SEC is a dynamic organization which constantly re-examines the market structure to fine-tune its regulations to meet current conditions. However, despite the results of the examination can take years to implement because of the need to comply with statutes which govern rule making. The SEC’s website,, gives the viewer, through EDGAR, access to the public filings of all registrants that are required to file periodic reports, and to the applicable statutes and regulations, the major stock exchanges and state regulators, recent news releases, proposed rules and many links. For instance it links to The Security Lawyers Desk Book on the University of Cincinnati’s website, The SEC is experimenting with a number of large companies to make EDGAR an interactive site. This will make it easier to access specific data for any particular company. Meanwhile, there are a number of commercial websites that contain all the EDGAR material and provide additional and searchable information.

What the State Commissioners Look At

Every state has some type of blue sky Law, i.e., a statute requiring the licensing of securities firms and requiring the registration of securities to be sold in that state. Thirty-seven or more states have passed the Uniform Securities Act, in some form. However, Florida, Illinois, California, New York and Texas have not. All states have agencies, usually blue sky Commissioners, which administer these laws. The October 1996 amendments to the Federal Securities laws drastically changed the relationship between federal and state registration of securities. “Covered securities,” those which are listed on certain designated securities exchanges, are exempt by statute from filing with the states by registration or “qualification” although “notice” of sale of covered securities must still be filed with the states. The statute names the NYSE, AMEX, and NASDAQ-NMS. By regulation, the SEC has added Tier I of the Pacific Exchange, Tier I of the NYSE Arca, Inc. and the Chicago Options Exchange, options listed on the International Options Exchange, LLC and NASDAQ-NCM so long as their standards continue to be similar to those of NASDAQ-NMS.

While listing eliminates state review of public issues of more substantial companies, smaller and more regional public issues not so listed remain subject to state regulation. Note that SEC registration is not the key to make a covered security; listing is what counts. If the security is not listed, it may be exempt from registration or qualification pursuant to one or the many exemptions provided for in each state’s blue-sky law. When the security is not a “covered” security, a blue-sky survey of the states in which the issue is to be offered must be prepared. This is customarily done by underwriter’s counsel utilizing specialty sources to minimize cost.

In regard to issues which are not covered securities, the state law requirements may be more stringent than the federal rules, since some state authorities (including California, Illinois, Ohio and Michigan) have authority to determine whether the issue is priced fairly, i.e., to do a merit review. Merit reviews take into account what similar public companies are selling for, the prices paid by private investors, the length of time they have held their investments, the multiple of earnings at which the shares are priced, and whether subsequent events justify an increase. Normally such considerations have gone into the thinking of the investment banker in pricing the offering, but speculative offerings may be rejected by certain states. Some states may require that management and investors’ shares be held off the market until pre-negotiated financial results are met.

The Blue Sky Commissioners, through the NASAA, have been developing and adopting uniform forms and regulations for certain types of offerings and banding together in groups to review registrations. Under the latter system, the review of a designated lead Commission will constitute the review of a specified issue for all the states in the group. The lead review system has worked well for many years in Canada, where the provinces regulate securities matters rather than the federal government, and it appears to be working well in the U.S.

Blue-sky commissions still have the function of regulating intra-state offerings and enforcing anti-fraud laws even in national offerings. They are one of the main bulwarks against fraudulent behavior.

What FINRA Looks At

FINRA is a self-governing regulatory body to which all underwriting firms belong. FINRA’s rules require the underwriter to have thoroughly investigated the issue in order to determine its suitability for his customers. FINRA’s Conduct Rules prohibit its members from participating in distributions which are “unfair or unreasonable.” Although FINRA’s rules for evaluating the fairness and reasonableness of a deal may appear to be extensive in its Manual, how they are applied is somewhat opaque. Underwriter’s counsel will deal with this issue and telephoning FINRA’s Division of Corporate Finance may lend some guidance where there are specific questions. The underwriter must also investigate the company, do due diligence to determine the thoroughness and truthfulness of the documents to be distributed. The underwriter cannot simply rely on his lawyer to do this; it must do so itself. The matters looked into are outlined in Appendix B.

