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SPAC IPOs A Sign Of Impending M&A Opportunities

Posted by Securities Attorney Laura Anthony | June 15, 2020 Tags: SPAC IPOs A Sign Of Impending M&A Opportunities

The last time I wrote about special purpose acquisition companies (SPACs) in July 2018, I noted that SPACs had been growing in popularity, raising more money in 2017 than in any year since the last financial crisis (see HERE). Not only has the trend continued, but the Covid-19 crisis, while temporarily dampening other aspects of the IPO market, has caused a definite uptick in the SPAC IPO world.

In April, the Wall Street Journal (WSJ) reported that SPACs are booming and that “[S]o far this year, these special-purpose acquisition companies, or SPACs, have raised $6.5 billion, on pace for their biggest year ever, according to Dealogic. In April, 80% of all money raised for U.S. initial public offerings went to blank-check firms, compared with an average of 9% over the past decade.”

I’m not surprised. Within weeks of Covid-19 reaching a global crisis and causing a shutdown of the U.S. economy, instead of my phone not ringing, I was inundated with inquiries relating to SPACs and reverse mergers. The sentiment is that there will be significant buying opportunities as the virus subsides and the economy recovers, including an even further increase in technology and new industries for our new normal.

Similarly, many companies that were planning a traditional IPO have adjusted their focus to a reverse merger. The thought is to go public quietly, make sure governance and processes are buttoned up, and be ready for follow-on offerings, and merger and acquisition opportunities, using stock as currency at the uptick in valuation that comes with the liquidity available to publicly traded companies.

Mid-tier bankers are in on the opportunities. Not all businesses are cash-strapped; in fact, some are enjoying the highest growth in their life cycle. Food-delivery businesses of all sorts, direct-to-consumer household product suppliers, personal protective equipment, including hand sanitizer manufacturers, video meeting and conferencing companies, virtual event planners and organizers and underlying technology providers and of course, e-commerce personalization technology companies, life science and biotech companies, including those that were already deep in viral or immunotherapy research and development, digital currency platforms are all booming. Many of these companies are looking at reverse merger opportunities and small-cap bankers are willing to invest a few million betting on the larger follow-on raise to come.

Those looking to go public via a SPAC or reverse merger have options. At the same time that the SPAC IPO market is booming, unfortunately, many public companies have been hard hit by the crisis and management is considering options, including taking the current business private or discontinuing operations, and finding value for their shareholders by completing a reverse acquisition.

Of course the benefit of a SPAC is that it comes with cash, but that is not a certainty either. A SPAC’s public stockholders can elect to have their shares redeemed for cash in connection with the business combination and as such, the amount of cash available for post-closing operations is uncertain. The target may require a minimum cash closing condition or, perhaps more importantly, that the SPAC have committed acquisition financing. As such, a SPAC can be substantially the same as any reverse merger with a simultaneous PIPE transaction.

Background on SPACs

A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.

The sponsor of a SPAC contributes 10% of the total post initial public offering (IPO) capital of the company. The sponsor’s 10% capital is used to cover the IPO and ongoing SEC reporting and administration expenses. Although a sponsor will invest 10% of the capital, they typically receive founder’s shares in the SPAC that results in approximately 20% ownership in the post IPO company. Sponsors do not make money unless a successful business combination is completed and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.

When a SPAC completes its IPO, usually 100%, but in no event less than 90%, of the funds raised are held in escrow to be released either upon completion of a business combination transaction, or back to shareholders in the event a transaction is not completed within a set period of time. Upon closing of a business combination, the SPAC investors can elect to continue as shareholders of the combined business or redeem their shares for cash. A SPAC business combination must have a market value of at least 80% of the value of the amount held in escrow at the time of the agreement to enter into the transaction.

A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.

SPAC IPOs are usually structured as unit offerings with both stock and warrants to entice investors to bet on the unknown future opportunity. The number of warrants and exercise price can vary. Although sponsors with a prominent track record can generally attract better valuations and investor deals, with the continuing popularity of SPACs over the years, that has become less important. As an alternative to warrants, some SPAC sponsors agree to over-fund the IPO trust account by some multiple to the investment amount, which over-funded amount would be distributed to the SPAC investors if a business combination is not completed.

