Understanding The I.P.O. Process

Why go public?

The most important reason for going public is to MAKE MONEY.  If that is not reason enough, here are several others for going public: It becomes easier to borrow money. Debt financing is an alternative way to raise capital. It is easier to issue bonds or take a line of credit if a lender can easily value your business. An IPO sets a benchmark for the value of your business; It becomes easier to finance the growth of your business. You can use your stock like currency to buy other companies; It becomes easier to attract top-notch talent to your business.

About the IPO Process:

When a corporation needs to raise capital, they either issue debt securities (bonds) or by equity (selling stock). Anytime a corporation issues new stock it comes from 'Authorized But Not Yet Issued Stock'. If the corporation has sold stock before, this is known as a 'Primary Offering'. A company can have many Primary Offerings. If the corporation has never sold stock before it is known as an 'Initial Public Offering'. A company can only have one Initial Public Offering. The first step for the corporation is to hire an investment bank. The investment bank will act as the advisor and the distributor. This firm is also known as the Underwriter. Underwriting is the actual process of raising capital through debt or equity. The corporation seeking to raise capital doesn't necessarily need to use an investment bank. There are no rules that say that they have to. If they wanted to, they could go door to door selling their bonds or stock.  Assuming that the company is using an investment bank (they almost always do), there are several things the two parties need to discuss, negotiate, and agree to. They need to agree on the amount of capital needed by the corporation, the type of security to be issued, the price of the security, any special features of the security, and the cost to the firm to issue the securities. If they can agree on these things, the investment bank will act as the middleman between the corporation and the general public.

There are two different types of agreements between the investment bank and the corporation. The first of these is the Firm Commitment.  With a Firm Commitment the investment bank agrees to purchase the entire issue from the corporation and then re-offer them to the general public. With this type of an agreement, the investment bank has guaranteed to provide a certain amount of money to the corporation. The risk of the issue falls entirely upon the investment bank. If it fails to re-sell the amounts of securities it purchased, the investment bank still has to pay the agreed upon sum of money to the corporation.

The second type of agreement is known as a Best Efforts agreement.   With a Best Efforts agreement, the investment bank agrees to sell the securities for the corporation but does not guarantee the amount of capital raised by the issue. When a company makes a public offering it must comply with the Act of Full Disclosure. This is the Securities Act of 1933. They must file a 'Registration Statement'. The investment bank will file the registration statement with the SEC. The day the investment bank turns in the registration statement with the SEC is known as the filing date. Contained in this registration statement will be a description of the business raising the money, biographical material on the officers and directors of the company, the amount of shares each insider (officers, directors, and shareholders owning more than 10% of the securities) owns, complete financial statements including existing debt and equity securities and how they are capitalized, where the proceeds of the offering are going (use of funds), and any legal proceedings involving the company including strikes, lawsuits, antitrust actions, copyright/patent infringement suits, all for the present time period or if they are aware of impending or future actions.

After the registration statement is filed by the investment bank on behalf of the issuing corporation, the SEC requires a Cooling Off Period. During the Cooling Off Period, the issue is considered as 'In Registration'. During the Cooling Off Period, while the issue is in registration, the SEC will investigate and make sure that 'Full Disclosure' has been made. Originally, the Cooling Off Period was 20 days. It is now much longer. Nevertheless, assuming the issue is approved by the SEC, the stock will be offered to the general public.  This date is the 'Effective Date'. If the SEC does not approve the issue, a 'Letter of Deficiency' is issued. The letter of deficiency will notify the company what was wrong. Thus, the effective date will be postponed.

During the cooling off period the investment bank will try to drum up interest in the issue. They do this by distributing a 'Preliminary Prospectus'. The preliminary prospectus is also known as a Red Herring. It has red printing across the top and in the margins. The investment bank pays for the printing of the red herring. The red herring acquaints the customer (general public) with the corporation. Contained in the red herring is much of the information from the registration statement including a description of the company, a description of the securities to be issued, the company's financial statements, the company's current activities, the regulatory bodies overseeing the company (if any), the nature of the company's competition, who the management of the company is, and the use of funds from the issue.

