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THE INITIAL PUBLIC OFFERING Second Edition

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WILSON SONSINI GOODRICH & ROSATI

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008485 IPO Handbook cvr

THE INITIAL
PUBLIC OFFERING
A Guidebook for Executives and
Boards of Directors
Second Edition
>

PATRICK J. SCHULTHEIS
CHRISTIAN E. MONTEGUT
ROBERT G. OCONNOR
SHAWN J. LINDQUIST
J. RANDALL LEWIS
WILSON SONSINI GOODRICH & ROSATI, PROFESSIONAL CORPORATION

Print Date: June 8, 2004

This publication is designed to provide accurate and authoritative

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SECOND EDITION

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THE INITIAL PUBLIC OFFERING:

A GUIDEBOOK FOR EXECUTIVES
AND BOARDS OF DIRECTORS
Second Edition
Patrick J. Schultheis
Christian E. Montegut
Robert G. OConnor
Shawn J. Lindquist
J. Randall Lewis

2004, Patrick J. Schultheis, Christian E. Montegut, Robert G.

OConnor, Shawn J. Lindquist, and J. Randall Lewis. All or part of this
book has been or may be used in other materials published by the
authors or their colleagues at Wilson Sonsini Goodrich & Rosati. All
rights reserved. No part of this book may be reproduced or transmitted
in any form by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system,
without prior written permission.

About the Authors

WILSON SONSINI GOODRICH & ROSATI, PROFESSIONAL
CORPORATION is the premier legal advisor to technology and growth
business enterprises worldwide, as well as the investment banks and
venture capital firms that finance them. Over the last 5 years, the firm has
completed more than 350 public offerings, representing issuers and
underwriters in more public equity offerings in the U.S. than any other
law firm. Over the past four decades, Wilson Sonsini Goodrich & Rosati
has established its reputation by having unmatched knowledge of its
clients industries, as well as deep and long-standing contacts
throughout the technology sector. The firms legal expertise serves clients at
all stages of growth, from venture-backed start-up companies to multibillion dollar global enterprises. The firms clients include some of the
most recognized names in the technology, retail, life sciences, venture
capital and finance sectors. The firms broad range of services and legal
disciplines are focused on serving the principal challenges faced by management and the board of directors of the business enterprise. The firm
is nationally recognized as a leader in corporate governance, public and
private offerings of equity and debt securities, mergers and acquisitions, securities class action litigation, intellectual property litigation,
joint ventures and strategic alliances, and technology licensing and other
intellectual property transactions. The firm, which is headquartered in
Palo Alto, has offices in Austin, New York City, Reston, Salt Lake City,
San Diego, San Francisco and Seattle. For more information about Wilson
Sonsini Goodrich & Rosati, please visit the firms web site at
www.wsgr.com.
PATRICK J. SCHULTHEIS is a Partner at Wilson Sonsini Goodrich
& Rosati. Mr. Schultheiss practice focuses on the corporate representation of emerging growth companies, underwriters and investors.
Mr. Schultheis joined the firm in 1989, and he has practiced at the firm
since that time. Mr. Schultheis is the Managing Partner of the Seattle
office. Mr. Schultheis represents a range of technology, life sciences and
other emerging growth companies. These companies range from startups to large public companies. In addition, Mr. Schultheis regularly
represents underwriters and venture capital investors. Mr. Schultheis has
extensive transactional experience in public offerings, mergers and acquisitions and private financings. Mr. Schultheis received his A.B. in History

(with distinction and departmental honors) from Stanford University

and his J.D. from the University of Chicago. Mr. Schultheis is admitted
to practice in Washington and California.
CHRISTIAN E. MONTEGUT is a Partner at Wilson Sonsini
Goodrich & Rosati. Mr. Monteguts practice focuses on corporate and
securities matters for emerging growth companies and venture capital
firms. Mr. Montegut has broad experience in the following areas: technology company startup issues; venture capital transactions, representing both companies and venture capitalists; public offerings, including
initial public offerings and follow-on offerings, representing both issuers
and underwriters; and mergers and acquisitions transactions, including
representing public and private companies. Mr. Montegut represents
companies on an ongoing basis in both Washington and Silicon Valley.
He enjoys working with entrepreneurs in turning exciting technology
ideas into great companies. Mr. Montegut joined the firms Seattle,
Washington office in December of 1999, after practicing in the firms Palo
Alto, California office. Mr. Montegut received his B.A. in economics from
Yale University and his J.D. from New York University School of Law.
Mr. Montegut is admitted to practice in California, Connecticut and Washington.
ROBERT G. OCONNOR is a Partner at Wilson Sonsini Goodrich &
Rosati. Mr. OConnors practice focuses on advising technology, life
sciences and emerging growth companies in organizing and capitalizing
businesses, raising capital through private and public debt and equity
financings, and buying and selling companies and technologies. Mr.
OConnor is the Managing Partner of the Salt Lake City office. Mr.
OConnor has extensive transactional experience in representing companies and underwriters in public offerings, mergers and acquisitions and
private financings. Mr. OConnor is a regular speaker on capital raising
strategies, including at VentureOne Summit and the Ernst & Young IPO
Value Journey Retreat for CEOs. Mr. OConnor received his B.A. in economics and history from the University of California at Los Angeles and
his J.D. from Loyola Law School. Mr. OConnor is admitted to practice in
Utah and California.

