Corporate Makeover

Corporate Makeovers - Positioning a Company for a Future IPO or M&A by David Lubin

There is no better time than the present to position your company for its IPO. The lull in the market provides the perfect opportunity to prepare, insuring that you will be ready to soar when the IPO window opens again. While revenues, profits and market potential are all vital elements to being a successful IPO candidate, good, clean corporate housekeeping is also an important factor. The areas identified below are intended as guideposts to enhance a company's ability to conduct an IPO more efficiently. Such areas should also make the company a more attractive merger or acquisition candidate. A company that has its house in order will be regarded more favorably by an investment banking firm that could underwrite the IPO. The same preparation will also ease the due diligence undertaken by a potential buyer of the company.

Organizational and Operational Structure

The company should be organized so that the investing public understands the business and corporate structure of the company. A complex organization which conducts its business through trusts and other entities is generally more difficult to explain to the investment community. In addition, investment bankers are extremely reluctant to underwrite a partnership or limited liability company.

It may also be advisable to restructure the company, including separating the core business from those ventures which detract from its operations. Such modifications must be undertaken with the proper tax and accounting consequences carefully analyzed. Actions taken now will have an effect not only on the disclosure required in the prospectus but also on the future potential of mergers, acquisitions and other corporate transactions.

Corporate formalities, such as properly documenting directors' and stockholders' meetings and resolutions, should be carefully followed. Whether it is the investment bankers, accountants or lawyers, many sophisticated individuals will be spending hours of their time reviewing the books and records of the company. If the books are kept in proper fashion from the time the company is formed, it will not only make the task of due diligence easier (and therefore quicker and cheaper), but will also provide the investigators with a greater level of comfort with respect to the company.

Capital Stock Matters

A complex capital structure that makes it difficult for investors to understand and analyze the merits of the offering should be avoided. It is best to minimize the number of classes of securities with different rights and preferences. In addition, the company should limit granting of options and warrants. The state securities administrators who review the company's prospectus want to prevent the interests of IPO investors from being excessively diluted if company insiders are holding a significant amount of options.

The issued and outstanding capital stock of the company must be properly memorialized. You don't' want to be in a position where, after the company goes public or is acquired, someone turns up claiming that he actually owns stock in the company.

Management and Investors

The prospectus must disclose certain bankruptcy filings and securities or commodities law violations, as well as criminal convictions, to which each director and executive officer was a party during the five years prior to the IPO. Compensation for the company's officers should also be reviewed, since the salary (including non-cash perquisites) and option grants for the chief executive officer and the four most highly compensated officers must also be described in detail in the prospectus. In addition, as independent directors are required to be on the board of a listed company, the company may want to begin cultivating relationships with people who might serve in such capacity.

Certain disclosure with respect to the majority stockholders of a company is also a required part of the prospectus. More importantly, these investors should be considered on the basis of not only their current cash contributions, but for their ability to fund the company in future rounds and their expertise in product development, marketing and other operating areas.

Contracts and Operating Practices

A review of the company's material agreements with its suppliers, lenders, customers, employees and distributors should be undertaken to identify any provisions and operating practices that could harm a future IPO. Contractual provisions limiting the company's growth or future operations should be scrutinized. Examples of such provisions include exclusivity rights granted to a third party and inadequate protection of the company's intellectual property rights. The adequacy of insurance and warranties should also be reviewed. Remember that descriptions of the company's material agreements must be disclosed in the prospectus.

Compliance with Securities Laws

All issuances of securities by the company need to be reviewed to determine the availability of exemptions from the registration requirements of the Securities Act of 1933, as amended, as well as state blue-sky laws. Exemptions relied on during the three-year period prior to the IPO will need to be identified in the registration statements. The 1933 Act and most blue-sky laws give purchasers of illegally unregistered shares a right, generally within three or fewer years after the sale, to rescind the purchaser or to obtain damages from the company if they no longer want the shares. Such causes of action at time of an IPO can threaten its success. Care must be exercised to assure that federal and state securities registration exemptions are available even for the rescission offer itself.

Compliance with State Corporate Law

A review should be undertaken of the company's articles of incorporation, by-laws, stock transfer records as well as minutes and resolutions from meeting of the stockholders and the board of directors of the company. Is the company legally incorporated and qualified to do business in those states where its activities require such qualification? Has it paid its state franchise taxes? Have all the necessary approvals of stockholders been obtained? For example, increases in the company's authorized share capital and other amendments to the company's articles require stockholder approval. Have all the required approvals been obtained of its board of directors, such as for the appointment of officers and issuances of stock? Has stock been issued for valid consideration and not in violation of preemptive rights? Has the company conducted its corporate proceedings, such a proper notice for meetings, in accordance with its articles, by-laws and state law? Did the company comply with applicable state business combination statutes in connection with a transaction with an interested stockholder or director?

Insider Transactions

Often a private company will have numerous transactions and relationships among its officers, directors, stockholders or members of their immediate families. SEC rules require disclosure of any such business relationship if the transaction involves more than $60,000 in a year. The investing community typically reacts negatively to a company that has been run for the benefit of the insiders. Conflicts of interest between the company and its insiders will hurt the IPO candidacy.

Financial Statements and Accounting Practices

The form used for most IPOs requires audited balance sheets for the last two fiscal years and audited statements of income, cash flows and changes in stockholders' equity for the last three fiscal years. The financial statements must be prepared in accordance with GAAP (generally accepted accounting principals) and Regulation S-X, the SEC rules regarding accounting principles contained in SEC filings. The statements must also be audited in accordance with generally accepted accounting standards by a qualified independent accountant. For "small business issuers", those with annual revenues of less than $25 million, the audited financial statements requirements are reduced by one year and certain Regulation S-X requirements are relaxed. It is also important to remember that SEC accounting rules require the prospectus to present separate audited financial statements for predecessor companies and for certain other significant businesses that recently were or are soon to be acquired by a company. Those rules should be considered in connection with any acquisitions or mergers prior to an IPO.

Most company leaders do not want to immerse themselves in the minutiae involved in maintaining their books and records and the other matters described above. However, just as sales and marketing are essential to a company's health, it is equally important for a company to take care of these matters if it wants to ascend to the next level of growth and success.

Published in Empire Magazine June 2002