EXCERPTS FROM SPEECH BY FREDERICK D. LIPMAN ON ADVANCED
PLANNING FOR U.S. IPOS BY CHINESE COMPANIES
CHINA CHANGSHA INVESTMENT BANKING FORUM
There are 11 advanced planning techniques that should be considered by all potential IPO
candidates.
1.
Develop an impressive management and professional team.
Underwriters look for companies with impressive management teams. Reputable
underwriters shy away from one-man companies. They also avoid companies headed by
inventors or technology experts who lack executive skills. It has been suggested that this was the
reason Jim Barksdale became CEO of Netscape before its IPO, rather than Marc Andreesen.
Your chief financial officer must be an impressive as well as competent person and must
speak fluent English. This is particularly true if your CFO will be the main contact person for
investment analysts after your IPO.
The major method of marketing IPOs is through the so-called “road show”, which is a
period of one or two weeks in which the management team makes presentations in various cities
before institutional and other investors and securities analysts. Potential IPO underwriters
constantly ask themselves the question of whether the management team would be impressive to
institutional and other investors and securities analysts in the road show presentations.
The assembly of your management team should not occur on the eve of your IPO. If you
have a weakness in management, the time to upgrade your key employees is several years before
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your IPO target date. It may be prudent to obtain an objective evaluation of you and your
management team by a reputable management consultant.
Your auditor and your attorneys must also be impressive to the investment community.
Hire accounting firms and law firms that have the SEC background and expertise to guide you up
to and through the IPO. Use laws firms who have the ability to introduce your company to
potential underwriters.
2.
Obtain audited or auditable financial statements.
You cannot go public without audited financial statements. I had a client come to me
several years ago to take his company public. His company had tremendous growth prospects
and would have been a natural candidate for an IPO with high valuations. Unfortunately, the
client decided to save accounting costs by refusing to spend the extra money needed to obtain
audited financial statements, and his financial statements could not be retroactively audited. As a
result of the client’s bad decision to save a few dollars on audit fees, the client was unable to take
his company public and missed a unique opportunity for an IPO.
The U.S. Securities and Exchange Commission normally requires audited income
statements for three years in order to go public, if you or a predecessor have been in business that
long. It may not be possible, on the eve of the IPO, to retroactively obtain audited financial
statements. This is particularly true if sales of inventory account for a significant portion of your
revenues and no auditor has ever observed your inventory.
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Therefore, it is preferable to obtain either currently audited financial statements or to
obtain “auditable” financial statements, i.e., financial statements which are capable of being
audited retroactively at the time of your IPO.
Waiting until the eve of your IPO to obtain audited financial statements can delay your
IPO and cause you to lose an IPO window. Therefore, if you are planning an IPO in the near
future, start your audit immediately since it can take at least six months to obtain audited
financial statements.
Although it is preferable to use an auditing firm which is affiliated with the international
“Big Four”, it is not always necessary to do so if cost is an important consideration.
International accounting firms which are not part of the “Big Four”, such as BDO Seidman and
Grant Thornton, will usually be acceptable to the investment markets and significantly less
expensive.
Under U.S. securities laws, you must have effective internal controls before the IPO.
You should request your auditing firm to evaluate the effectiveness of your internal controls
before the IPO. If there are any weaknesses in your internal controls, they should be corrected
before the IPO.
Insist that the national SEC specialist of your accounting firm review your revenue
recognition and other accounting policies. I suspect that this is how China Life got into trouble.
3.
Consider accepting private equity from IPO motivated professional investors.
A majority of the U.S. IPOs today are companies backed by private equity, sometimes
called venture capital.
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A private equity fund investor can provide prestige for your company and facilitate
obtaining a top tier underwriter. Some institutional buyers of IPO securities obtain greater
confidence in IPO candidates because of the willingness of a private equity fund to invest their
own money in the company. A private equity fund can help locate potential underwriters and
help to convince them to underwrite the IPO. Private equity investors can also assist the
company in developing its growth strategy and the corporate governance and internal controls
which the company will need to comply with U.S. securities laws and related stock market rules.
Most importantly, private equity funds can help locate other companies to merge with you to
help to increase your IPO valuation.