The public offering price and the effective date are not contained in the red herring. These two things are not known during the cooling off period. Generally, the public offering price is determined on the effective date. That way, the issue can be prices in accordance with current market conditions.  While the issue is in registration (during the cooling off period) the investment bank may not provide any other information to its clients other than what is contained in the red herring. They can't provide research reports, recommendations, sales literature, or anything from any other firm about the company. They can only provide the client with the red herring.

If the investment banks client is interested in the issue, the client (general public) will give his stockbroker (working for the investment bank) an 'Indication of Interest'. The stockbroker can't take an order for the issue from the client. All the client is allowed to do is indicate that he is interested. The higher the indication of interest is from clients, the better for the offering. In fact, it will probably aid the investment bank in making pricing decisions.

Just before the effective date the investment bank will sit down with their client (the issuing corporation) and have a Due Diligence meeting. They will iron out any last minute things which have come up. And they will make sure that there are no material changes which have taken place between the registration date and the effective date.  Keep in mind that Due Diligence is an ongoing process for the underwriter.

Once the effective date arrives, the security can be sold and money collected. Also, the Final Prospectus is issued. This will be very similar to the red herring. Except it will have the missing numbers for the public offering price and the effective date filled in. It also won't have any red writing on it.

Many times investment banks don't want to take on all the risk of an issuing all by themselves. Instead they form Syndicates. A syndicate is a group of investment bankers (underwriters) who will participate in selling the issue. Usually, the Syndicate Manager or Underwriting Manager is the head of the syndicate. The underwriting manager will then sign a letter of intent with the issuing corporation. This formalizes the relationship. However, it is a non-binding arrangement. Once the SEC has approved the issue, all parties to the agreement sign a binding contract which binds the parties to the letter of intent. There are three primary underwriting contracts. These are the Agreement Among Underwriters, the 'Underwriting Agreement', and the 'Dealer Agreement'.

The Agreement Among Underwriters (AAU) is an agreement which establishes the relationship between the underwriters. It designates the syndicate manager to act on their behalf. The syndicate manager is the one who determines the public offering price, enters into the underwriting agreement, modifies the offering price (if necessary), determines when to make the offering, responds to deficiency letters by the SEC, modifies the selling commission, and controls all advertising. The Underwriters Allotment is the amount of the security each underwriter agrees to purchase.

The 'Underwriting Agreement' (UA) is a contract which is what establishes the relationship between the corporate issuer of the securities and the underwriters comprising the syndicate. Or it might be just with one underwriter if there is no syndicate. The UA is executed by the managing underwriter based on the authority it has been given by the AAU.

Last, is the Dealer Agreement. The dealer agreement or selling agreement, is the agreement in which securities dealers who are not part of the syndicate, are contracted to purchase some of the securities from the issue. The underwriters may not be able to locate enough purchasers for the issues. They approach other securities dealers and see if they might want to participate. These other securities dealers may have even been offered a chance to participate as an underwriter but chose not to. What these other securities dealers can do is help move the product (the securities) to the general public. Basically, they are another distribution channel. However, these securities dealers don't have any risk at all. The Dealer Agreement or selling agreement will allow these dealers to purchase the securities at a discount from the offering price in order to fill order they may have gotten after the effective date from their clients.

The underwriters and dealers get paid out of the proceeds of the issue offering. The public offering price is what the general public pays. This is the amount on the face of the prospectus. However, the issuing corporation receives a lower price than that from the managing underwriter. The difference between these two prices is the Spread. Any firm participating in the underwriting is compensated out of the spread. The amount of the spread is determined through a negotiation between the managing underwriter and the corporate issuer. However, there are certain parameters which are known to have taken place in previous underwriting and the negotiations take place around these. All members of the syndicate are paid out of the spread. The managing underwriter receives a fixed amount for each share which is sold. This is referred to as the managers fee. Also, a portion is kept by each member of the underwriting syndicate. This is referred to as the underwriting or syndicate allowance. This compensates each member of the underwriting syndicate for their expenses and the risk they incur. The selling group which sells the securities is also allocated a portion of the spread. This is known as the selling concession. A re-allowance is paid to securities firms which contacts one of the members of the syndicate to purchase part of the issue to fill its own customer orders after the effective date. Because this firm has incurred no risk and made virtually no effort in the underwriting, this is the smallest fee earned by any firm.

