How to go Private... and Why

Patrick Daugherty, Timothy P. Hanley, Christopher C. McMahon and Peter C. Underwood

Why And How To 'Go Private' Concerns over the high costs of complying with Sarbanes-Oxley (SOX) and other corporate governance reforms are causing an increasing number of public companies - especially small- and mid-cap companies - to consider going private. Such a decision, said Peter C. Underwood, a member of the Transactional & Securities Practice Group in the Foley & Lardner Milwaukee office, "is like a reverse IPO." Traditionally, going public was a sign that a company had reached a certain threshold of size and profitability to attract public investors.

Mr. Underwood introduced a panel of experts at a breakout session, "Why and How to 'Go Private'," that was part of the 2004 National Directors Institute (NDI) held in Chicago. The theme of the conference was "Corporate Governance Reform: What's Working and What Isn't."

Going private is "typically initiated by the majority shareholder or group of shareholders and often includes members of management," Mr. Underwood said. The transaction could take many forms, each with its own implications for disclosure, timing, and cost, including a:

  • A cash merger, where the subject company merges with a company controlled by the majority stockholder or group of them
  • A tender offer by the issuer
  • A reverse stock split - increasingly common with smaller companies - where the majority stockholder or group of stockholders remaining after the transaction remain invested, while minority shareholders are cashed out

If the transaction is ever challenged, the legal standard of review can differ depending on the form, Mr. Underwood said. "Any transaction that is subject to a shareholder vote requires filing a proxy or information statement as well as other 'going private' forms with the U.S. Securities and Exchange Commission (SEC). Those filings will undergo a preliminary review, and you can count on a fairly extensive comment period."

Such filings also require "lots of disclosure," he said, covering such matters as the purpose of the transaction, expenses incurred in the transaction, the alternatives considered and why they were rejected, reasons for the timing, and why the issuer or affiliate believes the transaction is fair. A tender offer is not subject to such a review, Mr. Underwood noted, so it can be accomplished much more quickly. Typically, the shorter the time period, the less costly the transaction becomes. Most companies don't have the liquidity or available capital to compensate minority shareholders, so these transactions often require additional financing, he said.

The rules do not require disclosure of projections, but the SEC often will require it through a supplement to the filing, Mr. Underwood said in response to an attendee question. This might be triggered when the filer includes a fairness opinion by an investment banker or other appraisal.

If projections had been communicated to the board, that must also be mentioned, added panelist Patrick Daugherty, former SEC counsel and a current partner in the Foley & Lardner Detroit office and a member of the Transactional & Securities Practice Group. If projections were developed by company managers involved in this transaction, they would likely have to be disclosed in the filings, he said.

Reasons To Go Private

Complying with corporate governance requirements have added to the costs of being public, and this reason is often cited as a reason to delist, Mr. Underwood said. These costs include:

  • Legal and accounting costs
  • Management time and attention to SEC filing rules and SOX provisions
  • Maintenance of an investor relations department, annual meetings, and reports
  • Fielding calls from securities analysts
  • Rising insurance premiums for directors and officers (D&O)

Between 2002 - when SOX was adopted - and 2004, compliance costs for a small-cap company rose 130 percent, Mr. Underwood said. Mr. Daugherty noted that, by delisting, small companies can save up to $2 million annually. "If you have a company with net earnings of $10 million a year, and suddenly that increases to $11 million or $12 million, it really boosts the company's value," he said.

(Going private primarily to escape the strictures of SOX might not relieve all those costs, however. In another 2004 NDI breakout session, "What Private Companies and Non-Profits Need to Know About SOX," a panel of experts concluded that many provisions of the law are being voluntarily adopted by private companies. Currently, SOX extends just two provisions to private firms - retention of documents and whistle-blower protections. Recently, however, a number of state attorneys general have introduced legislation extending SOX-like provisions to private organizations, including charities.)

Undervaluation Drives Some Going-Private Decisions

Some companies, smaller ones especially, choose to go private because management believes their stock is undervalued, Mr. Underwood said. The market doesn't fully reflect the inherent value of a company because of a lack of liquidity, a lack of volume, or perhaps a high bid/ask spread. "Analysts' coverage can be hard to get for smaller companies," he said.

