IPO Reform: Some Immodest Proposals (Part 3)

Joseph W. Bartlett, Founder of VC

There are a number of reasons why venture capital has flourished in the United States, surpassing the performance of any other country or region (at least until now), some of which have to do with the legal and accounting structure which has been, sometimes overtly and sometimes stealthily, friendly to emerging growth finance. However, there are certain, undeniable problems with the current IPO system. In Part 1 of this article, we looked at the current IPO process and identified some of the most apparent flaws. In Part 2, we presented a series of specific (immodest) proposals for IPO reform. In this part, we set out a hypothetical comparison of the current system (the Short Runway) vs. the suggested option (the Long Runway).

Assume a venture-backed company, with real revenues and customers wants to consider an IPO as the preferred liquidity event for its investors. The board is presented with two options, which I will call the Short Runway and the Long Runway.

The Short Runway is the traditional path to an IPO. The Company engages investment bankers, enters a "quiet period", calls an "all hands" meeting, drafts and files a registration statement ... all of which typically takes a few of months. Thirty days later, the registrant gets an SEC staff letter of comment. It re-files in two or three weeks, responding to 80 or so comments, most of them having to do with the MD&A plain English, the financial presentation and executive compensation. On filing the amended registration statement and prospectus, the Company prints the "reds" and starts out on a month-long road show. The underwriters calibrate the reactions of the institutions which are their major targets, and the offering is priced to stimulate interest. The floatation goes public and, hopefully, sells out on the effective date. (In a volatile market, the issue is in doubt right up until 4 o'clock on the day the Company officially goes public; the underwriters have the opportunity to pull the deal if the initial indications of interest prove to be chimerical.) In the aftermarket, the stock usually trades up, perhaps substantially, and then settles down to a price which is hopefully somewhere north of the price on the effective date. 180 days later, the insiders are allowed to start selling. The whole process takes 6+ months, from commencement to closing.

I have left out a lot of steps, of course, in this exegesis, which simply highlights the major events. In the long run, the Company is put at risk for transaction costs (not including the underwriters' compensation) somewhere north of a million dollars. Plus, for the entire 6+ month period, the great bulk of management time is spent in preparing for the IPO, and the Company's operating business is more or less on automatic pilot.

The Long Runway would operate as follows:

The Company, under new rules we assume the SEC will adopt, takes the placement memorandum used in its most recent private offering, updates it and posts it on its website. This memorandum contains information which the private investors deemed material and complete. Certain sensitive information is redacted so as not to give competitors an advantage. The public is invited to take a look; but no stock is issued and no trading activity occurs. From time to time, the Company may edit, amend and/or add to the posted business plan, including particularly information on the all important question as to how the Company is performing against plan... a variance report, in other words, of actual results compared to projections. The Company management otherwise does not spend much time on the process. It sticks to its knitting, except to answer relevant questions posted by potential investors.

Can a private financing be undertaken during this period? The answer is 'Yes.' Under the new rules, the posting of the PPM is not deemed "general solicitation" or "general advertising;" extending a private offering to a limited number of accredited investors is not contaminated by the website filing.

After six months or so, the Company may elect to withdraw the information and go about its business, depending on what it perceives as market conditions or, alternatively, start entertaining queries from qualified underwriters. A number of underwriters express interest, compelled by soundings they have taken in the community of likely institutional buyers, and some express a 'guesstimate' on a likely market valuation when and if the Company decides to go public. Management and counsel ask the underwriters to indicate what additional information should be added to the PPM; and the Company and its lawyers and accountants, at their own pace, add that information to the site. The underwriters identify potential problems, for example a contingency involving a patent the Company holds which potentially infringes on other patents, which would be a potential a drag on any offering the Company attempts. Alerted to the issue, the Company has time to straighten out the issue, such as settling the claim or going to AIG and getting a quote to arrange insurance coverage which would make the market comfortable.