Private Placements:

Private Placements are the direct sale of an issue of securities to large institutional investors and large private investors. There is no public offering. Also, there is no registration statement. The registration statement's purpose is to protect the public. Regulation D covers Private Placements. Under Reg. D. an accredited investor is either an institution such as banks or insurance companies, Broker/Dealers purchasing for their own accounts, Employee benefit plans and non-individual entities with net worth of at least $5,000,000, Insiders of the issuer, Individuals with a net worth of at least $1,000,000 (spouse may be included); or individuals with $200,000 in earnings for each of the past 2 years as well as this year (if spouse is included then $300,000). Also, the maximum number of non-accredited purchases is limited to 35. No advertising is permitted. A non-sophisticated investor must be represented by a Purchaser Representative. This person must be an attorney, accountant, or financial planner, etc. There are also restrictions on the resale of the securities.

The Registration Process:

The basic rules concerning the registration and issuance of securities is covered by the 1933 Act. The 1933 Act not only applies to the initial public offering IPO but also any further issuance of securities.  As a general rule, the 1933 Act requires that any securities must be registered with the SEC prior to offering the securities to the public.  This not only applies to stocks but also bonds and any other type of security.  Explaining the registration process simply, it begins with the filing of a registration statement approximately 45 days prior to the date the company intends to begin selling the securities (the effective date).  Once the registration statement is filed, the only communication with potential investors must be by prospectus only. Between the filing of the registration statement and the effective date, their may be an ongoing dialog between the company and the SEC and this may result in changes to the preliminary prospectus. When the SEC finally approves the registration statement the company may begin selling the securities.  Private placements and SCOR offerings are exempt from the filing requirements of the SEC. Although, SCOR offerings must be registered under the Blue Sky laws with each state in which it intends to sell the stock. And one short form does need to be filed with the SEC notifying them of the offering.   The 1934 Act provides the framework under which the company may communicate non-offering material with investors. It is the 1934 Act which mandates the filing of periodic reports with the SEC. It is under Section 10b5 of the 1934 Act which prevents false or misleading statements and imposes civil liability for those statements.

Traditionally, an initial public offering IPO is brought out by underwriters. They draft the prospectus and assist with the filings.  They solicit interest from investors who might be interested in the initial public offering IPO. They determine the price at which the shares can be sold. In a true underwriting they purchase the shares of stock from the company at the offering price (less the underwriters' discount). They then sell the stock to investors.  However, with the growing popularity of the internet, some companies have been able to take their company public with an initial public offering IPO without the assistance of an underwriter. The Spring Street Brewery initial public offering IPO is a good example of this. While the Spring Street Brewery initial public offering IPO was a Regulation A offering, the SEC allowed the offering to proceed as one which was made solely through electronic documents. Despite this, it is still desirable to use an underwriter or a broker/dealer to help market the initial public offering IPO securities if you can get one.

A company which offers stock through an internet initial public offering IPO must comply with the same disclosure obligations as it would have had it done its initial public offering IPO in the traditional manner. The SEC has said that simply posting the company's disclosure documents on its Website is not good enough when the company is required to deliver specific information to prospective shareholders, or shareholders. In other words, in general it's OK, for specifics it's not OK. The theory behind this is that the company cannot presume that everyone has access to the internet. The test is whether "such distribution results in the delivery to the intended recipients of substantially equivalent information" to shareholders or potential shareholders as they "would have had if the information were delivered to them in paper form."

In deciding if posting of the information on the Website satisfies delivery obligations and provides timely and adequate notice to investors, the company should consider a supplemental communication that would provide a similar notice to that of paper.  Any investor document must be provided separately from the Website unless the company can prove that delivery to the investor has been made or is not required.   The SEC also stated that if a document is made available by its posting on the internet or an online service, it should be available and accessible on the internet for as long as the delivery requirement exists. The document posted on the internet should also be available so that the investor has ongoing access to it and it is the same as the person retaining it themselves.

Blue Sky Laws

When people think of securities regulation the Securities and Exchange Commission - SEC is what comes to mind. However, every state has some form of a Securities Commissioner who is responsible for securities regulation inside that state. The agency varies from state to state. But most often it is part of the State Department of that particular state or the Commerce Department.  Each state does have its own securities act. The laws are generally known as the Blue Sky laws. And this is important to know for a company considering a small initial public offering IPO or any initial public offering IPO for that matter.