The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will either have applied for a listing on a national exchange or, following the closing of the offering, will work with a market maker who will file a Form 211 application with FINRA to receive a trading symbol to trade on the OTCQX. The OTCQX is the only tier of OTC Markets that allows for SPAC trading. Also, although both NASDAQ and the NYSE have proposed SPAC eligibility rule changes over the years, as of now, they remain the same as for any other company seeking a listing as part of an IPO.

At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO registration statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to testing the waters and public communications during the IPO process.

When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.

Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements.

Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction, or as talked about above, that a simultaneous PIPE transaction provide the needed cash. The exchanges all require that the newly combined company satisfy their particular continued listing requirements.

SPACs are, by nature, “shell companies” as defined by the federal securities laws. Accordingly, SPACs have all the same limitations as other shell companies, including, but not limited to:

A SPAC is an ineligible issuer that is not entitled to use a free writing prospectus in its IPO or subsequent offerings within three years of completing a business combination.
After completing the IPO and until it completes a business combination, the SPAC must identify its shell company status on the cover of its Exchange Act periodic reports.
A SPAC cannot use a Form S-8 to register any management equity plans until 60 days after completing a business combination.
A SPAC may not file an S-3 in reliance on Instruction 1.B.6 (the baby shelf rule) until 12 months after it ceases to be a shell and has filed “Form 10” information (i.e., the information that would be required if the company were filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company. See HERE on S-3 eligibility. Also, recently the SEC has been issuing comment letters where the company is filing an S-3 relying on Instructions 1.B.1 (full shelf) or 1.B.3 (re-sale) following a SPAC deal, suggesting they want those entities to wait 12 months as well. Historically, the SEC would include the SEC filings of the SPAC in the general requirement that the company have a class of securities registered for 12 months prior to use of S-3, but it seems they are changing their view and want the operating business to be public for the full 12 months. I wouldn’t be surprised if we see a rule change aligning all S-3 use with the current shell company requirements in Instruction 1.B.6.
Holders of SPAC securities may not rely on Rule 144 for resales of their securities after the SPAC completes a business combination until one year after the company has filed current “Form 10” information with the SEC reflecting its status as an entity that is no longer a shell company and so long as the SPAC remains current in its SEC reporting obligations.

Conclusion

Although all forms of going public have pros and cons, in a SPAC deal or other reverse merger, you have a motivated buyer. SPACs are required to liquidate if they do not complete a business combination within the legally specified time period, and the sponsor will lose their investment. In a reverse merger, the current public company must continue to fund SEC reporting requirements, EDGAR fees, transfer agent fees and the usual fees associated with being public, in addition to facing shareholder pressure to either make the current business work, or find an opportunity that has the potential to bring them future value.

For companies that are looking to go public without the traditional IPO, and especially those looking for growth through M&A activity, now is a great time to look at SPACs and reverse merger opportunities.

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An IPO Without The SEC

Posted by Securities Attorney Laura Anthony | January 29, 2019 Tags: An IPO Without The SEC

On January 23, 2019, biotechnology company Gossamer Bio, Inc., filed an amended S-1 pricing its $230 million initial public offering, taking advantage of a rarely used SEC Rule that will allow the S-1 to go effective, and the IPO to be completed, 20 days from filing, without action by the SEC. Since the government shutdown, several companies have opted to proceed with the effectiveness of a registration statement for a follow-on offering without SEC review or approval, but this marks the first full IPO, and certainly the first of any significant size. The Gossamer IPO is being underwritten by Bank of America Merrill Lynch, SVB Leerink, Barclays and Evercore ISI. On January 24, 2019, Nasdaq issued five FAQ addressing their position on listing companies utilizing Section 8(a). Although the SEC has recommenced full operations as of today, there has non-the-less been a transformation in the methods used to access capital markets, and the use of 8(a) is just another small step in a new direction.

Section 8(a) of the Securities Act

Section 8(a) of the Securities Act of 1933 (“Securities Act”) provides for the effectiveness of registration statements and amendments. In particular, the statute provides that a registration statement shall automatically go effective on the 20th day after its filing or such earlier date as the SEC may determine. Section 8(b) gives the SEC the power to issue a stop order to prevent a registration statement from going effective in accordance under Section 8(a) if the registration statement is “on its face incomplete or inaccurate in any material respect.”

In practice, companies avoid the Section 8(a) effectiveness by adding language to their registration statements known as the “delaying amendment.” The typical language for a delaying amendment is similar to the following:

The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.