The cost of an IPO can easily exceed $1.7 million as you can see from the list of 7
Chinese IPOs in the material supplied to you. The median cost (excluding underwriter’s
discounts) in the seven IPOs of Chinese companies was over $10 million, although most of the
smaller Chinese IPOs had costs in the $2 million range. You may need private equity from a
venture capitalist to finance this high cost. This is especially true since there is no guarantee that
the IPO window will not close in the middle of your IPO, in which case no funds would be raised
to finance your IPO expenses. Although most financial printers and professionals are willing to
discount their fees if the IPO is unsuccessful, the cost of an unsuccessful IPO can still be
significant. The earlier the IPO is aborted in the process, the lower the potential costs which
have to be financed by the company.
The disadvantage of a private equity investment is that you will be given a low valuation
for your business, which would be dilutive to the current owners, compared to the potential IPO
valuation. This is a serious disadvantage of a private equity investment which causes many
potential IPO companies to avoid private equity.
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The best way of solving the dilution problem is to minimize the amount of equity that
you take from the private equity funds. Prior to the IPO, you should try to locate a private equity
fund which has a low threshold for the minimum amount that they will invest in a company.
Some private investors are not IPO motivated and would prefer a sale of the business as
their exit strategy. Therefore, you should be careful to choose an IPO motivated private equity
fund as an investor.
Some private companies do not want to live with the dilution caused by a private equity
investment or with the restrictions on the company that may be imposed by these funds. Some of
these private companies will still, nonetheless, qualify for an IPO. Accordingly, I have phrased
this recommendation as something to be considered as desirable, rather than something that is
mandatory.
As a general rule, the smaller the company, the greater the advantages of having a private
equity fund as an investor.
4.
Adopt a stock option plan.
A stock option plan should be adopted as early as five years before the target date for
your IPO.
There are three primary advantages of granting options this early:
First: The company can grant options to its founders and key management employees at
low exercise prices. The earlier the options are granted in the company’s growth cycle, the lower
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will be the appraised market value of the founder’s shares and, consequently, the lower the
option exercise price.
Second: The prospect (even long-term) of an IPO will be an incentive for the company’s
existing key employees and permit the company to attract new key employees with stock
options. Many stories circulate about key employees who became instant millionaires with their
stock options after an IPO. In the Google IPO, it was estimated that each employee held stock
worth an average of $2.2 million and 900 employees became millionaires.
Third: The options will reduce the dilution of the founder’s equity when the IPO occurs,
since underwriters usually do not consider a reasonable number of outstanding options in valuing
the company. In effect, the option granted to the founder assists the founder in minimizing the
dilution suffered in the IPO.
Most companies adopt a stock option plan on the eve of their IPO. This is the wrong
time to do this, since the options then have to be granted at the higher “market value” caused by
your earnings growth and the imminent IPO. Moreover, you have lost a golden opportunity to
motivate your key employees and attract new key employees during the years preceding the IPO.
What if you never have an IPO? The company may make the granted stock options not
exercisable unless and until there is a public offering. If your company never has a public
offering, the options expire unexercised.
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5.
Growing your business with an eye to the public market
Growing your business with an eye on the public market place requires you to become
familiar with publicly-held companies similar to your own business. If you are engaged in two
or more businesses, become familiar with publicly traded companies in each of your businesses.
If the price-earnings multiple of one of your two businesses is very low and is much
higher for the other business, focus your attention on growing the business with the higher priceearnings multiple. Your growth efforts will receive greater reward by concentrating them on the
business with the most potential.
Underwriters are particularly interested in businesses which are dominant in their field.
Again, focus your efforts in becoming dominant in a niche business.
Your goal in growing your business is to obtain a sufficient IPO valuation to attract a toptier IPO underwriter and top-tier securities analysts who will follow the company after the IPO.
Today, it is difficult to interest a top-tier securities analyst in companies which have a market
valuation of much less than $250 million. Likewise, certain institutions will not purchase the
stock of companies that have too small of a market valuation.
Even if it is not possible to grow your company to a $250 million valuation, it is still
possible to have an IPO. It just becomes more difficult to find a top-tier underwriter and to
obtain coverage by a top-tier securities analyst. Indeed, companies with significantly less than
$100 million valuation have had successful IPOs. Some very small companies have
successfully gone public by the backdoor, that is to say, by merging themselves into an existing
public shell.
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6.
Show earnings and revenue growth before you go public.
