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IPO Reform: The Long Runway Approach

Joseph Bartlett, of VC Experts.com and Zachary J. Shulman, Cornell University The Johnson School


Introduction

Only 31 companies went public on the major U. S. stock exchanges in 2008, an 85% decrease in the number of IPOs over 2007. According to Hoover's Inc., the 31 IPOs offered on the NYSE, NASDAQ and AMEX in 2008 raised $24.1 billion, compared to 209 IPOs in 2007 which raised $48.6 billion. Consulting firm Dealogic reports that the nearly 300 IPOs that were withdrawn worldwide in 2008 is almost double the number withdrawn in 2007.

While much of this recent decline in the number of companies going public is the result of the global financial crisis, there are some problems inherent in the current IPO system that should be addressed. This week VC Expert's founder, Joseph Bartlett, along with Zachary J. Shulman, visiting senior lecturer at the Johnson Graduate School of Management at Cornell University, introduce some very intriguing and revolutionary ideas that could revamp and improve the IPO process. As you read this week's fascinating article concerning IPO reform, remember the famous words of Albert Einstein: "We cannot solve our problems with the same thinking we used when we created them."


IPOReform: Some ImmodestProposals

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. Part 1 of this article will look at the current IPO process and identify some of the most apparent flaws. In Part 2, we will present a series of specific (immodest) proposals for IPO reform. In Part 3, we will set out a hypothetical comparison of the current system (the Short Runway) vs. the suggested option (the Long Runway).

Part 1:The Current IPO Process and its Flaws

The basic foundation elements are familiar ... a stable legal system, an independent judiciary, specific rules governing commercial behavior (the Uniform Commercial Code, for example), enforceable contracts, disinterested government regulation, minimum official corruption and a relatively fair, nonconfiscatory tax regime. Other nations enjoy those benefits, such as the U.K. , for example, the original source of much of U.S. law and institutional structure. Science has had a lot to do with it as well. Science developed in government laboratories (National Institutes of Health and the Defense Department) and in government-supported academic institutions like Harvard, MIT, CalTech, Stanford, Berkeley. Again, however, other nations enjoy at least most of the cited resources with the possible exception of the spin-offs from DOD- sponsored research, e.g., at Los Alamos, Argonne , and the DARPA Project.

Lesser-known legal accommodations, friendly and sometimes critical to the rise of venture capital, include such well-kept secrets (at least to the non-professional eye) as the Plan Asset Regulation, a Department of Labor ruling (years in the making) which quietly but effectively released the assets of private and public pension funds for venture capital investing. Literally trillions of dollars have flowed into this space since 1979, [1] when DOL insulated the fiduciaries of pension assets from liability for investing in high-risk/high-reward situations such as venture capital funds. Similarly, Regulation D brought order out of semi-chaos in the private placement arena, freeing up private equity investment from a number of nonsensical regulatory burdens (keeping track of the number of offerees, for example) and thus stimulating legitimate activity enormously. In the tax area, Revenue Procedure 92-73 has legitimized the practice of compensating the managers of venture capital funds (and making them very rich in the process) with tax-free grants of profits interests, the tax burden to be imposed only when portfolio assets are in fact harvested. Rev. Proc. 92-73 actually crystallized a practice that had been going on since the business began; but the IRS made the rules clear and safe from idiosyncratic and eccentric threats, such as occurred in the early stages of the 8th Circuit Campbell case ( Campbell v. Comm'r ). In fact, the Internal Revenue Code has been quite generally accommodating to the early-stage sector. Entrepreneurs can obtain valuable equity interests in a start-up company through Section 351, built in part on the semi-fictional notion that they are contributing "property" to the mix in exchange, tax free, for sweat equity. Sweat equity is also available at bargain prices (again without immediate tax) through the Service's tacit recognition of the counterintuitive idea of "eat 'em up preferred," the preferred stock's liquidation preference sheltering real economic value in the common stock from tax whenever common stock is being, in effect, given away to the firm's managers. And, that glorious American invention, the employee stock option, has enabled startup firms to pay their help with non-cash consideration, non-taxable as of the date of the grant ... and, indeed, not even a charge to the firm's GAAP income. The tax treatment of "non-qualified" stock options is in fact one of the reasons a high-tech company like Microsoft can enjoy what amounts to phantom tax deductions, significantly sheltering its income in periods when Microsoft stock is rising. (In fact, U.S. corporations generally are paying out less and less of their cash in taxes to the Internal Revenue Service but that is another story.)

