To Be Or Not To Be A Public Company

By Neil J.F. Steenberg

Volume 3:3 July 2000

The following is a brief discussion of the going public process which is derived from a more extensive and specific case study. It is addressed specifically to emerging technology enterprises which form a major part of our business and technology practice. For management of these businesses and for the Gowlings team working with them, the going public process has been compelling, demanding (almost to the point of being all consuming) and always exciting.

This paper will examine and analyse various issues and challenges common to the financing of technology-driven enterprises. These issues include,

• the decision to "go public";
• contrasting the two most common methods of going public - i.e., the reverse takeover ("RTO") and the fully marketed initial public offering ("IPO");;
• preparation for the process; and ;
• miscellaneous challenges facing the new public company.

A large proportion of the new and emerging technology companies with which we deal are ‘concept' enterprises owned and operated by one or more owner/entrepreneurs whose principal skills relate to creating or marketing their own technology. Only a few of these owner/entrepreneurs have had experience with public companies or the process of becoming one. On the other hand, they have been bombarded with media stories and, possibly, with proposals from enterprising promoters or investment dealers which they think might make them overnight billionaires through going public. As we all know, however, it takes months or even years of hard work and preparation to become an overnight success.

The challenge for professional advisors assisting these owner entrepreneurs with the decision to go public has 3 aspects:

• assessing whether going public is appropriate for their venture at all;
• assuring that they are ready to go public; and
• educating them as to the process.

The decision as to whether or not to go public is usually based on many factors some of which may be personal to the owner/entrepreneur. Serious consideration must be given as to whether the technology business itself has sufficient growth prospects to sustain long term investor interest after the company has become publicly traded. The technology company should have the prospect of expansion into new and exciting product lines and new markets which if successful will provide revenue and profit growth which in turn will support higher share prices. Without this, investors will not buy the shares. When share values languish, it becomes difficult for the company to achieve many of the original objectives of going public. Development of a realistic and well-developed business plan is critical at this stage. Some of the factors to be considered include:

1. Equity Vs. Debt Financing Conventional debt financing has been difficult to obtain for enterprises where there are few tangible assets and no cash flow for collateral and where the products or services being developed are frequently at the concept stage, unproven commercially and at times incomprehensible to traditional lenders. This has the effect of driving entrepreneurs towards the public equity markets. This situation appears to be changing, however, as the financial services industry adapts to service the New Economy.
2. Liquidity Going public provides readily determinable market value for the owner/entrepreneur's stake in the enterprise and subject to securities law and escrow restrictions a means of cashing in some of such value. In early stage situations, however, many owner/entrepreneurs appear more interested in seeing their projects through to fulfilment.
3. Public Forum In many instances, becoming a publicly traded company provides an enhanced public presence for an enterprise and access to a larger audience of potential investors and potential consumers of the enterprise's products and services. This in turn enables the enterprise to promote brand awareness and sales. The business environment for high technology enterprises is characterized by rapid change due to a constant stream of technological advances which receive a great deal of media attention. This climate can create a high level of volatility in the investing community based on perceptions as to whether the enterprise continues to be competitive and whether it will be capable of maintaining or accelerating its growth. The technology company's need to properly manage this level of visibility is acute since each step in the development of its business and the execution of its business strategy is exposed to public scrutiny and comment. More than once, the management of such companies have viewed themselves as living in a fish bowl.
4. Employee Reward The recruitment and retention of skilled employees is one of the greatest challenges for the technology company especially in its early development stage. The demand for these workers is high and it is a fiercely competitive sellers' market. The financial means to pay high salaries and bonuses are often not adequate and the typical employee is looking to share in the upside growth of the business through a results-based reward system. Stock option plans, stock purchase plans and stock appreciation rights are essential to attract and motivate the technology company's work force. They are expected by the participants in this market. Without a public market for the company's shares neither the company nor the employees can readily determine the value of such incentive-driven compensation schemes. Without a public market the company cannot shift the cost of such plans on to the investing public and must itself provide liquidity for them.

Once the owner/entrepreneur has decided to take his or her enterprise into the domain of public companies the next question becomes choosing which of the two usual methods to be followed - the fully marketed IPO underwritten by one or more investment dealers or the RTO. For the purposes of this paper, a "reverse takeover" means a transaction or series of transactions whereby the owner/entrepreneur of a private, closely held enterprise transfers ownership of the enterprise to a public company for a significant equity position in the public company resulting in the acquisition of control of the public company by the owner/entrepreneur. The pre-existing shareholders of the public company retain a minority position in the ongoing company. The IPO involves the creation of a detailed marketing presentation and the preparation and filing of a preliminary prospectus. This is generally followed by extensive marketing which is stage managed by the underwriter and takes several weeks. The prospectus is then finalized, cleared through the regulators and receipted such that the shares are legally qualified for sale to the public. The shares are sold to retail and institutional investors with the goal of achieving a wide enough distribution to meet stock exchange listing requirements and to establish liquidity for the shares in the market place. The offering is usually completed within 6 weeks of final qualification of the shares.

The choice between IPO and RTO can be complex and should be made only after a thorough consideration of the relative advantages and disadvantages of both.