Despite the fact that the states do have the power to bring actions against violators of the securities laws, they have pretty much left enforcement of the securities laws up to the Securities and Exchange Commission - SEC and the Self Regulatory Organizations (New York Stock Exchange, AMEX, NASD, etc.).

Before any security can be sold in any state, that security must be registered pursuant to the Blue Sky laws. Additionally, the brokerage firm, and the stock brokers who will be selling the securities in the state must also be registered there unless there is an exemption from the registration requirements. SCOR offerings are all regulated primarily through the state. This type of an initial public offering IPO is exempt from Federal regulations.  The difficult part of dealing with all the different states is that the laws in each state are different. Most of the states securities regulations are modeled after the Uniform Securities Act as drafted by the National Conference of Commissioners on Uniform State Laws.  Despite this, they all put their own little spin on things and all have their own small differences. Therefore, it is important to find out beforehand what is permitted, what is not permitted, and what forms need to be followed. Most of the states require the U-7, U-1, U-2, and U-2a to be filed. Some states allow specific state forms to be filed instead. Some don't require all these forms. And some require additional forms to be filed. Even states with identical language may have different interpretations. Knowing that dealing with the states can be difficult and time consuming, the states have very good personnel available to answer questions and assist filers. This is very important for small companies undergoing a small initial public offering IPO and particularly SCOR offerings.

The Small Corporation Offering Registration (SCOR)
The Small Business Investment Act of 1980 (contained in Section 19 of the 1933 Securities Act) made certain changes to the Federal securities law. Subsequent to these changes Regulation D became effective in 1982. Rule 504 was developed to make it easier for a company to raise up to $1,000,000 without Federal registration for an initial public offering IPO. Although, the SEC does need to be notified. It is within rule 504 that the SCOR registration developed.  The firm must have at least 10% equity equal to the amount of capital being raised. It can offer either common stock, preferred stock, or debt. Any stock issued must be priced at a minimum of $5.00 per share for both investors and insiders.

In 1989 the North American Securities Administrators Association adopted the use of the Small Corporation Offering Registration (SCOR) for an initial public offering IPO. By 1992 it had come into its own. For companies that need to raise capital of $1,000,000 (in any 12 month period) or less, the SCOR offering is an excellent vehicle. The SCOR registration process is far easier and less complex than a full blown initial public offering IPO done under the Securities Act of 1934.

The problem most small businesses and almost all young businesses face is raising capital. Professional investors are usually not interested in these companies and investment banks won't underwrite an initial public offering IPO this small. The alternative is banks which will gladly loan you money as long as it is fully collateralized by the company assets and the business owner personally. In other words, no loan at all.

When a small business owner decides to undergo a SCOR offering, a simplified for U-7 must be completed. The U-7 resembles a detailed business plan more than a prospectus. And different states may specify different information which has to be contained in the U-7. This U-7 has to be submitted to each state in which the business intends to sell its stock. For reference purposes a Form D must also be submitted to the Securities and Exchange Commission (SEC). Most states will also require the filing of a U-1, a U-2, and a U-2a. Some will require additional forms and some state specific forms.

Many states are what is called "Merit" states. That is, they have to pass on the merits of the initial public offering IPO before they approve the offering. They must believe that there is some value to the potential shareholders.

When the regulators of each state receive the material, they will review it. Quite often, they will request additional information. This additional information could pertain to any area of the filing. However, most often it will reference financial data.

When the state securities regulators are satisfied with the initial public offering IPO and approve the filing, the firm may then begin selling the securities which are described in the offering. The company will now attempt to break escrow in an effort to raise the amount of capital (money) specified in the SCOR offering.

As previously mentioned, there are merit states and non-merit states.   In merit states, the regulator may request any additional information that it feels is necessary to pass on the merit of the initial public offering IPO and make sure that there is full and fair disclosure. The state may restrict the initial public offering IPO according to its merit.