There are other happy elements, some of them deliberate and some of them accidents, favoring venture capital. A low rate of tax on capital gains, for example, is important, along with an extremely low rate for longterm investment in "qualified small businesses," and no tax at all if the investment is rolled over within a relatively short period into another venture capital opportunity. Somewhat farther afield, a relatively efficient bankruptcy process gives the participants comfort that business failure is not a lifelong catastrophe. The Private Securities Litigation Reform Act and the "bespeaks caution" doctrine, coupled with the tendencies of an increasingly conservative federal bench, have cut back on the exposure of directors of early-stage companies to personal loss in the event of business failure. Pre-emption of state "blue sky" laws has also removed a large and sometimes expensive level of nuisance regulation.

The foregoing list is not meant to be exhaustive. It simply illustrates that venture capital is widely recognized as critically beneficial to this country in any number of ways. The technology itself is useful and, in the case of biotech, sometimes life saving; the jobs created are generally high end; and the wealth has been extraordinary. Naturally enough, the bureaucrats swallowed their inherent instincts ... to regulate wherever possible ... and have given the "animal spirits" of U.S. entrepreneurs relatively free run.

Given that pattern of successful adaptation, the occasional, and quite important, failures to adapt are particularly noticeable.

Thus, for example, for any number of years regulators and the industry have attempted to devise ways to introduce small investors to the private venture capital space. There have been a number of initiatives to overcome the seemingly insuperable problems. An obstacle of long standing stems from the structure of private investment vehicles focused on venture capital; to be successful, they must be exempt from entity level tax. Existing VC funds are tax exempt, as partnerships, under Subchapter K of the Internal Revenue Code as long as they don't creep into "publicly traded partnership" status ... i.e., have too many individual partners. Since, by definition, an investment vehicle fueled by small investors is likely, if it wants to be a real player, to wind up with more than the allowed number of partners (and thus be liable to entity level tax, which is competitively fatal), the only recourse is Subchapter M of the Internal Revenue Code ... the exemption for registered investment companies. However, the strictures of the Investment Company Act of 1940 simply do not fit well with venture capital investing. A VC fund's portfolio is highly illiquid, meaning that the shareholders themselves are illiquid and cannot be allowed to redeem in any realistic sense ... an open-end mutual fund structure is not feasible. Closed-end funds, which do not redeem shares periodically, are at a disadvantage because they customarily sell at a discount from net asset value, meaning that the fund is worth more dead than alive. Moreover, some of the compensation features of the typical venture capital fund offend the very foundations of the Investment Company Act, to the extent that the latter is designed to discourage excessive speculation. Some of those problems were worked out in a 1980 amendment to the Investment Company Act creating "business development companies"; but the legislation did not accomplish much in the final analysis. Most of the BDCs formed post-1980 have gone out of business for one reason or another. And, publicly traded partnerships were eliminated as pass-through entities (and, therefore, eliminated "period") with a few grandfathered exceptions, by the 1987 anti-tax shelter legislation. Finally, the Idealabs, CMGI, Divine, etc. conception ... that a public holding company could function as a de facto public venture capital fund ... was put to sleep (perhaps forever) by the dismal performance of those entities, labeled "incubators," post the dotcom meltdown.

Given the amount of capital available from institutional and super-high-net-worth individuals, plus corporate venturers, the space does not lack for liquidity, however, and the failure to include the "little guy" in the process has not been a major disadvantage. In fact, it may be that small investor doesn't belong in high-risk/high reward, highly illiquid venture capital investing ... particularly if he or she has no realistic ability to understand the risks and to bear the potential consequences of total loss of capital.