1. Speed: Generally speaking, the RTO is a faster process. Typically the process can be completed within 2½ to 3 months after the business deal with the public company target is struck. Within this time frame, a special shareholders meeting of the target company is convened to obtain required shareholder approval and a detailed management proxy circular containing prospectus level disclosure prepared and mailed to shareholders and filed with the regulators. In the case of the IPO, the underwriter selection process, prospectus drafting, marketing presentations and completion of the distribution generally takes 3 to 4 months;
2. Cost: The RTO is frequently perceived as being much cheaper than the IPO because there are no underwriter's fees (usually 7% to 8% plus 10% compensation options); there are no marketing costs (all of which would be paid by the issuer in addition to underwriting fees); and printing and professional costs are significantly less. The hidden cost of the RTO is found in the size of the minority position retained by the former shareholders of the RTO target company. In one case, for example, shareholders of the RTO target retained 720,000 or 7.5% of the new public enterprise. Within 2 years, the benefit of 20/20 hindsight revealed the hidden cost of the RTO at share prices prevailing a short 2 years later to be in excess of $7.0 million;
3. Size: Most Canadian investment dealers will not consider assuming the risk of an IPO unless the technology company is sufficiently advanced in its development to support a pre-money valuation which justifies a minimum size for the IPO. This minimum size for an IPO varies from between $10 and $30 million which should represent between 20% and 30% of the enterprise's issued shares after the IPO is complete. Many early stage technology companies cannot demonstrate the necessary valuations to fit within these parameters. Thresholds in the United States are perceived to be higher still. In these circumstances, the RTO may be the only option for some early stage technology companies to go public.
4. Use Of Management Resources: Generally, an IPO consumes significantly more of management's time and resources due to the lengthy prospectus drafting, due diligence and marketing process involved.
5. Need For Future Financing: A significant disadvantage of the RTO process is that after spending the time and money to go public through this process there is no new injection of capital for the new public enterprise unless a private placement is completed simultaneously. Companies in the highly competitive and rapidly changing technology industry require large amounts of capital to support the necessary research and development to stay competitive and continue to grow. Therefore, the technology company which has become publicly traded by way of an RTO will often find itself having to seek additional capital fairly soon after completion of the RTO. The existence of a widely distributed, public market for its shares, will assist the new public technology company to obtain required financing.
6. Managing The Aftermarket: In many instances the newly created public technology company which has completed an RTO, faces a significant minority of its shareholders who are holding shares in what had been prior to the RTO, a failed business. These shareholders frequently want to cash out their investment as soon as they can thus exerting downward pressure on the company's stock price. In the case of an IPO, the new shareholders have invested specifically in the technology company after being educated by the prospectus and the underwriters and not in a predecessor business which may have operated in an entirely different sector (eg. mineral exploration). The challenge for the technology company is to quickly educate this group to persuade them to be active investors or to interest other potential investors to buy up the disaffected minority's shares.

Having made the decision to go public and having decided as between an RTO and an IPO on how to get there, the technology enterprise needs to be fully prepared for the process. Some of this preparation needs to begin long before the going public process itself is launched. One of the more important early decisions is to retain proper advisors who can provide specific advice and expertise to prepare the company and its management team for the process. Such advice can be provided by traditional accounting and law firms, although many companies select a financial advisor with specific corporate finance expertise. Specific areas to be addressed during the preparation process include:

1. Audited financial statements must be in existence for at least the most recently completed financial year and for the 2 previous financial years to meet the disclosure requirement of applicable securities law. These also evidence the fact that appropriate financial controls are in place.
2. All appropriate legal protection for the technology company's intellectual property must be in place because these property rights are often mission critical and form the core of the company's assets and the basis of its value. This protection is achieved from the combination of patents, trademarks, trade secrets, copyrights, non-disclosure and confidentiality agreements which is appropriate in the specific circumstances of the technology company. It must be remembered in this regard that full, true and plain disclosure of all material facts about the enterprise's business, assets and financial situation must be made in the course of the going public process which could expose intellectual property assets to risks of appropriation by competitors in the absence of available legal protections.
3. Appropriate management resources and human capital must be in place to meet the time demands not only of the going public process (especially in the case of an IPO) but also of the continuous and timely disclosure requirement to which the company will become subject. Investor relations is an essential management responsibility that is virtually non-existent for the non-public company. Many emerging technology companies initially underestimate the magnitude of these management responsibilities but have since been successful in addressing them through recruiting in-house legal counsel and investor relations professionals.
4. Another aspect of human capital to be addressed is to ensure that all employees and independent contractors with access to confidential and proprietary information be bound by proper non-disclosure agreements. In addition, employees and independent contractors involved in the research and development of the company's technology or the creation of new intellectual property assets must assign all rights they may have to such intellectual property to the company in writing.
5. In the case of an IPO, in particular, the technology company should spend sufficient time to select a lead underwriter to market the company's offering. Several underwriters should be invited to make presentations to the company and its advisers as to why they should be selected. The relationship with an underwriter continues well after the completion of the offering and is very important in providing market support and ongoing research coverage.

Finally, the prospective public company should have in place and be following a comprehensive strategic plan for the development of its business. This ensures that future public disclosures may be placed in the appropriate context. It also underscores the company's ongoing growth prospects.

All of these preparatory steps will assist greatly in the due diligence review that must be conducted prior to going public.