Simultaneously with the filing of the initial registration with the SEC, the underwriter will file the same documents (but without exhibits except for the proposed underwriting agreement) with FINRA’s Department of Corporate Finance. Pursuant to its extensive Securities Distribution rules, FINRA will examine three principal areas: (1) FINRA member involvement with the issuer; (2) the underwriter’s compensation arrangements; and (3) marketing arrangements.

FINRA Member Involvement with the Issuer: Although most FINRA rules do not directly deal with non-FINRA members, FINRA will consider investments or other arrangements with (i) persons affiliated with the underwriter, (ii) persons related to the underwriter, and (iii) persons “associated” with the underwriter. These words are all carefully defined in the FINRA manual and are used in different situations to describe the extent of FINRA concern with the underwriter’s involvement with the issuer, its compensation and marketing arrangements.

Under FINRA policy statement regarding its members being involved in venture capital investments, if a FINRA member participates in an underwriting, any prior private investment in that company and those of its officers, directors, general partners or controlling persons must be wholly retained (no sale, pledge, loan, assignment, etc.) by those persons for twelve months after the effective date of the offering, except for transfers to persons to whom the same restrictions apply. Special circumstances may permit exceptions to this NASD rule, such as holding the securities for twelve months prior to the effective date.

FINRA’s Rules sets forth criteria which must be met before a member-firm may participate in the distribution of an “affiliate.” “Affiliate” generally means directly or indirectly controlling, controlled by, or in common control with the issuer, or ownership or control of 10% of the stock of FINRA member. Where an issuer has significant involvement with affiliates of the underwriter, the issue will have to be priced by two qualified independent underwriters if no bona-fide independent market exists.

Compensation Arrangements: FINRA will review the fee being charged by the investment banker. In this regard, FINRA will look (i) to the number of any securities the underwriter and associated or “related ” persons and other broker/dealers acquire in the issuer, and (ii) to the dollar value of the underwriting compensation. In addition to determining if the number of securities (shares, warrants, etc.) obtained is fair and reasonable, the purchase of an issuer’s securities by this group within 180 days prior to the filing of the registration with the SEC will be reviewed. If FINRA deems the investment to be related to, or in anticipation of, the public issue (which it usually will for purchases within 180 days, it may require the securities to be wholly retained for 180 days following the effective date of the registration. FINRA’s oversight is effective on smaller deals, but of little aid to the issuer on larger deals where there is more competition to be the underwriter.

Marketing Arrangements: FINRA additionally oversees the manner in which shares are sold, to ensure that a “hot” or popular new issue is distributed fairly to public investors rather than being held back for the benefit of relatives of the underwriter, members of the investment community, and similarly situated people. Strict rules govern the practice of issuers directing shares to officers, directors, employees, sources of supply and customers. Similar rules govern an underwriter directing shares to its employees and other underwriter-related persons. The maximum number of shares which all parties may direct is 10%.

In addition, people associated with or related to an underwriter may not be sold securities in a public distribution which goes to an immediate premium (approximately 10% or more) because FINRA Board of Governors’ Interpretation with Respect to “Free-Riding and Withholding” may be applied to them. As already noted, FINRA has rules restricting allocations to favored customers who are not affiliates of the underwriters.

FINRA makes a special effort to crack down on fraud perpetrated by broker-dealers. FINRA has stated it would be happy to respond to any question regarding marketing arrangements in advance and will consider unusual circumstances in the interpretation of its rules upon written submission of the details surrounding a proposed course of action.

Special Penny Stock Rules: There are special SEC rules governing the way securities priced at retail below $5 per security may be sold and requiring extensive disclosure in the prospectus (or Regulation A offering circular) of the high risk of these issues and of special limitations on marketing them. FINRA and the SEC both watch the marketing of these so-called “penny stock” issues to make sure the rules are enforced. Penny stocks tend to attract a more gullible investor who has been convinced that this kind of volatile investment will bring quick riches. The prohibited practices that must be disclosed are less likely to take place in higher priced issues attracting more sober investors.