The more important failure, and the one that this piece focuses on, is our (i.e., government and industry) inability to rationalize the IPO process, a particularly important failing since IPOs are a major driver of successful venture capital investment. Without realistic IPO exit opportunities, much of the attractiveness of this important sector may wither.

To illustrate, consider the current state of play, based on what I am labeling (see hypothetical case study in Part 3 of this monograph) the Short Runway model. IPO securities are, typically, sold to the public on the basis of a hectic flurry of activity surrounding the effective date of the offering. There are, to be sure, oral indications of interest collected by the underwriters from potential buyers over a period of time prior to the effective date ... after the so-called "Red Herring" prospectuses (named for the red label attached to the front page) have been distributed to institutions and investment banks. The actual sales fulfillment process is, however, very tightly compressed. To get the final version of the prospectus in shape the company, its counsel, its accountants and underwriters work heroic hours, often staying up for two straight days and nights at the printer so that the documents can be filed and become effective by 10 AM. in the morning on the targeted effective date. Form orders are accepted until 4 P . M . that day, when the underwriting syndicate decides whether it goes "firm" and in fact underwrites the offering, or abandons it, ... in the former case, underwriting it in the true sense of the word, meaning that the investment banks put their own capital on the line to ensure that the securities are in fact sold and paid for. (The settlement date is three days away, T + 3 as it is called.) The syndicate members are on the phone nonstop to firm up the orders they have orally solicited. The potential buyers do not, in fact, know the exact price until the morning of the effective date and have to make up their minds in a very short period of time (although they have had clear indications of the pricing objectives since the target range has been widely disseminated). The supply of shares is inelastic; other than the company (and, subject to the so-called "Green Shoe" option which allows the underwriters to call another 15% of the offered shares from the company), there is no other supply; consequently, if the demand exceeds the supply. After the initial allotment has been sold, anybody who wants to buy the stock has to buy it from someone who was lucky enough to get in the initial offering price, despite the fact that initial buyers are discouraged from "flipping" in the early stages of trading and the managers of the offering, the investment banks, threaten to refuse to allot stock in subsequent IPOs to individuals and institutions who engage in "flipping." As a consequence, there is a very restricted supply in after-market trading once the initial stock has been distributed; if the demand exceeds the supply, and in robust IPO periods the demand almost always does exceed the supply, fundamental economics indicate that the price of the commodity, in this case, stock, will shoot up. The danger that the underwriter will be a real underwriter ... i.e., be long on the stock, versus just acting as an agent ... is therefore minimized.

The problems with the Short Runway structure are obvious. The prospectus and registration statement contain a plethora of information concerning the applicant, data which has been circulated extensively (as required) during the pre-effective period bit, outside of the institutions which invest in IPOs professionally, there is a real question whether the market itself has had the time or the quiet space in which to absorb the data and compare it in a state of reflection. For the lucky few, getting an allocation of stock at the IPO price is, in effect, the equivalent of getting free cash. But, those who own stock at the trading price zenith are frustrated and angry. A lot of the current litigation involving IPOs, the Congressional hearings, the grand juries, and the general gnashing of teeth at the practices of the leading investment banks, is driven by the process itself. If one sifts through the hyperbole and looks at what is actually happening in the marketplace, one realizes that, by and large, the law has not been technically broken. Whether the buying public or the Congress or the U.S. Attorney's office is reacting to disappointment driven by the very nature of the process itself or the peccadillos of any one individual or group of individuals, the problem should be attacked structurally, rather than by seeking headlines and scapegoats. In the last section of this piece, we address an alternative, which we call the Long Runway option, and urge its adoption.

There are, unfortunately, a number of other problems in today's public markets which also suggest that structural reform, in order to enhance the IPO model, is in order. First, some sobering statistics (from a presentation made by US Bancorp Piper Jaffray at a recent conference):

  • Institutional investors account for approximately 80% of all trading volume for stocks listed on the three major stock exchanges.
  • A typical investment bank's sell-side equity analyst needs to generate $10 million in trading commissions per year to support the sales/trading operation and the costs of research[2]
  • Over 95% of the total market capitalization of companies on the Nasdaq, American and New York stock exchanges is accounted for by companies with greater than $500 million in market capitalization.
  • Conclusion: Mergers and acquisitions represent the only real means for most mid-cap companies to realize a premium valuation and significant liquidity.