… and with that provision, Section 8(a) is avoided. A company then goes through a comment, review and amendment process with the SEC which ultimately results in the SEC informing the company that it has cleared comments. A company then files a letter with the SEC, relying on another rule (Rule 461) requesting that the registration statement become effective. Technically the request is that the SEC accelerate the effectiveness of the registration statement so that a company does not have to file a final amendment removing the “delaying amendment” language and adding Section 8(a) language and then waiting 20 days for the registration statement to go effective.

The reasons that Section 8(a) is not used in practice are twofold. The first is that a company and its attorneys, auditors and underwriters believe that there is too much risk of litigation associated with forgoing SEC review. If the registration statement disclosures are later shown to have shortcomings, the unusual lack of SEC review adds fuel to the plaintiff’s lawyer’s claims. However, the SEC does not conduct a merit review, but rather just reviews to determine if the disclosures comply with the rules and regulations. Not only does the SEC not pass on whether a deal is good or bad, but making a statement to the contrary is a criminal offense and Item 501 of Regulation S-K specifically requires a disclaimer on the subject with suggested language, to wit:

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

It seems that if a company has competent counsel and the underwriter has competent counsel, they can together review the disclosures to determine if they are accurate and complete. Moreover, the fact is that if the stock price goes way down, the company is likely to face an investor lawsuit anyway, regardless of what the SEC reviews or doesn’t review. Besides, risk factors are designed to warn investors of potential issues, and Gossamer did so with its newest SEC filing adding the following risk factor:

As a result of the shutdown of the federal government, we have determined to rely on Section 8(a) of the Securities Act to cause the registration statement of which this prospectus forms a part to become effective automatically. Our reliance on Section 8(a) could result in a number of adverse consequences, including the potential for a need for us to file a post-effective amendment and distribute an updated prospectus to investors, or a stop order issued preventing use of the registration statement, and a corresponding substantial stock price decline, litigation, reputational harm or other negative results.

The registration statement of which this prospectus forms a part is expected to become automatically effective by operation of Section 8(a) of the Securities Act on the 20th calendar day after the most recent amendment of the registration statement filed with the SEC, in lieu of the SEC declaring the registration statement effective following the completion of its review. Although our reliance on Section 8(a) does not relieve us and other parties from the responsibility for the adequacy and accuracy of the disclosure set forth in the registration statement and for ensuring that the registration statement complies with applicable requirements, use of Section 8(a) poses a risk that, after the date of this prospectus, we may be required to file a post-effective amendment to the registration statement and distribute an updated prospectus to investors, or otherwise abandon this offering, if changes to the information in this prospectus are required, or if a stop order under Section 8(d) of the Securities Act prevents continued use of the registration statement. These or similar events could cause the trading price of our common stock to decline substantially, result in securities class action or other litigation, and subject us to significant monetary damages, reputational harm and other negative results.

The second is that the S-1, which will go effective after 20 days, must be totally complete, including pricing information. In a traditional IPO or follow-on offering, the company does not file the final amendment with pricing information until the day it goes effective. This allows a company to judge the market at the moment of sale to choose the best price, which is especially important in a firm commitment underwritten deal where the underwriter buys all the company’s registered stock in the IPO and immediately resells it to customers and syndicated broker-dealers. A company also may get feedback during its roadshow, which typically occurs in the 10-15 days prior to effectiveness that affects pricing decisions.

Interestingly, Gossamer has decided to ignore these market factors and let the world know its believed value up front. I’m actually not surprised at all. This is just another way that capital markets are shifting. There has been a recent rise in different methods of going public including direct public listings without an IPO (see HERE).

Nasdaq FAQ

On January 24, 2019, Nasdaq issued five FAQ addressing the listing of new companies during the government shutdown and the impact on already listed companies. Nasdaq will list companies that had cleared comments, but whose registration statement had not yet been declared effective at the time of the shutdown. Likewise if a company has substantially cleared comments, Nasdaq is willing to proceed with the listing under certain circumstances. In particular, the company will have had to clearly address the outstanding comments and Nasdaq will require a representation from the company’s counsel and auditor that they believe all disclosure and accounting comments have been fully addressed. Nasdaq will not list a company that has not yet received SEC comments or that first filed for its IPO during the shutdown. Gossamer announced that it has applied for the Nasdaq Global Select Market and so it will likely amend its S-1 to allow SEC review.