Another three months pass while the Company fleshes out its disclosure with additional public information. Again, the time of the Company's management is largely devoted to running the business; the board meets frequently and informally to apprise itself of the situation during this period. An offer may be received in the interim from a strategic investor, which has in mind to buy the entire Company. Another offer may come in to take down the entire tranche of offered securities privately and assume a major position in the Company's stock. The board strokes its collective beard. Some enterprising institutional buyers come by to talk to the Company and kick the tires in anticipation of a public offering. The Company, as demand requires, holds online conference calls for potential institutional investors, answers questions and honors requests for additional information the investors say they would like to see in the public disclosure statements.

Further during this period, a formal filing is made with the SEC ... much less onerous than what is currently required, and the Staff is asked to comment. A minimum registration fee is paid at this point. The Staff's comments, which are to be received in the traditional 30 day period, are given under a new set of rules, meaning, first, that annoying and busybody-type comments are disregarded. In fact, the new rules impose on the Company a limitation on the number of pages in the prospectus ... no more than, say, 50. If a U.S. Supreme Court brief is not allowed to run more than 50 pages, why would anybody deem a prospectus of more than 50 pages a readable document?

Once the Staff comments have been received and answered, the Company is ready to go public ... and another board meeting is held. There is, again, no time pressure. The board can yank the public document anytime it feels like it, or leave it in place indefinitely. The board is advised by the selected lead underwriter on market conditions and elects to meet again in 30 days to make a final decision. After one final review and filing, all the documents are ready to go.

At this point, the Company's management is starting to devote the bulk of its time to the IPO. Additional online and video-conference meetings are held with potential institutional buyers. There is no road show as such, no flying from city to city in an attempt to stir up interest. All the meetings are held electronically. The lead underwriter decides to establish a range but only for the purposes of advising the board in aid of its decision whether to sell publicly or not. Listing requirements are complied with; the appropriate stock exchange is satisfied and signs off.

Once market conditions appear to be ripe, the Company will make a final filing with the SEC and declare electronically (and perhaps in a newspaper ads) that the issue is on the block. The Dutch auction technique, pioneered by W.R. Hambrecht, is the preferred method of selling securities under the Long Runway model. The Dutch auction technique avoids any flavor of favoritism; although 10% unit of the total can be allocated to customers, vendors and others whom the Company has business reasons to favor, the other 90% will be priced and sold strictly according to market conditions. The Dutch auction comes up with the highest price which clears the market and bids are accepted pro rata. At four o'clock on the effective date (or, indeed, at four o'clock on any date if the election is held open for more than twenty-four hours) the Company has the opportunity to accept or reject the bids. The prospectus delivery requirement, which still exists, is totally online; there are no printed prospectuses.

Note what this Long Runway process accomplishes. First, investors will have, in the typical case, months to kick the tires, to ask questions, to analyze and track the Company's performance before the bid is due. The pricing is as market driven as pricing can be. The expenses (e.g., staying up all night at the printers, legal bills and accounting fees for crash performance, road show expenses), etc. are minimized. Moreover, the largest item expense, the investment of management time, is spread over a much longer period and, therefore, its impact in any one week or month is ameliorated. Management can continue to run the Company throughout this entire period, only turning frenetically to the IPO itself in, say, the last week or ten days preceding the opening event. Aftermarket trading, because of the investment community's familiarity with the product, is expected to be relatively serene. The 180 day lockup is replaced by a gradual loosening of the restrictions on insider selling; over the period of the next year, insiders are able to sell a certain amount each month so that the impact is spread out. Thus, there is no Big Bang on the 180th day, when insiders, lined up to sell, all dump their stock on the market. The entire process in effect smoothes out the high octane nature of the transaction, the thesis that one can and should cram the process into a few frantic and frenetic weeks, the prize going to that individual who can stay up the greatest number of hours.

In my opinion, this is a better way in at least some circumstances. Moreover, note the two Runways are not mutually exclusive. Under my suggested system, any registrant could (and may well) take off from the Short Runway. My point is that, for those who can use it profitably the Long Runway should be an option. There isn't much of an IPO window today; would not a more peaceful, stately and deliberative process be better than none at all?