How do I read this data? For the reasons stated below, the IPO window may be shut for a long, long time.

Thus, the data illustrates something that has been known to insiders for the last several years. There is a growing "orphanage" in the U.S. public markets, peopled by companies the valuation of which is below the necessary threshold ... below that market cap (about $500 million) which commands the attention of the analysts, and, therefore, institutional buyers. Reinforcing the bias against small-cap public companies, many of the asset managers have merged in recent years; an individual who used to manage $1 billion (and could get in and out of a small-cap company without her trade moving the market against the trader) now manages $10 billion.

A company whose stock is in the orphanage has the worst of all possible worlds ... the expense and nuisance of public registration not counterbalanced by genuine liquidity nor an accurate trading price which real liquidity would bring. Moreover, thinly traded stock tends to trade off. Stock that came public at a share price of, say, $15, once fallen into the orphanage, can slip into single digits even though the company is doing just fine. Perhaps the worst statistic of them, vide a study recently reported in The New York Times, [3] is that a stock which slips from double to single digits has only a 3.4% chance of recovering into double digit land.

Absent analyst coverage, then, it is up to the management of the company to create interest one way or another in the stock ... a long and arduous process which has given rise to the saying, "The road show never ends." One wonders what the CEO and the CFO are doing about running the business if most of their time is spent hopping from city to city to keep the interest in their stock from flagging. Another way of putting the problem is the view entertained by some shrewd critics of the system, who claim that the cost of IPO capital is a notional (or implied) 25% (plus or minus), compounded. The central idea is that, whenever any company essays an IPO, there is an expectation that, at least for companies not extremely well positioned, the results will compound at a rate of something like 25%, an expectation that is encouraged by promotional material in the course of the pre-IPO road shows. [4] When and as there is a subsequent hiccup in that result (e.g., by way of a missed quarter), the market tends to kill the stock these days, particularly for companies in the orphanage, driving the shares below the magic $10 figure ... a dungeon from which, apparently, they almost never recover.

In short, one wonders whether there could not be a way of fixing a lot of the problems with emancipated and forward-looking regulation and institutional restructuring. This is the question we will seek to answer in Parts 2 and 3 of this article.

Part 2: A Few (Immodest) Proposals for IPO Reform

Coverage

First, focusing on the analysts and their limited ranges, this problem may take care of itself as and if a modern-day equivalent of Glass-Steagall passes. We may, sooner rather than later, see a rule that the business of analyzing and reporting publicly on public securities must be divorced from the business of agenting their sale. Is this likely to happen? On the one hand, a conservative federal legislature may be highly wary of a reincarnation of Glass-Steagall. On the other hand, the SEC, of late and without much push-back from the Congress, has been rigorous in enforcing the independence of public accountants, compelling them to shed significant profits from their consulting businesses or, at least, to distinguish between clients. However, we do not think a negative approach is, of and by itself, the way to go.

Thus, we do not believe that simply dividing invest ment banking and securities analysis would do the trick adequately. The reform we prefer entails the establishment of security analysis as a separate (and presumably independent) business which, if rightly structured, would extend the reach of the analytical community to any company with a specified minimum level of investor interest. As indicated, there is a chicken-and egg-problem underlying the current landscape. If a company's fortunes are subject to published analysis, then investor interest will follow in most cases, including interest from individuals and the small-cap mutual funds. The idea is, therefore, to structure the rules to the end that either 1) existing institutions (law, consulting and perhaps even accounting firms) are induced to organize subsidiaries or affiliates, open to all, which hire, train, qualify and publish the results of securities analysis; and/or 2) alternatively, free standing organizations, ultimately mimicking the "Big Five," spring up to provide the service, if the price is right.

