Lola Miranda Hale
The decision to go public involves a fair amount of preparation and education as to the responsibilities and obligations that will be assumed by the public company and its management. This article will touch upon some of the areas and issues that your technology company should examine, in advance, so that it is properly prepared when the time comes to move forward with an initial public offering (“IPO”).
Among the areas that must be reviewed and probably restructured are the corporate governance features of your company, including its board of directors and corporate capital structure, the quality of its management, management’s relations and transactions with the company, the integrity of the company’s financial statements, and the internal controls relating to those statements. Most of these changes can be made more easily, and should be fixed or altered, before the company goes public.
Board of Directors
A company contemplating an IPO must decide on the appropriate size for its board, as well as the board’s composition and structure. Should the CEO also be the chairman of the board? Should the board be classified so that only a portion of the entire board would be elected in any annual shareholders’ meeting? Should there be a change in the manner of electing directors? If cumulative voting is present, should and could it be removed? Are directors elected by means of a plurality or majority vote?
If the company wishes to list its shares on an exchange, it must comply with the corporate governance rules of that exchange after the grace period for the newly listed public company expires. These rules include a requirement that a majority of the board members be independent of management. In addition, there is a requirement that the board establish audit, compensation, and nominating committees. The audit committee must include a “financial expert” (a defined term under Securities and Exchange Commission (“SEC”) regulations) and all members of these committees must be independent. A substantial amount of time will be necessary to find qualified persons to serve on the board.
The SEC has defined the “audit committee financial expert” as a person who has: (i) an understanding of generally accepted accounting principles and financial statements; (ii) the ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves; (iii) experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements, or experience actively supervising one or more persons engaged in such activities; (iv) an understanding of internal control over financial reporting; and (v) an understanding of audit committee functions.
One independent member of the board is sufficient upon listing. At least one more is required 90 days later. One year after listing, all members of the audit, nominating, and compensation committees and a majority of the members of the board must be independent.
Review the capital structure of the company. What changes are necessary or appropriate to best situate the company going forward?
Typically, there will be a split of the stock to increase the number of common shares outstanding. This may require an amendment to the charter to increase the number of authorized shares. Does or should the company have more than one class of common stock? What percentage of holders of the capital stock have a right to call special meetings? Should that number be increased? Could or should that right be eliminated? What percentage vote is required to amend the charter, bylaws, or take other organic action? Should the required percentage be increased from a majority to a supermajority number? Should the company adopt a shareholder rights plan (poison pill plan) to give the board leverage in the face of a hostile takeover, e.g.,voting and non-voting common stock? Keep in mind that certain types of provisions may adversely affect the marketability of the common stock, although the marketing impact recently has been minimal for these sorts of structures.
Code of Ethics – Corporate Policies
The NYSE and NASDAQ require that the company adopt a code of ethics for directors, officers, and employees to address conflicts of interest. Any waivers or amendments of the code must be disclosed. Although the SEC has no rule requiring the adoption of a code of ethics, it does require disclosure of whether or not a code affecting the CEO and senior financial officers has been adopted. If no code has been adopted, the company must explain its reasons for not having one. Any waivers or amendments of an existing code must also be disclosed to the SEC.
Establish communications, whistleblower, and insider-trading policies.
Does management have any prior public company experience? What gaps exist? Will management be able to handle the ongoing reporting obligations and responsibilities of a public company? Is there a proper staff in place to handle ongoing reporting responsibilities? Does the company have adequate disclosure controls and procedures? What employment agreements exist with management? Should any of those agreements be terminated or amended?
Identify and review for fairness all existing leases, loans, guarantees, and similar transactions with management and principal stockholders. Eliminate these insider transactions to the extent possible and desirable. The Sarbanes-Oxley Act prohibits insider loans; thus, they must be eliminated before filing. Establish procedures for future approvals of any insider transactions.
Employee Benefit Plans
Review and revise existing employee benefit plans, as appropriate, before filing. Adopt or revise plans. Typically, an increase in the number of shares reserved for such plans will be appropriate. Consider providing for automatic grants to directors. Should there be an employee stock purchase plan and a director stock option plan? Identify and consider terminating any rights of first refusal or repurchase rights. Should grants be made before the offering? Consider fair market value issues for grants made immediately before the offering. Address cheap stock issues and consider obtaining a valuation from an independent firm.
Accounting Issues – Financial Statements
Financial statements meeting the requirements of the SEC regulations will be required in the IPO filing. Generally, audited balance sheets as of the end of the two most recently completed fiscal years must be included, unless the company has been in existence for less than one fiscal year. Depending on when the filing will be effected, there may also be a requirement to file an interim balance sheet. In addition, two years (for “smaller reporting companies”) or three years of audited consolidated statements of income, cash flows, and changes in stockholders equity are required for the filing. If significant acquisitions have been made prior to going public, audited financial statements of the acquired companies and pro forma financial statements may be required, and special rules may apply. In the case of an IPO, a “smaller reporting company” is defined as a company that had a public float of its equity securities of less than $75 million as of a date within 30 days of the date of the filing of the registration statement.
Early on, select an auditing firm that has knowledge of SEC accounting rules and procedures. The auditing firm should critically review the financial statements and accounting policies to assess technical compliance with GAAP accounting and standards of materiality. In light of present and expected business developments, are the policies and presentation the most appropriate? Review and revise, as necessary, the accounting controls that are in place. What are the material weaknesses that may have been identified in the auditors’ management letters? Ensure that the company’s internal control systems comply with Sarbanes-Oxley Act requirements.
The IPO represents an opportunity to reexamine, refine and, to an extent, reformulate accounting policies and presentation.
Addressing these issues in a timely manner will assure that your technology company is not only ready, but also properly positioned, to succeed regardless of whether the decision to go public is ultimately implemented.
News from the Technology Team
On September 15, 2010, Phil Mitchell was a featured panelist, along with Dr. Lee Aase (Mayo Clinic) and Sarah Peterson (Sr. VP of Main Line Health), at the Third Annual Lee White Innovation Institute, sponsored by the suburban Philadelphia chapter of the American Academy of Healthcare Executives. This year’s Institute focused on the use of social media in the health care setting.
What is the Technology Team?
The Technology Team is a multidisciplinary team of lawyers at Epstein, Becker & Green, P.C., who have dedicated themselves to serving the needs of technology companies—public and private, large and small. The Technology Team’s members all have extensive experience representing technology companies—such as software companies, electronic device manufacturers, medical device producers, and wireless telecommunications companies—and bring their diverse skills and collective understanding of the needs of technology companies to the task of helping these clients solve a variety of matters and problems.
Working in a coordinated manner, the Technology Team is able to efficiently provide comprehensive legal services, across a broad spectrum of matters, including entity formation, securities, debt financing, acquisitions/divestitures, regulatory issues, employee benefits and executive compensation, labor and employment law, intellectual property, and commercial litigation. And because the members work as a team, they can tailor the type and level of legal services to the particular needs of the client in a cost- efficient manner.