For at least one or more fiscal years prior to your IPO target date, you should begin
showing earnings and revenue growth for financial accounting purposes. Many private
companies are operated in a manner to minimize income tax and therefore reflect lower amounts
of taxable income. However, the goal of minimizing taxes may be inconsistent with obtaining
the best possible valuation in the IPO. Techniques can be developed for many companies which
minimize taxes without necessarily minimizing accounting earnings.
Investors are normally interested in the post-IPO growth of accounting earnings. If your
company is not in a hot industry, your pre-IPO earnings growth is important to investors as a
predictor of your post-IPO earnings growth. You may have the greatest business in the world,
but if you do not show your accounting earnings because of your minimization of taxes, you will
not get the best price for your stock when you do go public. You may not even be able to have
an IPO at all if you do not show sufficient earnings.
Underwriters also look at earnings trends to make certain that a consistent history of
earnings growth over several years is reflected prior to the IPO. The investment community is
justifiably suspicious of companies that show earnings for only one fiscal year just prior to the
IPO target date.
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7.
Clean up your act (comply with all laws)
Public companies operate in a fish bowl. If you engage in illegal or other questionable
practices as a private company, you may have created contingent liabilities for your company
which may have to be publicly disclosed in the IPO registration statement. Few investors will
buy the securities of a company which may have significant contingent liabilities resulting from
questionable practices.
Likewise, insider transactions must be carefully scrutinized for overall fairness and
supporting documentation must be obtained.
The best example of an IPO that failed as a result of illegal acts was the 1988 IPO of the
Mustang Ranch, a house of prostitution in Nevada. Although prostitution was perfectly legal in
the counties of Nevada in which the Mustang Ranch was located, the IPO failed when the U.S.
Internal Revenue Service declared that the prostitutes were really employees of the Mustang
Ranch, rather than independent contractors, and the Ranch owed a huge amount of payroll tax
withholding. This was unfortunate since the IPO would likely have been oversubscribed as a
result of trophy value of the stock certificates.
Google was embarrassed because of illegal acts that had to be remedied in the Google
IPO. Google issued stock to employees in excess of what the securities laws permitted without
registration and is now forced to make a rescission offer to its employees in its IPO prospectus.
I strongly recommend that you have your operations reviewed for legal compliance well
before your IPO target date. Under the U.S. securities laws, underwriters have a due diligence
obligation to carefully scrutinize the company before the IPO or they can be liable for material
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misstatements or omissions in the IPO prospectus. The IPO underwriter will employ an attorney
who will perform a detailed investigation of your company before permitting an IPO registration
statement to be filed with the underwriter’s name on it with the U. S. Securities and Exchange
Commission.
You do not want your company embarrassed by the disclosures resulting from the
underwriter’s due diligence. I have seen situations where IPO underwriters withdrew from the
offering because of undisclosed legal problems. Even though Google survived its problems,
weaker IPO candidates may not. Any problems that you have should be identified well in
advance of the IPO target date and corrected, if possible, before approaching an underwriter.
The process of correcting any legal problems you may have may take several years and you
cannot wait for the last minute.
8.
Establish two classes of stock or other anti-takeover defenses.
Consider adopting defenses against hostile takeovers well before the IPO. Although
there is no guarantee that the IPO underwriter will permit you to retain these defenses, the longer
they are in place in your company, the better chance they have to survive the IPO. Most Chinese
IPOs are conducted through Cayman Island exempted limited liability companies that have
limited anti-takeover protections. It may be desirable well before the IPO to form a Cayman
Island entity with two classes of stock, and sell American Depository Receipts for the lower
voting stock in the U.S. IPO.
A few U.S. public companies have two classes of stock. In the Google IPO, Google sold
Class A common stock that has 1/10th of the voting power of Class B common stock held by
insiders. In the Martha Stewart Living Omnimedia, Inc. IPO, offered in October 1999,
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approximately $130 million of Class A common stock was sold to investors in a very successful
public offering managed by Morgan Stanley Dean Witter. Each holder of Class A common
stock was entitled to one vote per share. Martha Stewart continued to personally own all of the
Class B common stock, which was entitled to 10 votes per share. As a result, Martha Stewart
personally had 96% of the total voting power of the company after the IPO even though
approximately 15 percent of the company’s equity was sold in the IPO. Another famous
example of a public company with two classes of stock is Comcast Corporation.