Finding the money for this function should be the easiest part of the problem to solve. Assume there are 8,000 public companies which lack analytical following. Assume 4,000 or so are in a position, and have the wherewithal and motivation, to attract analytical coverage. The price, then, could be $100,000 per company per year. That number is well under what many companies in the orphanage now spend in terms of executive time, travel costs and the like in order to stimulate investor interest. We are talking about a lot of money, $400 million a year, even if you assume a good analyst makes a million dollars a year for covering a maximum of 20 companies. To get 200 analysts, you need $200 million, which leaves $200 million left over for the guys who all cover Microsoft, etc.

If the project correctly sorts itself out, it is a win/win situation. Conflict of interest is negated and investor choice is enhanced ... the best analysts would get the most money, bonuses for finishing at the top quartile based on the always correct influence of hindsight. Analysts will develop track records and be judged thereby ... compensated, hired and fired on the basis of performance like everybody else, instead of how many investment banking clients they snare.

Costs of Going Public

The next issue to tackle has to do with the extraordinary, often prohibitive, costs of going public under the current regime. We are talking about up-front costs of $2 million in cash, not counting fees and expenses to the investment bankers, a portion of which is designed to compensate the professionals for the fact that some deals may abort at the last minute and leave them holding the bag. A large part of that significant expense is driven by the awkwardness of the process itself and much of the rest by the threat of liability under Section 11 of the '33 Act ... absolute liability if something goes wrong. If the hypothetical Man from Mars were to revisit this costly and inefficient system imaginable, we suspect he or she would come up with a series of recommendations like the following:

First, the Congress should repeal Section 11. There is no reason for near-absolute liability in the sale of public securities, as opposed to other transactions. The threat of securities fraud is obviously real and difficult; but Section 11 is not the way to police it. In fact, if one were to get rid of the Hollywood-opening type of marketing system in favor of a more thoughtful and leisurely (if you will) review of the issuer and its prospects by investors and professional advisers, then the system would be much more reliable, transparent and free from intentional fraud. One, although not the only, way to go about the business would be along the following lines ... our second recommendation.

Disclosure Standards

The next chapter in the project to enhance the attractiveness of valid and productive IPOs is to reform the standards of disclosure so that they are both realistic and affordable for legitimate issuers and their functionaries. The first chore is to make the standards understandable and clear. And the place to start is with the Regulations S-X, S-K and the definition of generally accepted accounting standards ("GAAP"). The idea would be to convene a committee not only of accountants but also of investment professionals, principally venture capitalists, who are charged with the responsibility of making investments in this space. The committee is asked: What, in terms of transparency, do you deem most valuable? The committee might take off from the "SEC-inspired" Garten Committee report. [5]

Offhand, we can think of a number of items, which are not highlighted in current financial disclosures:

  • Effect of Dilution: What is the practical economic effect of the overhang of employee options and other securities capable of diluting the IPO investors' percentage interest? Can dilution be expressed by a number that explains what it would cost to buy back all the warrants and options and options at the proposed IPO price?
  • No Liability for Forecasts: Professional private investors want to look at forecasts, and this means it is time to insulate the issuer from liability of any kind (absent outright fraud) in connection with the promulgation of a forecast. No other standard will produce the desired results. [6]
  • Past Performance: Perhaps the most reluctantly produced number by the management of any company is how the firm has been doing against the prior plan. Presumably, there are forecasts in connection with previous private placements; variance reports keyed to those forecasts are highly instructive.
  • Cut the Clutter: Reduce the number of subjects which go into the prospectus. Cut back to the model of a well-drafted private placement memorandum and identify sources within the company where the investors can access information.

The point is that we spend a good deal of time quibbling about matters of very little importance. Who cares whether the company records a one-time charge for the issuance of cheap stock, warrants or options in anticipation of an IPO? Investors want to know the dilutive effect of those derivative securities and be able to compare apples and apples ... how rich is the option plan vis-…-vis industry comparables.