Civil Liability

The possibility of being sued because of what a registration says, or does not say, or how an underwriter sells the deal, is a concern of the venture capitalist. Securities class action suits typically name a host of defendants, the company, the principal officers of the company, any sellers of securities (including venture capitalists) and anybody the plaintiffs think could be held responsible for the alleged errors or omissions. Previously, the class action bar attacked the people involved in any IPO where the stock price dropped shortly after the issue’s effective date on the ground that if the price dropped there had to be something wrong. High tech hot issues bore the brunt of the attacks. However, statutory sections limiting the commencement of class actions and adjusting some of the liabilities were passed, and the battleground has shifted to the state courts. The dotcom bubble has produced a deluge of private actions and class actions complaining about how underwriters managed these IPOs. Now large institutions have discovered their oxen have been gored and are lending their support to some class actions. However Congress has decreed that securities class actions involving classes of investors in more than the state in which the action is brought must be brought in federal court. Bringing and maintaining these actions has become more and more difficult, although many are brought ever y year. Nevertheless, venture capitalists will insist that adequate Directors and Officers (D&O) insurance be purchased early to at least cover the high cost of defending these cases.

What the Prospective Purchaser Looks At

No one can be totally sure what will attract the future IPO investor. Fads for certain types of issues come and go. However, a venture capitalist can assist in the positioning of the company and in recruiting experienced outside directors.

The following table indicates the dramatic ebb and flow of interest in new issues for venture- backed companies.

Venture-Backed New Issues*

2002 (through June)
2007 (through June)
No. of Companies
Total Raised (Millions)

*Information obtained form the PWC Money Tree.

This table is indicative of, but not mathematically proportional to, the new issues market of smaller companies as a whole. Venture-backed companies typically only account for 20-30% of all IPOs. The number of venture-backed IPOs began to rise at the end of 2006 and during the first half of 2007 (though quarterly totals remained at less than half of the numbers achieved in the bubble years of 1999 and 2000). However, the recent chaos in the market has brought a rapid decline in expectations, again showing that you should not bet your portfolio company’s future on a prospective IPO.

Alternatives to Going Public through a U.S. Underwriting

As you can see, “going public” by contracting with an underwriter and listing the company on NASDAQ or an exchange is expensive and time consuming. In recent years several alternatives have become more popular. The thrust of any going public endeavor is to provide liquidity for the company’s stock by providing an active market into which the major holders of its shares can sell them to the public. And if they sell them to institutions, they too want the ability to sell to a wider public.

Thus, most companies will want the ability to attract public investors afforded by being a reporting company. Even if a company has less than 500 stockholders and $10 million in gross assets, it may opt to be a reporting company for those reasons even though it need not be required to. But how to get there without the time consuming expense of an underwriting is another story. Reverse mergers into shell companies, and their variant, the blank check company, are possible routes.

U.S. Alternatives To Going Public Through Underwritings

Reverse Mergers: Reverse mergers refers to the purchase of control of a company which has a public stockholder base but is not doing business. There are two basic kinds of these shells. First there are those companies which went public and found that their business failed. All they presently have is a group of stockholders, and perhaps a few assets of little worth, and perhaps some cash. The ones of greater value are the shells which continue to file periodic reports with the SEC. That is a plus because it allows the public investors to see that their company is alive; that in turn gives the potential of creating an active market even without an underwriter.

A second type of shell is the “blank check company or a “Virgin Shell.” These are companies set up by sponsors. Frequently, a Reverse Merger will be accompanied by a PIPE (Private Investment in Public Equity). These transactions have become very popular recently as they open wider the opportunity to receive capital from a hedge fund.

Special Purpose Acquisition Companies: These “SPACs” have raised money from an IPO, in which they state that they are looking for a company with which to consummate a Reverse Merger. These SPACs are also sometimes called blank-check companies. SPACs must consummate an approved acquisition by some date, usually requiring a supermajority of shareholders, or return the monies raised. (SPACs that have raised money on AIM may have somewhat easier requirements.) Currently, there are only 52 SPACs looking for acquisitions, but they control over $5B. (Despite the huge odds, one of Ken Rind’s portfolio companies achieved liquidity by merging with a SPAC.)