Examples of some of the restrictions a merit state may impose on the initial public offering IPO are the number and type of securities that can be sold and lock-in periods for officers of the firm who hold stock. A lock-in period restricts the period of time that an officer of the corporation can sell stock. Otherwise, unsavory individuals could sell stock in the company and then after the initial public offering IPO sell it at a profit and disappear or go bankrupt. Nevertheless, filers are able to successfully complete SCOR offerings in these states and the difficult standards don't seem to pose a problem for a legitimate initial public offering IPO.

On the other hand, in a non-merit state the regulators merely check to make sure that there is full and fair disclosure and the filer complies with the law's requirements.

While the regulatory hurdles are not a problem, small businesses are often very unsure of how to market the investment opportunity to potential investors in the initial public offering IPO.

The success of SCOR offerings varies widely by state. One of the major problems faced by business owners is how to market the initial public offering IPO once it is approved. This is an area Equity Analytics, Ltd. can help. We assist the company in finding a broker dealer to sell the offering.

Another problem faced by many business owners is the submission of faulty paperwork in the U-7 and other filing documents as well as the omission of documents. This is another area in which Equity Analytics, Ltd. can help. We make sure that all the information is contained in the documents and that all the appropriate documents are filed for the initial public offering IPO in a SCOR offering.

The Pacific Stock Exchange will list SCOR offerings. This is a major comfort for business owners as shareholders may trade the securities in a public forum and it provides a market for the stock. However, to date no company that has been successful with a SCOR offering has been able to meet the listing requirements for the PSE. Nevertheless, it is inevitable that companies will soon be able to meet these requirements as more companies undergo a SCOR offering as an initial public offering IPO.

Many companies try to raise the full $1,000,000 in their SCOR offering. However, they are unable to do so. The first thing the business owner should do is set their escrow level to the minimum amount needed for their plan. Otherwise, the company may be able to raise part of the money required but which doesn't meet the goals outlined in the filing.

The SEC will not require the SCOR offering applicant to file financial statements. However, each state will require the filing of financial statements. A few states will require audited financial statements. And all states reserve the right to require audited financials. Once each year the company will be required to produce a very short Annual Report. The financials for this Annual Report does not typically have to be audited. Of course, if the state finds any irregularity in the company's reporting, it may require an audit.

The company usually has up to 12 months to sell the offering.   When the minimum level set for escrow is reached, the company can break escrow and receive the money from the initial public offering IPO.  The offering can be sold in as many states in which the company feels that it can sell a reasonable amount of stock. Keep in mind that the securities have to comply with the Blue Sky laws in each state. In other words, the offering has to be registered in each state. And it costs money to register in each state. Therefore, it is generally better to register in the primary states only. Many states participate in regional offerings. This makes offering and registering the securities in each state easier and less complicated.

The company may sell the offer direct. Although, in some states the selling officer or director must be registered. Otherwise, a commissioned selling agent or broker/dealer may sell the offering. Mass solicitations may be used for selling purposes. Public meetings may be used. And advertising is permitted but may need to be pre-approved by state regulators.

Officers and directors of a company must be very careful when preparing the filing documents. Directors and officers of the company could be liable for civil or criminal penalties. Honest and accidental errors or omissions can still require the company to pay back all the money received plus interest, penalties, attorney's fees, and sanctions.

As with any initial public offering IPO there are four very distinct phases of the offering. Although, the specifics are a little different in a SCOR offering.   The first is to evaluate and prepare the company for the initial public offering IPO. This includes a review of all corporate documents, restructuring the capital structure of the company, and last, determining which states to file the offering in.   The second phase of the process is to actually prepare the U-7, U-1, U-2, U-2a, and any other documents which need to be filed. In doing this, it is usually preferable to also generate a business plan at the same time. It is not necessary. However, the company is preparing for the future and this plan is a very good first step in setting up the company's goals and objectives as well as the steps required to get there and the benchmark measurements. Also at this time the escrow arrangements need to be made. And finally, permission to actually sell the initial public offering IPO or SCOR offering needs to be obtained.   The third step in the process is to advertise the offering. Sufficient investor interest needs to be present for the company to break escrow. Designing, printing, and distributing the offering documents needs to be done at this time. The last step is what every executive is looking for. Actually retailing or selling the offering to investors and closing on the sale of stock.