"That realization does not happen all at once," Mr. Daugherty added. "There's a dawning recognition over a period of years during which management typically will try several devices to increase the company's visibility to the market, increase analysts' coverage, get a better profile, and basically move the stock price up." When they are frustrated in these efforts, management will decide to go private, he said.

Other Advantages To Going Private

Mr. Underwood noted that going private has advantages, including eliminating many disclosure requirements, It also can put a company in a better competitive position with other private enterprises. He cited other advantages to going private, including:

  • Freeing majority owners from SOX restrictions about engaging in related-party transactions
  • Giving companies greater freedom in structuring their boards and committees
  • Providing liquidity to minority shareholders without brokerage fees and commissions, and at capital-gain tax rates
  • Affording greater flexibility in estate planning
  • Allowing management to focus on long-term goals, rather than managing quarter to quarter to meet earnings expectations
  • Giving management a better knowledge of and control over their shareholder base
  • Reducing the potential for director and officer liability

Reasons To Remain Public

Financial constraints - Timothy P. Hanley, a partner in the Milwaukee office of Deloitte & Touche LLP, said many companies end up remaining public because they cannot raise the funding to go private through debt financing. "They may not have a business model that allows them to take on the debt necessary to buy out control and continue operations," he said. Mr. Daugherty added that the inability to finance the deal might be the reason only a few companies have been able to go private recently, instead of the tidal wave that had been predicted after the passage of SOX. "There is nothing private about going private," he added.

"Typically the debt taken on in going private really limits a company's flexibility" to make acquisitions and other capital expenditures, Mr. Hanley said. "With that debt often come significant financial covenants" that give lenders - including banks and insurance companies - tight control over the ability to make capital expenditures.

This inflexibility can limit how a company compensates its executives, especially equity incentives, he said. That could make it more difficult to attract executives who would expect options or restricted stock, or some combination, Mr. Hanley continued.

"'Going private' costs about one year's worth of savings," Mr. Daugherty said. "The cost would be $2 million for legal, accounting, and banking fees...80 percent of going-private transactions, the costs will go even higher," he said.

Time involved in a going-private transaction - In addition to the cash outlays for legal, accounting and lending services, the time involved in completing the transaction for SEC review can be considerable, Mr. Hanley noted.

Loss of prestige - Being a public company carried a certain cachet, at least until the recent wave of scandals. That opinion might be changing, Mr. Hanley said. "I would say this is probably a lower priority, particularly in the Midwest," where large private companies are viewed highly, he added.

Going Private Is Not For Everyone: Some Considerations, Tips, And Traps To Avoid

Mr. Daugherty suggested companies carefully weigh the costs and benefits of staying public, and he offered a checklist of questions:

  • Is the company taking advantage of its public status? Stock can be used as incentive compensation or acquisition currency, and public companies can frequently access the debt markets.
  • Is the company prepared for the effect that financing the transaction will have on the balance sheet?
  • Is the company prepared for intense scrutiny by the SEC and the time involved? Mr. Daugherty estimated the process would take four to six months. This includes collecting and filing all metrics used in determining price, negotiation history, and the independence of the directors and committee members.
  • Is the company's D&O liability coverage adequate?

Mr. Daugherty offered these tips for success:

  • Run a good process to obtain the best price and avert liability
  • Keep detailed and accurate records of all proceedings
  • Prepare and file thorough and accurate disclosures
  • Ensure arm's length negotiations to avert charges of "sweetheart deals" and litigation
  • Ensure the independence of directors and special committee members
  • Retain experienced legal, accounting, and financial advisers

He listed what he called "traps for the unwary," including:

  • If a financial adviser is used or a fairness opinion is sought, be careful about what is discussed, or about what the adviser might give to the special committee reviewing the transaction. Nearly all material affecting valuation must be disclosed with the SEC.
  • Be cautious about taking an action that could constitute a "first step." Disclosure material must be filed immediately after the transaction commences. The rules apply not only to a single transaction but to a series; thus the "first step" could be construed to be an action taken within the previous two years, such as a stock repurchase.
  • Once the transaction becomes public, the company is "in play." If it is a management buyout, the board has an obligation to disclose it and to pursue other bids.
  • Select the appropriate type of transaction. For smaller companies, the cost of the transaction could trigger delays and mean less return for minority shareholders. Mergers and stock splits could trigger appraisal rights.
  • Beware of the "filing person" trap. The SEC takes an expansive view of who is required to file. In addition to the primary buyer, it could include equity sponsors, members of senior management, subsidiaries, or other parties.