In each of these situations the better sponsors, make sure that they comply with the applicable blue-sky laws. The appropriate form is filed with the SEC and voila! we have a reporting company. It has never done business and therefore the problem of some hidden liability showing up is unlikely. Once a sponsor sets up a shell, he ha s a formula for repeating the process over and over again. The sponsor then sells his interest to the controlling persons interested in taking their operating company public. The sponsor makes his profit by selling his controlling shares.

The controlling people of the shell make their money by either selling their control shares to the operating company, or its controlling people, by later selling into the public market, or a combination thereof.

Disclosure and regulation is not escaped. Within five days of the closing of the merger of the public reporting company and the operating company, a comprehensive disclosure document must be filed with the SEC. Thereafter the newly minted company, its controlling stockholders and affiliates must file the same reports and adhere to the same corporate governance standards as any other periodic reporting company. While an underwriter need not be involved, a financial public relations firm may be engaged to inform the investing public. The process may take as long as an underwriting but will probably not be as financially taxing or time consuming of management as going public through an underwriting.

Foreign Markets: A few U.S. companies have decided to go public on the London AIM market or other foreign markets. So long as a company does not have 500 shareholders of record in the United States (and $10 million in assets) it can escape being required to file periodic reports SEC. However that does not mean that it will escape governmental or market oversight. Many countries have passed corporate governance laws similar to Sarbanes-Oxley, but they are reported not to be as stringent as SOX. Many countries have also established their own PCAOBs. However, liquidity for venture-backed companies on foreign stock exchanges has been generally disappointing, though they can be a source of capital. Two of Ken Rind’s portfolio companies found true liquidity on the Taiwan Stock Exchange.

The economic weight of non-U.S. securities markets is certainly growing. Witness the daily news reports of what markets have done overnight in London, Hong Kong, and Tokyo. However, for U.S. companies and U.S.-based investors, the NYSE and NASDAQ markets still hold the most interest and potential for floating stocks. Non-U.S. markets are more likely to attract non-U.S. investors. If a company’s business is one naturally based in the U.S. where investors can see it and evaluate it, it will be more likely to attract investor interest in its home country, the U.S. However if its products or services are those which will attract overseas interest or worldwide interest it may decide to sell its securities offshore. In other words, care must be taken in making the business decision as to whether the desired results are likely to be obtained. Here are some alternative markets.

The AIM Market: This is a junior market sponsored by the London Stock Exchange. Founded in 1995, it has about 1,600 listed companies of which 400 are foreign. Seventy-six of these companies are U.S. companies. (Some of the U.S. companies are hedge funds which have difficulty going public here.) While for listing, the AIM market does not require a minimum number of shares in the hands of the public, an existing trading record, prior shareholder approval of transactions, or a minimum capitalization the listing process is not freewheeling. A “Nominated Advisor,” known as a NOMAD, must be engaged, from an approved list. There are now 85 NOMADs. The NOMAD’s function is to vet the company through extensive due diligence, and to mentor the company through the listing process. Once the company is listed, the NOMAD also becomes something of a watchdog regarding the company. A London Exchange brokerage must be engaged as a Sponsor to handle the float (read underwriting), appropriately registered Chartered Accountant and other entities similarly engaged. The AIM is government regulated in a system parallel to the U.S. system described in this article, but the regulations are principle based, not prescriptive based as in the U.S.

Other Foreign Exchanges: All developed countries and most developing countries have securities exchanges. The exposition above could be made for any number of them. Suffice it to say that they tend to list local companies and companies based in their part of the world. However, they should not be overlooked. Two of Ken Rind’s portfolio companies found true liquidity on the Taiwan Stock Exchange.

Read More:
Part 1: Summary
Part II: The Sea Change of 2002
Part IV: The Possibilities of Rule 144A; Rule 144; and Conclusion
Appendices: Typical S-1 Prospectus Format; Underwriter’s Due Diligence Procedures

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