Nasdaq will also allow certain up-listings from the OTC Markets to proceed as long as the company satisfies the listing requirement. In particular, if the company only needs to file a registration statement under the Securities Exchange Act of 1934 (“Exchange Act”), such as a Form 10 or Form 8-A, Nasdaq will allow it to continue. Keep in mind a registration statement under the Exchange Act does not involve the offer or sale of any securities. However, if the up-listing involves an offering and the filing of a registration statement under the Securities Act, Nasdaq will review the application the same as a new IPO. That is, if the company has already cleared or substantially cleared comments, they may continue, if not, they will need to complete the SEC review process.

If a company is already listed on Nasdaq, they may proceed with a follow-on offering without SEC review.

Although the SEC is again operational, they will be backlogged, so presumably Nasdaq is still willing to proceed with certain companies without SEC action. Companies that have already filed a registration statement without the delaying amendment and with the appropriate Section 8(a) amendment will likely proceed. For those that had one or two unsubstantial comments left, they will need to assess which route will be the quickest, wait for the SEC to review the final comments or file a new fully completed registration using Section 8(a). Of course, Nasdaq may issue updated FAQ altering their position on accepting these applications.

Continued Shifting Capital Markets

The rise of decentralized platforms and imminent change in how the capital markets function as a whole and the role of intermediaries in the process has opened the market’s view to relying less on the SEC’s input in their disclosures. tZero is scheduled to launch its security token platform this week, introducing a new way in which securities, or fractional ownership interests in a company, can be bought and sold. tZero is starting with launching its own securities tokens on the platform but will soon open up to third-party companies and reportedly already has applications from over 60 companies. tZero may be the first to launch, but it will not be the only and soon we will have independent markets competing with Nasdaq and the NYSE. Moreover, the securities token markets will have sectors for private company markets and public company markets, blurring the current private equity silo with public trading.

Much more significantly, though, is that this is the first step in a retooling and complete change in how the clearing and settlement of securities functions (for more on the current clearing and settlement, see HERE and HERE). The new blockchain technology will allow for instantaneous clearing and settlement, a big change from the current t+2 and sometimes t+3 settlement of today (thus the name tZero). Notably, blockchain eliminates the need for a trusted intermediary, thus opening up the question as to the future role of DTC and its custodial arm, Cede & Co.

No regulator, the SEC or FINRA included, is ready for a complete disruption of the capital markets system, but they have been thinking about it for a while. FINRA published a report on the implications of blockchain for the securities industry back in January 2017 (see HERE). Furthermore, the SEC has reportedly told tZero, and presumably others following in their lead, that they will allow incremental changes in the market system.

This is a small concession considering that they will have no choice as the proverbial train has left the station. tZero is launching a joint venture with Boston Options Exchange, which is one of 12 SEC-listed security exchanges which together comprise the National Market System network. The joint venture seeks to launch a marketplace able to deal in both public securities and digital tokens. Nasdaq Financial Framework, a software company owned by the exchange, just closed a $20 million Series B funding round into Symbiont which is working to “give Nasdaq the ability to originate a financial instrument and the smart contract to custody it on a blockchain, to allow trading to occur with their matching engine, to allow surveillance to occur across the network using Nasdaq technology and then to perform settlement on a blockchain.”

Meanwhile, the SEC is clearly not against forgoing the comment and review process and relying on Section 8(a). As it was shutting down, the SEC posted an FAQ on its website reminding companies that they can proceed to rely on Section 8(a) to effectuate their registration statements, and even providing the exact language that needs to be included in order to accomplish this. In particular: “This registration statement shall hereafter become effective in accordance with the provisions of Section 8(a) of the Securities Act of 1933.” Even with the re-opening of the SEC, CorpFin will be exponentially backlogged compared to the time it was shutdown. It will be interesting to see how the SEC handles the workload – perhaps in addition to simply foregoing comments on many filings, the SEC will continue to support the use of 8(a) on others, especially follow-on offerings completed for a company that has had a full review in the last few years.

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Multiple Classes of Stock and the Public Company

Posted by Securities Attorney Laura Anthony | May 29, 2018 Tags: Classes of Stock, ETFs, Inc., IPO, Multiple Classes of Stock and the Public Company, NYSE, Public Company, Snap

In March 2017, Snap Inc. completed its IPO, selling only non-voting Class A common shares to the investing public and beginning an ongoing discussion of the viability and morality of multiple classes of stock in the public company setting. No other company has gone public with non-voting stock on a U.S. exchange. Although Facebook and Alphabet have dual-class stock structures, shareholders still have voting rights, even though insiders hold substantial control with super-voting preferred stock.