Structuring The Deal

Despite the costs and time constraints, more public companies are going private now than did so a decade ago, said Christopher C. McMahon of the Chicago office of Robert W. Baird & Co. (Baird). In 1993, 17 companies went private; in 1993, the number had increased to 70. The average transaction size has recently declined, from $187 million in 2002 to $113 million in 2004. Most were cash mergers, a result of low interest rates and abundant equity capital, said Mr. McMahon, who is head of Baird's U.S. Mergers & Acquisitions activities.

Executing going-private transactions has become more difficult, Mr. McMahon said, because valuations are up and strategic buyers are back in the market. He described a recent example of an Illinois family-owned company going private through a series of steps. First, it conducted a "Dutch auction" to provide a single class of stock, giving family owners 50 percent control. (In a Dutch auction, a seller seeks bids within a specified price range, usually for a large block of stock or bonds. After evaluating the range of bid prices received, the seller accepts the lowest price that will allow him or her to dispose of the entire block.) In this case, a strategic player overbid, forcing the family to raise the bid price. Ultimately the family succeeded in bringing the company private but at a higher price than it initially announced.

"If you head down this path," Mr. Daugherty cautioned, "there's a chance you will lose the company. You have to expect that possible outcome and plan around it."

Mr. Hanley noted that SOX Section 404 - which requires corporate managers to create tight controls over financial reporting, assess them regularly, and have independent outside auditors attest to their effectiveness - comes into play in such transactions. "This adds a significant amount of effort" and cost to complete the deal, he noted. Transactions must meet the test of "entire fairness" in both procedure and price to minority shareholders. "Entire fairness" presents a higher legal standard for directors than the business judgment rule, he noted.

The Current Environment For Going Private

"The most significant difference in how deals are being structured today versus 10 or 20 years ago is how they're being structured and the amount of equity capital that's going into the transactions," Mr. McMahon said. "In the 1980s, it was common to see the equity component being five to 10 percent of the overall transaction. In the early 1990s, it had risen to 20 or 25 percent. Now you commonly see roughly 40 percent of the overall consideration being equity capital."

Although private equity investors are interested in companies planning to go private, they are demanding certain characteristics, Mr. McMahon said. "Most private equity firms are really looking at cash flow after capital expenditures, so they like asset-rich businesses. They like predictable cash flows. They like businesses that have been around for a while. They like sustainable business models."

Because of the abundance of available funding, as well as other factors, he continued, private equity firms today are looking for a pretax internal rate of return in the range of high teens to low twenties - a dramatic change from several years ago when the return threshold was in the 35 percent range. The debt-to-cash flow ratio has also crept up, he said, from multiples of three or four a few years ago, to approaching five or more today.

"You would be surprised at how many private equity firms are very happy to do $50 million transactions and how much capital people are willing to put in," Mr. McMahon said, noting that many private equity firms think along the following lines: "Let's take this $10 million cash flow business and let's make it a $20 to $25 million cash flow business."

"And by the way," Mr. Daugherty added, "if you're a $10 million cash flow business and you go private, after the first year - just by going private - you can add 10 percent to your cash flow by saving $1 million, and that really builds value quickly."

He described a recent Foley & Lardner case in which a client went private three years ago, when its stock was trading for approximately $1 per share. A four-person management group that owned 30 percent of the company raised enough money to buy out the remaining shares for $20 million. In mid-May 2004, they sold the company and cleared $200 million pretax after retiring all the debt.

"The IRR [internal rate of return] on that investment is several hundred percent, and that's why you do it. You take it private because you're going to sell it some day. When you do, you hope to have captured the benefits for yourselves," Mr. Daugherty said.

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