ii

SHAWN J. LINDQUIST is a corporate and securities attorney with

Wilson Sonsini Goodrich & Rosati. His principal experience has been in
public offerings of securities, corporate governance, mergers and acquisitions and private equity and debt financings. Mr. Lindquist began his
career in the firms Palo Alto, California office, and he was a member of
the team that established the firms first regional office in Seattle, Washington and later a member of the team that established the firms Salt
Lake City, Utah office. He has also served as Vice President and General
Counsel of a venture-backed company and as an attorney in the legal
department of Novell, Inc., and he is currently an Adjunct Professor of
Law at The J. Reuben Clark Law School at Brigham Young University
(BYU). Mr. Lindquist received his B.S. in Business Management-Finance
from BYU, where he also participated in the NCAA Mens Basketball
Tournament. He received his J.D. from The J. Reuben Clark Law School
at BYU, where he was a member of the Law Review and the Moot Court.
He is the author of U.S. v. O'Hagan: The Eighth Circuit Throws the Second
Strike to the Misappropriation Theory of Rule 10b-5 Liability, 1997 BYU L. Rev.
197. He is admitted to practice in Utah, Washington and California.
J. RANDALL LEWIS is a corporate and securities attorney with
Wilson Sonsini Goodrich & Rosati. His practice includes all aspects of
public and private company representation. Throughout his career
Mr. Lewis has represented a broad range of emerging growth and technology companies in many sectors, including software, Internet, life
sciences and Internet infrastructure. Mr. Lewis has extensive experience
representing clients in connection with public offerings, private placements and mergers and acquisition and corporate governance. Mr. Lewis
received his B.S. from Boston University and his J.D. from the University of Chicago. Mr. Lewis is admitted to practice in Utah and California.

iii

Acknowledgements
There are numerous current and former partners, associates and
other colleagues who contributed to this edition of The Initial Public Offering, by contributing to our collective education as to how to conduct a
successful initial public offering, by reviewing and contributing to the
text of this edition, or a combination of both. While the individuals who
fall within those categories are too numerous to mention, we would specifically like to thank the following: current colleagues Larry W. Sonsini,
Jeffrey D. Saper, Donna M. Petkanics, Donald E. Bradley, Mark A.
Bertelsen, Steven E. Bochner, Ann Yvonne Walker, John A. Fore,
Douglas H. Collom, Martin W. Korman, Katherine A. Martin, Nora L.
Gibson, David J. Segre, Jose F. Macias, Douglas J. Clark, Matthew W.
Sonsini, Eric J. Finseth, J. Robert Suffoletta, Robert G. Day, Mark Bonham, Karen A. Dempsey, Raj. S. Judge, Kurt J. Berney, Craig D. Norris,
Rafik A. Bawa, Margo M. Eakin, Donald S. Harrison, Matthew G. Wells,
Jason K. Robertson, C. Christopher Shoff and David J. McCraigh;
former colleagues Alan K. Austin, Barry E. Taylor, Howard S. Zeprun,
Harry K. Plant, Priya Cherian Huskins (particularly with respect to
Chapter 4), Julie Bell and Jonathan Golightly; and Craig H. Christensen. We also wish to acknowledge the dozens of attorneys who contributed hundreds of hours to the WSGR Knowledge Management
library, which was invaluable in connection with the preparation of this
edition of The Initial Public Offering.
Our former colleagues, Gail Clayton Husick and J. Michael
Arrington, wrote the first edition of this guidebook, which was published in 1998. We acknowledge and thank Gail and Michael for establishing the basic framework of this guidebook, as well as for setting a
standard of excellence that challenged us as we sought to write a book
that addressed a business, financial and legal landscape that changed
dramatically between 1998 and 2004. We only hope that this edition
approaches the quality of theirs.
We wish to specifically acknowledge Melissa M. Pierkowski and the
Corporate Finance Institute and thank them for providing valuable data
and other information included in this edition. We also thank Nancy Jean
Fulop Short and Paul Martini and the entire Bowne team, for encouraging
us to write the second edition, as well as for giving us the opportunity to
work with Bowne.
Finally, we thank our families, who certainly felt the effect of the
days, nights and weekends we spent writing this second edition.
v

