Client Alert

Achieving an IPO Exit While Taking the Long View

11/2/2004

Getting portfolio companies there and beyond

The last several months have seen both a significant increase in international appetite for initial public offerings in the U.S. by Chinese companies, as well as some increasing wariness given recent disclosure issues that have arisen in connection at least one recent offering. Companies such Linktone Ltd., which Morrison & Foerster LLP represented in its global IPO and continues to represent in ongoing compliance and corporate work, have recently achieved high profile listings on Nasdaq or the New York Stock Exchange.

In this environment, it is important for the board, management and in-house legal counsel of private companies planning their IPOs, or of public companies thinking of spinning off and listing one or more subsidiaries, to consider the basic elements which lay the groundwork for a successful IPO. Equally important, but sometimes overlooked in the excitement of the IPO process, are the practical implications of being a U.S. public company in the long-term and how these issues can impact companies' overall goals and resources -- and indeed affect the value at which a post-IPO exit for investors may be achieved. The following summarizes some of the key issues at the pre- and post-IPO stages that we have seen arise in our recent work.

Venture capitalists play an important advisory role during this process since they are often in a position (as board members and/or significant shareholders) to focus company management on these issues.

Pre-IPO

The obvious goal of any IPO is to complete the process in as short a period of time as reasonably possible, while concurrently preparing public disclosure documents that are complete and accurate to minimize any potential liability. Achieving this goal is often complicated by a number of IPO "hot buttons" which active venture capitalists can help company management to focus on and overcome early:

  • Accounting issues: encourage the company to appoint an internationally recognized auditor, identify key accounting issues early and agree on scope of, and nature of the engagement for, the comfort letter. Accounting issues almost always affect the timing of IPOs. This is particularly true for companies with their principal operations in China, where industry-specific business practices often give rise to unusual accounting issues. For example, wireless value-added services provides in China engage in fairly complex revenue estimations due to the nature of the wireless industry in China. Moreover, in this Sarbanes-Oxley era of heightened liability for securities offerings, increasing emphasis is being placed on the scope of "comfort letters" which a company's auditor provides to the underwriters and the company's board as part of its due diligence. A particularly sensitive issue in this regard is whether the auditor will require the lead underwriter to sign an engagement letter for the provision of the comfort letter. The purpose of this letter is to define the permissible use of the comfort letter and the auditor's liability in connection with issuing it.

  • The company's "story": consider the "story" that will be presented to potential investors and make sure management and the board fully understand and are able to effectively communicate this story as the road show nears. As illustrated by a recent IPO by a Chinese manufacturing company, statements by company management or its board that are inconsistent with its IPO prospectus disclosure may be embarrassing and adversely affect the company's stock price. It could also lead to potential liability under the U.S. securities laws.

  • Management and board composition: identify positions in senior and middle management that may need to be upgraded/expanded and any necessary changes in board composition. Encourage the company to take steps to identify any weaknesses in their current management team and fill-in any gaps that may exist so that they can comply with the demands of the U.S. securities laws and listing rules. In addition, non-U.S. companies will be subject next year to enhanced Nasdaq and New York Stock Exchange board composition rules which will require, among other things, that a majority of the board be "independent." (This is in addition to the current requirement that all members of audit committees must be independent directors, except in limited circumstances.) Companies operating in China may find it challenging to locate suitable independent board members.
Post-IPO

Completing a successful IPO on Nasdaq or the New York Stock Exchange is always an exciting time for a company -- the prestige of having made it on a high profile stock market, the press coverage and, most of all, the cash the company is suddenly sitting on to expand its business. But before a company formally initiates an IPO process with underwriters, legal counsel and accountants, it should give serious consideration to how it will maintain industry interest in its stock and maintain significant liquidity. Venture capitalists, particularly those with investment banking experience, are an important source of advice (through its board or shareholder status) on how a young company can seek to avoid the pitfalls of becoming a small cap stock with little liquidity.

Specifically, companies need to be aware that there is a growing "orphanage" in the U.S. public markets, populated by companies whose valuation is below the necessary threshold to command the attention of investment bank analysts, and, as a result, institutional buyers, whose trades typically comprise the majority of trading volume for most companies listed on Nasdaq and the New York Stock Exchange.

A company whose stock is "in the orphanage" is in a difficult situation. The expense and nuisance of public registration and burdensome ongoing disclosure requirements is not counterbalanced by genuine liquidity or an accurate trading price which real liquidity would bring. Moreover, a thinly traded stock tends to trade down. Stock that came public at a share price of, say, $15, once fallen into the orphanage, may slip into single digits even though the company is doing just fine. This can lead to ever-declining stock prices and trading volume which, in severe cases, may result in delisting.

We have seen companies follow this downward spiral, including a few which have bounced back dramatically such as NetEase.com, an Internet portal operator in China and a client of our firm. NetEase.com went from an IPO price of $15.50 to subsequently trading under $1 on Nasdaq and facing potential delisting in 2002, to trading well over $40 in recent quarters and the initiation of analyst coverage by several investment banks.

To stay out of the orphanage, a company's management and board should be ready to commit themselves for the long-term to not only growing the company and meeting analysts' expectations, but also to:

  • maintaining a seasoned, international caliber management team that effectively communicates the company's message to analysts, institutional investors and the public at large,

  • working closely with outside counsel and other advisors, ideally in conjunction with an internal multi-department disclosure committee of the company, in developing consistent public disclosure which accurately informs the public about material developments regarding the company, without creating potential bases for future class action litigation in the U.S. (e.g., overly positive forecasts of future product developments),

  • developing a corporate culture that consistently adheres to the company's internal controls and procedures, and thereby helps to minimize the possibility of an accounting restatement which is another red flag for U.S. class action litigation (including against companies with operations in China, which is increasingly common), and

  • causing management, the board and key board committees, in particular the audit committee, to allocate sufficient time in working with outside legal counsel and auditors to ensure that the company's periodic public disclosure filed with the U.S. Securities and Exchange Commission is complete and accurate.
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