Diligence Requirements

Once that chore has been accomplished, then another blue ribbon commission should be contemporaneously devising a legislative articulation of the appropriate levels of the diligence required of the various professionals, breathing life into the idealistic (and unrealistic) current requirements (see Judge MacLean in Bar Chris) and the penalties for failure to comply. In a perfect world, we would take plaintiffs' counsel, as private attorneys general, out of the picture, since much of that litigation is meretricious. In fact, if it can work, we would like to see a carryover of the insurance notion (currently available to back up representations and warranties in M&A and private equity transactions) imported into the IPO space. Why not create a pool to which all IPO candidates would contribute, underwritten either by major carriers, or by the market through the asset-backed securities device, and compensate therefrom victims of outright fraud and deception?

The core idea is to take the thrill out of the process and turn it into a relatively pacific business transaction, gradually and efficiently introducing public investors to a new security and initiating trading in that security when and only when sufficient investor interest has eventuated and the stock has been sufficiently incubated (through an active due diligence process performed by paid proxies for potential investors) so that the securities are in fact ready for market.

Dutch Auction

Next, we would make whatever small changes are necessary to accommodate (as the sole or primary option) the Dutch auction pricing formula currently promoted by W.R. Hambrecht. Thus, at some point in this leisurely process, an aspiring issuer, after sufficient prodding and poking has taken place, indicates publicly its appetite on the sell side ... how many shares it proposes to issue (perhaps a minimum and maximum offering), without specifying the price. Maybe a couple of electronic road show conferences are scheduled for final Q&A with interested investors in an electronic document room. The issuer schedules the opening of bids two weeks or a month from the date of the announcement, and everyone then has a chance to make whatever inquiries each sees fit, and to submit a bid. The bids are opened on the specified date and the price is established at the lowest price which clears the market. With this much time to sort out the orders, it may even be that same-day settlement is realistic, diminishing to the vanishing point the possibility of "fails" in the time between T-1 and T-3; successful bidders would be required to wire the funds immediately, thereby taking some of the rules out of the underwriting function ... and, in the process, a good deal of cost and expense. The amount of the securities locked up would be a disclosable item; locked-up securities held by insiders would be freed from restrictions ratably over a period of time ... 1% a day for the next 100 business days, so as to eliminate a land rush, on the 180th day.

Going Private

We suggest a quasi-fix for now public companies mired in the orphanage ... some 7,000 or 8,000 trading by appointment only. Many of these are good companies which went public (some through backdoor mergers into shells) inadvisably. They are strangling: They cannot finance publicly with their stock price in the cellar (except through toxic preferred stock); and few investors are buying PIPEs these days. Undervalued by Wall Street and unloved by analysts, an increasing number of companies are sidestepping the quarterly earnings game by going private. Last year, 62 publicly traded companies or units of public companies went private. That's 11 .4% of all takeovers of publicly held companies that year, compared with 2.2% five years earlier. It's also 77% more than the number that went private in 1999.

As US Bancorp Piper Jaffray Inc. notes in its "Endangered Species Updates," going private has become especially attractive for companies languishing in the purgatory of small- to mid-capitalization. Despite strong projected cash flows, such "market orphan" firms fail to attract institutional investors or coverage from the research departments at investment banks.

As a result, their shares trade at multiples of cash flow significantly below sale multiples for better-capitalized peers and at prices well below their IPO levels. Of companies in the Standard & Poor's 500 index, those with market caps below $100 million trade at 60% discount to the rest of the market.

Conveniently, undervaluation of small- to mid-cap issues coincides with growing inflows into private equity funds. Last year, financial buyers controlled $63.5 billion, up 61% from the previous year. Private equity groups can provide not only capital and managerial expertise, but also the credibility that is necessary to assuage reluctant lenders in a tight debt market.

From private equity's perspective, target companies ripe for private control share certain characteristics. Those include an enterprise value that reflects a single-digit multiple of EBITDA; strong projected cash flows and a substantial amount of cash on the balance sheet; adequate debt capacity; low trading volume; and relatively erratic earnings histories, including failures to meet analysts' earnings expectations.