Snap’s stock price was $10.79 on May 7, 2018, well below is IPO opening price of $17.00. Certainly the decline has a lot to do with the company’s floundering app, Snapchat, which famously lost $1.3 billion in value when reality star Kylie Jenner tweeted that she no longer used the app, but the negativity associated with the share structure has made it difficult to attract institutional investors, especially those with a history of activism. Although there was a net increase of $8.8 million in institutional ownership in the company for the quarter ending March 2018, the approximate 20% total institutional ownership is below average for the Internet software/services industry and the increase in the quarter resulted from purchases by 2 institutions where 8 others decreased their holdings.

Moreover, many institutions, including pension funds, have holdings in Snap because they buy index funds, including ETFs, and Snap is in the S&P 500. The Council of Institutional Investors has even sent Snap a letter urging it to reconsider its share structure.

The discussion has gained regulatory attention as well. On February 15, 2018, SEC Commissioner Robert J. Jackson Jr. gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” in which he talked about the detriments of closely held perpetual control stock in a public company.

Days prior to Commissioner Jackson’s speech, Commissioner Kara Stein gave a speech at Stanford University about the role of corporate shareholders. Commissioner Stein posits that the relationship between a company and its shareholders should be mutual, including in areas involving cyber threats, board composition, shareholder activism and dual-class capital structures. Stein sees dual-class structures as purposefully disenfranchising shareholders and being inherently undemocratic.

Perhaps feeling the pressure, on May 2, 2018, Zynga founder Mark Pincus announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure. As a result of the conversion, Pincus’ voting power was reduced from 70% to 10%. His prior 10% economic stake remains unchanged.

SEC Commissioner Robert J. Jackson Jr.’s Speech: Perpetual Dual-Class Stock: The Case Against Corporate Royalty

On February 15, 2018, SEC Commissioner Robert J. Jackson Jr., gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” at the University of California, Berkley campus. Commissioner Jackson began the substantive portion of his speech with a summary background of a dual-class stock structure. I’ve supplemented his explanation with additional information.

Dual-class voting typically involves two more or more classes of stock, with one class having significantly more voting power than the others. The higher voting shares are often called “super-voting.” Typically, in a dual-class structure, the equity issued to the public is common equity with one vote per share and equity issued to insiders would be super-voting preferred stock. A company may also have other classes of preferred stock with various rights issued to different investors. Snap’s issuance of non-voting common stock to the public takes this structure one step further.

Historically, the NYSE did not allow companies to go public with dual-class voting structures. However, the takeover battles in the 1980s resulted in a change in the rules to allow for insider and management anti-takeover voting protection. Today, it is common for companies to go public with dual classes of voting stock. Public companies using dual-class are today worth more than $5 trillion, and more than 14% of the 133 companies that listed on U.S. exchanges in 2015 have dual-class voting. That compares with 12% of firms that listed on U.S. exchanges in 2014, and just 1% in 2005. Nearly half of the companies with dual-class shares give corporate insiders super-voting rights in perpetuity.

Commissioner Jackson acknowledges the reasons for a dual-class structure, and the desire by entrepreneurs and founders to go public while retaining control; however, he also quickly asserts that such a structure undermines accountability. Prior to accessing public markets, management control is beneficial in that it allows visionaries and entrepreneurs to innovate and disrupt industries without the short-term pressure of a loss of control over their efforts. However, perpetual outsized voting rights not only provide ultimate control to founders and entrepreneurs, but to their heirs as well, who may or may not be strong managers, entrepreneurs and visionaries.

Although many market players are recently strongly advocating for a change in rules to prohibit companies from going public with a dual-class structure, Commissioner Jackson advocates a change such that a dual-class structure has a time limit or expiration date. There may be benefits to management control for a period of time, but that benefit ultimately runs out after a company is public and certainly once the founding management retires, leaves, passes away or otherwise ceases their entrepreneurial run. He suggests that the exchanges propose amended rules in this regard.