Many underwriters will object to two classes of stock since it is more difficult to market
the IPO. You may have to create other anti-takeover strategies, such as staggering the election of
members of the board of directors and creating blank check preferred stock, as was done in the
Linktone Limited IPO completed in March 2004.
9.
Select your own independent board members.
Under the rules of the major U.S. stock markets, after your IPO, you will need within one
year after the IPO at least three independent directors for your audit committee and at least one
independent director on your audit committee at the time of your IPO. You may also need a
majority of independent directors on your board after the IPO if you are not a so-called
controlled company.
Consideration should be given to appointing independent directors to your board prior to
the IPO. Since the company will need independent directors anyway for the IPO, why not obtain
the benefit of their knowledge even before the IPO? Appointing them to the board of directors
before the IPO also gives you a chance to evaluate them as directors. It may also forestall a
request by the underwriters to have their own designees appointed to the board; however there is
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no assurance of this. Even if you never have an IPO, many private companies find that having
independent directors on their board is helpful since they can give dispassionate advice in the
operation of your business.
Some potential directors prefer to be appointed to an advisory committee pre-IPO rather
than to the board of directors, because of liability concerns. If the person has outstanding
credentials and the company does not maintain liability insurance for directors and officers, the
company may wish to accommodate their request. However, it should be understood that the
person will join the company’s board of directors when the IPO occurs since, presumably, the
company will then purchase directors and officers liability insurance for them.
Such independent directors can, if they have outstanding credentials, help establish the
credibility of your management team to potential underwriters. They can also be helpful in
introducing you to potential underwriters and guiding you through the IPO process. Finally, the
existence of independent directors can help familiarize your company with the corporate
governance rules, which will become applicable after your IPO.
10.
Create insider bailout opportunities.
Underwriters of IPOs are very wary of permitting founders or other insiders of the
company to sell any significant amount of their stock in the IPO. It looks like a bailout.
However, underwriters typically do not object to using a portion of the IPO proceeds to fund the
withdraw of cash equal to income previously taxed to the insiders and the repayment of debt due
to the insiders, including debt resulting from real estate leases, patent licenses or sales of real
estate or other property by the insider to the company. Accordingly, consideration should be
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given long prior to the IPO to structuring transactions between the company and the insiders that
will permit them to indirectly receive a small portion of the IPO proceeds.
For example, in the 1996 IPO by Donna Karan International, the company raised
approximately $242 million of which $116 million was paid to Donna and her partners
personally in satisfaction of promissory notes representing their previously taxed undistributed
income. The $116 million was received from the IPO even though no shares were sold in the
IPO by either Donna or her partners.
If all of your assets are not needed in your business, consider transferring the excess
assets to the founder and other shareholders, keeping only the core assets in the business. These
pre-IPO transfers to the founders and other shareholders creates an indirect bailout.
11.
Taking advantage of IPO windows, fads and IPOs of similar companies.
There is a saying that if the stock market catches a cold, the IPO market catches
pneumonia.
IPO windows quickly open and close. Your short term planning should take advantage
of these windows. You may prefer to have your IPO in 6 months or a year. However, in 6
months or a year there may be no market for IPOs.
For example, during the first six months of 2003 there were only 28 IPO filings whereas
in the first six months of 2004 there were approximately 220 IPO’s filings.
Your plans must be flexible enough to take advantage of these windows.
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Fads often develop in IPOs when investor interest is high. If your company has a product
line that can be fitted within a fad, you may want to change your IPO target date to take
advantage of this fad.
The history of IPO fads is that the highest valuations are given to the earliest companies
who have IPO’s. Ultimately, the supply of companies feeding the fad increases and begins to
overwhelm investor demand. This results in lower valuations for the later fad companies.
Particular attention should be paid to IPOs of other companies in your industry. If
another company in your business recently had a successful IPO, underwriters will be eager to
market your company’s public issue, particularly underwriters who compete with the underwriter
of the prior IPO. This is particularly true if the current market price of the stock of the similar
company is above the IPO price. Your stock will be attractive to underwriters since they can
market your IPOs to potential investors with the analogy of the prior successful IPO.
Hopefully, in the audience today are Chinese companies thinking about a U.S. IPO in
their future. If you follow these 11 advanced planning steps, you will facilitate converting your
private company into a public company, and increase the likelihood of attracting a top-tier
underwriter and of having a successful IPO.
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