Characteristics also include devalued employee options; able but frustrated senior management; and an inability or unwillingness to complete strategic acquisitions because of a low stock price or dilution concerns. Problems are amplified where the company is in a sector that is disfavored by investors. From the target company's perspective, going private involves numerous advantages. Companies that go private find it easier to:

  • Pursue long-term growth strategies instead of Wall Street's quarterly goals;
  • Concentrate on their business plans and enhance shareholder value without expending time and money on investor relations programs and filings with the Securities and Exchange Commission;
  • Divest themselves of tangential businesses where covenants in their banking agreements had constrained them from doing so; and
  • Improve employee morale and provide incentive to management. [7]

While going private under the present rules is easier than it has been in the past, the bulk of the "going private" transactions involve cash-out mergers financed by buyout funds. My suggestion is akin to the "check the box" regulations in the tax law. Allow management and the board to put the case to the shareholders and ask them to vote on a return to private status. Any company with fewer than, say, 2,500 shareholders would be eligible. No one has to sell or is squeezed out (except odd lot holders) ... maybe a simple, and cheap, and continuous tender to all holders and the owners of those pestiferous warrants which infernally confuse the balance sheet, coupled with reverse splits ... until the magic number is reached (say, 2,500). Listed trading ceases; public reporting is no more, meaning no more artificial pricing (and no more artificial plaintiffs). Let the business proceed in peace and quiet in the absence of the now-entirely-superfluous public registration.

Long Runway Alternatives

If a company has in mind going public at some time in the future, it would be open for the issuers (as it is now) to start filing voluntary public reports: Not a registration statement, but an abbreviated version of the same, which could be filed at any point in the journey from the embryo to the IPO. There would be no trading in the issuer's securities, or no public trading at least; but the public, including the investment banking and analyst community, would have an opportunity to look at the company in depth and over a period of time. (Read here a necessary amendment to Rule 502(c) regarding "general" solicitation and "general" advertising, to accommodate a streamlined version of interim PIPEs.) The company would be able with impunity to file for confidential treatment of specific items, subject, as is now the case under Regulation FD, to releasing that information to parties willing to sign nondisclosure agreements. Information would be posted online on the company's website and track generally Forms S-1 or SB-1. If the company wanted to pay the freight, as a form of spring training (if you like) for an IPO, it could be authorized (or indeed required) to pay the $100,000 and solicit analysts' reports from the newly organized Big Five. The company could conduct quarterly Q&As on-line and make information available to the analysts ... and to all hands under Regulation FD, if you like. But, since there would be no trading, it could limit the flow of information as it saw fit. Any time after filing a new version of a Form 10, the company (again at its leisure ... no timetable at this point) could solicit a letter of comment from the SEC staff and submit a listing application. The bulk of the initial documentation could be assembled in-house, tracking the forms and other examples of comparable public companies. The current custom ... a first, "all hands" meeting and drafting session with 15 or 20 people (mostly bystanders) in attendance ... would be avoided, along with the consequent expense.

Interest would then build over a period time, if at all, in the company. And, if the deal held promise, the "usual suspects," i.e., the investment banks, would come calling. By the time the bankers had risen to the bait, much of the legal infrastructure would have been cleared away ... the letter of comment filed and responded to, accounting issues sorted out with the Chief Accountant's office, some objective appraisals from the analyst community circulating and some institutional and retail interest aroused.

The Long Runway scenario is illustrated by a hypothetical case study set forth in the next section.

See the Exhibit 1 for examples of intangible assets and operating performance measures.

Part 3: The Short Runway Versus the Long Runway

Assume that 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 refiles 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 after-market, 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.