Commissioner Jackson waxes philosophical pointing out the foundation of the United States origins, the Constitution and government structure, all of which are designed to allow for a change in regime and a vote by the masses. Even in public markets, power is not meant to continue in perpetuity, which is one of the reasons that the U.S. requires public companies to report and provide disclosure to investors and shareholders. Jackson likens perpetual super-voting stock as creating corporate royalty.

However, for the sake of the debate, I note that in the free market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate royalty would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.

In fact, Jackson continues his speech with analytics indicating that companies with super-voting insider control, do not perform as well as their counterparts. A recent study by Martijn Cremers, Beni Lauterbach, and Anete Pajuste entitled The Life-Cycle of Dual-Class Firms (Jan. 1, 2018) shows that the costs and benefits of dual-class structures change over time, with such companies trading at a premium shortly after the IPO, but decreasing over time.

Jackson’s staff studied 157 dual-class IPOs that occurred within the past 15 years. Of the 157 companies, 71 had sunset provisions or provisions that terminated the dual-class structure over time, and 86 gave insiders control forever. Whereas the companies traded relatively equally for the first few years, after seven years, those with a perpetual dual-class structure traded at a substantial discount to the others. Furthermore, when a company with a perpetual dual-class structure voluntarily eliminated the second control class, there was a significant increase in valuation.

As mentioned, institutional investors and market participants have vocally opposed dual-class structures for public companies. In December 2017, the Investor as Owner Subcommittee of the SEC’s Investor Advisory Committee published a report entitled Discussion Draft: Dual Class and Other Entrenching Governance Structures in Public Companies strongly opposing the structure. In addition to its letter to Snap, the Council of Institutional Investors has published a page on its website discussing and advocating for one-share equal voting rights for public companies.

Furthermore, the FTSE Russell index will now exclude all companies whose float is less than 5% of total voting power, the S&P Dow will now exclude all dual-class companies and the MSCI will reduce dual-class companies from its indexes. Commissioner Jackson is concerned that excluding dual-class stock companies from indexes does more harm than good. Many Main Street investors own public equities through funds or ETFs that in turn either own or mirror indexes. By removing dual-class companies from index funds, Main Street investors lose the opportunity to invest in these companies, some of which are the most innovative in the country today.

Commissioner Jackson’s suggestion of finding a middle ground whereby a company could complete an IPO with a dual-class structure and allow its visionaries to build without short-term shareholder pressure, but then limiting that sole control to a defined period, was met with praise and approval. Several market participants, including the SEC’s Investor Advisory Committee and the Council of Institutional Investors, made comments supporting the suggestion.

More on Preferred Equity

Although the topic of super-voting features in dual-class stock structures has been hotly debated recently, it is not the only feature that may be in preferred stock. Preferred stock is the most commonly used investment instrument due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. It can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:

Dividends – a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an issuer to pay a dividend is based on state corporate law, the majority of which require that the issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments;

– As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);

– Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;

– Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities;

Voting Rights – as discussed, preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes);
Liquidation Preferences – a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company issuer. Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset. In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;

– In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, preferred stockholder gets entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company issuer; or preferred stockholder gets entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference);

Conversion or exchange rights – a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

– Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000);

– Conversion rights are generally at the option of the stockholder, but the issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (the issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

– The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

– conversion rights usually specify whether they are in whole or in part and, for public companies, limits are often set (conversion limited such that cannot own more than 4.99% of outstanding common stock at time of conversion);

Redemption/put rights – a redemption right in the form of a put right is the right of the holder to require the issuer to redeem the preferred stock investment (to “put” the preferred stock back to the issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor;
Redemption/call rights – a redemption right in favor of the issuer is a call option (the issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA);
Anti-dilution protection – anti-dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation. Generally the issuer agrees to issue additional securities to the holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (the holder will never own below 10% of the total issued capital of the issuer);
Registration rights – registration rights refer to SEC registration rights and can include demand registration rights (the holder can demand that the issuer register their equity securities) or piggyback registration rights (if the issuer is registering other securities, it will include the holder’s securities as well);
Transfer restrictions – preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the issuer or other security holders, or both;
Co-sale or tag along rights – co-sale or tag-along rights are rights of holders to participate in certain sales of stock by management or other key stockholders;
Drag-along rights – drag-along rights are the rights of the holder to require certain management or other key stockholders to participate in a sale of stock by the holder;
Other non-financial covenants – preferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the board of directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; prohibitions against the sale of certain key assets or intellectual property rights; in essence non-financial covenants can be any rights that the preferred stockholder investor negotiates for.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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Going Public Without An IPO

Posted by Securities Attorney Laura Anthony | May 8, 2018 Tags: Going Public Without An IPO, Spotify

On April 3, 2018, Spotify made a big board splash by debuting on the NYSE without an IPO. Instead, Spotify filed a resale registration statement registering the securities already held by its existing shareholders. The process is referred to as a direct listing. As most of those shareholders had invested in Spotify in private offerings, they were rewarded with a true exit strategy and liquidity by becoming the company’s initial public float.