EXHIBIT 1

Intangible Assets

Operating Performance Measures

Brand names

Customer acquisition cost

Patents

Revenue per customer

Trademarks/copyrights

Number of customers

Proprietary business processes

Inventory turnover

Skilled employees

Cost per unit

Business alliances

Market share

Product licenses

Time to market

Loyal or locked-in customers

Revenue pre-transaction

Customer lists

Employee turnover

Desirable locations

Manufacturing throughput

Preferential rights ( e.g. , drilling)

Order backlog

Landing rights

Revenue per employee

Airwave spectrum rights

Revenue from new products

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 videoconference 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 24 hours) the Company has the opportunity to accept or reject the bids. The prospectus delivery requirement, which still exists, is totally on-line; 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 printer's, legal bills and accounting fees for crash performance, road show expenses) 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 10 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 our opinion, this is a better way in at least some circumstances. Moreover, note the two Runways are not mutually exclusive. Under our suggested system, any registrant could (and may well) take off from the Short Runway. Our 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?


Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

Full Bio

Zachary J. Shulman, zjs2@cornell.edu, is a visiting senior lecturer at the Johnson Graduate School of Management of Cornell University. Mr. Shulman teaches courses on venture capital and law for high-growth businesses. He also serves as general counsel and faculty advisor to BR Ventures and BR Incubator, both Johnson School student-run organizations that provide business consulting services and investment funds. Shulman is currently a partner at Cayuga Venture Fund, a venture capital firm located in Ithaca, NY.

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[1] Lerner, Boom or Bust in the Venture Capital Industry and the Impact on Innovation , HBS Working Knowledge, Nov. 5, 2001.

[2] "One analyst's capacity to adequately understand and communicate the prospects for a company is about 20 specific names. As a result, the trading commissions per stock should be about $500,000 per year. The average institutional commission is $0.05/share on each side of a trade. The reported trading volume generated by the investment bank must be 10,000,000 shares per stock per year. (Note: the actual number of transactions may be as low as half of the reported figure due to double counting of NASDAQ trades). Estimated trading days in a year: 250. The resulting minimum reported daily trading volume for one investment bank is 40,000 shares/day per stock. If the investment bank is the most active market maker in the company's stock, it could represent up to half of the trading volume. Resulting minimum reported daily volume required is 80,000 shares/day." US Bancorp Piper Jaffray presentation, IIR Family Office Forum, June 25-26, 2001, Chicago .

[3] "'Bottom Fishers' beware. When stock prices sink to single digits, the odds are that they are sunk for good. That is the conclusion of a study by Thomas W. Watts, Internet infrastructure analyst at Merrill Lynch. Going back to 1985, Mr. Watts studied the trading of 1,900 publicly held companies spanning the technology sector. He found that of those companies whose stocks had fallen to single digits, only 3.4 percent rebounded to $15 or higher within the next year. Most of those that didn't bounce back in the first year never did." Morgenson, Market Watch, N.Y. Times Business 16 (Apr. 8, 2001).

[4] "The demand for small- and mid-cap stocks is gener ally restricted to opportunities in high growth companies in rapidly expanding markets with the prospect for the size of the company to grow substantially within the next 12 to 18 months." Ibid .

[5] To quote from the Committee Report:

Investors need a variety of information to project future profits and cash flow. Historical financial results are a starting point, but are rarely adequate by themselves. Investors need to understand the company's business model, the market for its products, the specific tangible and intangible assets that provide its competitive edge, and the quality of its management team. They also need to understand the key milestones for the development of the company and its progress on achieving key operating performance measures. Sometimes, the investors would also like to receive financial projections from the management of the company. Investors then take all this information to develop their profit and cash flow projections. The sum of this information about intangible assets, operating performance measures and forward looking information is the focus of our conclusions about improving the disclosures.

[6] I endorse the recommendation of the Garten Committee (which I arrived at before seeing the report):

Expand the safe harbor provisions of the PSLRA of 1995 for disclosures of forward looking information and softer historical information about intangible assets and operating performance indicators. For example, a broader prohibition against private suits could be considered. Even more ambitious would be the creation of a special section in investor communications (annual reports, investors presentations, company web sites) that would be entirely exempt from private suits. Investors would be cautioned about the lack of remedies they would have with respect to the information in that section. (Emphasis added.)

[7] "Orphan Story," Kaynor & Pereira, The Daily Deal (Aug. 28, 2001).