In order to complete the direct listing process, NYSE had to implement a rule change. NASDAQ already allows for direct listings, although it has historically been rarely used. To the contrary, a direct listing has often been used as a going public method on the OTC Markets and in the wake of Spotify, may gain in popularity on national exchanges as well.

As I will discuss below, there are some fundamental differences between the process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol up front and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol. For more on the 15c2-11 process, see HERE. Moreover, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A benefit to the company is that it has received funds much earlier in the process, rather than after a registration statement has cleared the SEC. The cost of completing an audit and legal fees associated with the registration process is expensive and is usually borne up front prior to receiving investor funds in a traditional IPO process.

Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering. One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees. For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.

The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Generally a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.

Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering.

Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace, a debate which has resulted in increased offering exemptions for non-accredited investors such as Regulation Crowdfunding, the fact remains that the early investors take on greater risk and as such need to be able to financially withstand that risk. For more on the accredited investor definition, see HERE.

The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.

Although Spotify’s shares increased in value since debuting on the NYSE, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option.

An overallotment option, often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing, is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.

A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).

Direct Listing on OTC Markets

There are some fundamental differences between the direct listing process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol upfront and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol. For more on the 15c2-11 process, see HERE.

When completing a direct listing onto OTC Markets, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

Overall the direct listing process is a little less expensive and little quicker than a direct IPO process. The reason for this is that the company can work with a market maker to apply for a trading symbol immediately upon effectiveness of the S-1 as opposed to having to wait until after an offering has been sold and closed out.

The following is a summary of the direct listing process for an OTC Markets listing. To begin, a company should retain its team including legal, accounting and auditor. The company will also need a transfer agent and EDGAR agent. Our firm often makes referrals and recommendations as to various other service providers. Moreover, a company may use a broker-dealer placement agent in the private offering phase.

Generally, counsel will prepare a full transaction checklist including who is responsible for what items from the beginning until completion of the direct listing. The beginning of the process includes gathering due diligence and completing any corporate cleanup or reorganization that may be necessary in advance of a public listing. All companies need some level of cleanup, which can include amending articles of incorporation and bylaws to make them public company-friendly; creating employee stock option plans; entering into employment contracts with key officers; ensuring that licensing agreements and intellectual property rights are secure; adding board members and committees such as an audit committee; and establishing corporate governance including an insider trading policy.

While the company’s accounting and auditing are being completed, legal counsel will complete corporate cleanup and begin to draft the private offering documents, if the company is completing a new private offering round (sometimes a company begins the process after several prior rounds of offerings and will not need to complete another). In addition, legal counsel, together with the investment bankers if any, and other advisors will work with the company to determine valuation and the best structure for the private offering and the registration statement pricing. The final registration statement pricing will not need to be determined until the final pre-effective amendment is filed with the SEC.

Ultimately a company will be registering common stock and that common stock will trade on the OTC Markets, but the private placement investment itself can take many forms, including convertible preferred stock, units consisting of current equity in the form of common and/or preferred stock and options or warrants, or units consisting of any combination of debt and equity. For more on the form of an investment and various options, see HERE. Furthermore, private offerings often include registration rights agreements to require the company to file a resale registration statement within a certain period of time.

In structuring the private offering(s) and subsequent resale registration statement, thought must be given to the public trading markets, including obtaining a trading symbol, qualifying for various tiers of OTC Markets, and hopefully, having an active trading market. Part of this process includes planning for the Form 211 Application, which will be filed by a market maker after effectiveness of the S-1 registration statement.

When reviewing a market maker’s Form 211 application for the issuance of a trading symbol, FINRA conducts an in-depth review of the company, its shareholders and capitalization. See HERE. One matter which FINRA reviews in determining whether to grant a trading symbol is “concentration of ownership.” FINRA will not grant a trading symbol unless there are enough non-affiliated shareholders holding freely tradeable shares, to establish a public float. Although there is no rule on this, my experience indicates that an initial float must be comprised of a minimum of 30 shareholders with more being better. FINRA will also consider the percentage of the company owned by these non-affiliated shareholders. Again, although there is no hard rule, in order to obtain a trading symbol, at least 20% or greater of the company’s common stock, on a fully diluted basis, should be in the hands of the public float.

Likewise, OTC Markets now considers concentration of ownership in determining whether to grant an application to trade on the OTCQB or OTCQX tiers. OTC Markets generally follows the same parameters as FINRA, though if other red flags or negative factors exist, such as recent shell company status, at least 25%-30% of the company common stock, on a fully diluted basis, will need to be in the hands of the public float in order to trade on these higher tiers.

Furthermore, counsel must be sure to assist with any blue sky compliance in the process. For more on blue sky compliance, see my two-part blog HERE and HERE.

Once all private offerings are completed and the company has its intended capital structure and number of shareholders, and the company audit is completed, the S-1 registration statement will be drafted and filed with the SEC. A company can choose to file confidentially but will need to make all filings public at least 15 days prior to the registration statements effectiveness. For more on confidential filings, see HERE.

Within 30 days of filing the S-1 registration statement, the company will receive initial comments from the SEC. The comment and review process will continue with the SEC for approximately 3-4 months, at which time the SEC will clear the S-1 to be declared effective. When a company is trading on a national exchange, they have generally timed the application with the exchange so that the shares begin trading shortly after the S-1 is declared effective and in particular, upon filing and effectiveness of a Form 8-A to complete the full registration process for the company. A Form 8-A is discussed further below.

In an OTC Markets listing, a Form 211 Application must be filed with FINRA to receive a ticker symbol and begin trading. The Form 211 is filed by a market maker. Generally, a company will begin to speak with a market maker shortly before the filing. The FINRA process will take a minimum of two weeks and can go on for several months. Preparation of an organized and complete file will make a big difference in the timing of the process.

Concurrent with the Form 211 process, the company will apply to OTC Markets and determine which tier it qualifies for. Once FINRA issues a ticker symbol, the company can trade; however, to gain liquidity the company will also need to obtain DTC eligibility. The market maker that assists with the Form 211 Application can submit the DTC application as well. The stockholders listed in the S-1 registration statement are free to sell their registered shares at the price registered with the SEC.

Direct Listing on NASDAQ

NASDAQ has allowed for a direct listing although historically it has rarely been used. The process to achieve a direct listing on NASDAQ is substantially the same as OTC Markets with some key differences. This section will only discuss the differences. The biggest difference is that when completing a direct listing onto an exchange, the exchange issues a trading symbol upon effectiveness of the registration statement and filing of an 8-A, and the shares are then available to be sold by the selling stockholders at prevailing market prices.

An S-1 registration statement is a registration statement filed under the Securities Act of 1933. In order to qualify to trade on a national exchange, a company must also be registered under the Securities Exchange Act of 1934. This is not a requirement for OTC Markets. A Form 8-A is a simple (generally 2-page) Exchange Act registration form used instead of a Form 10 for companies that have already filed the substantive Form 10 information with the SEC (generally through an S-1). When the Form 8-A is for registration with a national securities exchange under Section 12(b) of the Exchange Act, the 8-A becomes effective on the later of the day the 8-A if filed, the day the national exchange files a certification with the SEC confirming the listing, or the effective date of the S-1 registration statement.

Direct Listing on NYSE

An NYSE direct listing follows the same process on NASDAQ; however, previously NYSE rules required an underwriter to determine or at least sign off on valuation in connection with an initial public offering. On February 2, 2018, the SEC approved a proposed rule change by the NYSE to allow a company that had not previously been registered with the SEC and which is not being listed as part of an underwritten initial public offering, to apply for and if qualified, trade on the NYSE. The amended rules modify the provisions relating to qualification of companies listing without a prior Exchange Act registration in connection with an underwritten initial public offering and amend Exchange rules to address the opening procedures on the first day of trading of such securities.

The rule amendments modify the determination of market value such that the NYSE has discretion to determine that a company meets the minimum market value requirements for a listing based on an independent third-party valuation.

The Author

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