Since the first edition of this guidebook was published in 1998, there
have been numerous changes to the securities laws and the listing standards of the New York Stock Exchange and The Nasdaq Stock Market, as
well as changes in the U.S. equity markets, affecting the initial public
offering process and the post-offering requirements of a public company.
Additionally, the Sarbanes-Oxley Act of 2002 has resulted in significant
changes to the federal regulation of public company corporate governance and reporting obligations. The Sarbanes-Oxley Act has precipitated a volume and pace of new rulemaking that has fundamentally
changed the standards for accountability of directors and officers of public
companies and the auditors, securities analysts and counsel working
with them. In the face of these changes, our goal with this second edition
has been to present the current state of rulemaking from the SEC, the
NYSE, the NASD and NASDAQ and, where appropriate, anticipate and
present proposed rules. We do expect that rulemaking will continue and
we will seek to update this guidebook regularly.

The Authors welcome your comments and suggestions via email:

Patrick J. Schultheis:
Christian E. Montegut:
Robert G. OConnor:
Shawn J. Lindquist:
J. Randall Lewis:

[email protected]
[email protected]
[email protected]
[email protected]
[email protected]

PLEASE READ THIS DISCLAIMER: This book is intended to provide

a general, informational overview to non-lawyers and is not intended to
provide legal advice as to any particular situation. The laws, regulations
and other rules applicable to publicly traded companies and to the initial
public offering process are complex and subject to frequent change.
Experienced securities counsel should be involved in the planning, preparation and execution of any public offering of securities. The views
expressed in this book are those of the authors only and do not necessarily reflect the views of Wilson Sonsini Goodrich & Rosati, Professional
Corporation.

vi

TABLE OF CONTENTS
Chapter 1: Deciding to Go Public. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Brief Overview of the Legal Framework Governing
the IPO Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Burdens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Is the Company Ready?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Now or Later? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Chapter 2: Assembling Your IPO Team. . . . . . . . . . . . . . . . . . . . . . . . . . . 23
The Companys Management Team . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
The Companys Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
The Managing Underwriters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
The Companys Legal Counsel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
The Underwriters Legal Counsel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
The Companys Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
The Companys Financial Printer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Special Experts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Chapter 3: Gearing Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Chapter 4: D&O Liability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
The Need for D&O Liability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . 81
Outline of a D&O Insurance Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Selecting the Right Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
The Insurance Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Chapter 5: Managing Publicity during the Offering Process . . . . . . . . 89
The Pre-Filing Period; Gun Jumping Concerns . . . . . . . . . . . . . . . . . . 89
The Waiting Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
The Post-Effective Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Chapter 6: Hosting the Organizational Meeting and Management
Presentations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Agenda for the Organizational Meeting . . . . . . . . . . . . . . . . . . . . . . . 103
Management Presentations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Chapter 7: Potential Liability and the Role of Due Diligence . . . . . . 111
Potential Liability for Violations of Federal Securities Law. . . . . . . 111
What is Due Diligence? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
What is the "Due Diligence Defense"?. . . . . . . . . . . . . . . . . . . . . . . . . 115

vii

Why is Due Diligence Important to the Company,

the Board of Directors and Management? . . . . . . . . . . . . . . . . . . . . 116
Why is Due Diligence Important to the Underwriters? . . . . . . . . . . 117
Whats the Standard? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
Examples of Bad Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Examples of Good Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . .122
Different Diligence Standards for Different Participants . . . . . . . . .126
The Use of Experts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128
Chapter 8: Preparing the Registration Statement and
Going Effective. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133
Timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133
The Drafting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133
Contents of the Registration Statement. . . . . . . . . . . . . . . . . . . . . . . .135
A Word about Words: Plain English Disclosure . . . . . . . . . . . . . . . .146
Filing the Registration Statement with the SEC. . . . . . . . . . . . . . . . .147
Filing Exhibits with the SEC and Requesting Confidential
Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148
Exchange Act Registration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150
SEC Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151
Exchange Listing or Nasdaq Quotation (or Both) . . . . . . . . . . . . . . . 153
Going Effective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Post-Effective Matters and the Closing . . . . . . . . . . . . . . . . . . . . . . . . 156
Chapter 9: Underwriting Arrangements and Marketing . . . . . . . . . . 159
The Underwriting Fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
NASD Review of Underwriting Arrangements. . . . . . . . . . . . . . . . . 159
The Underwriting Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
The Comfort Letter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Other Underwriting Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Selling Stockholder Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Recent Reforms to IPO Allocation and Distributions Process . . . . . 173
The Changed Role of Research Analysts in the IPO Process
- Analyst Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Online Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
Dutch Auction Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
The Road Show . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
Pricing the IPO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Chapter 10: Now that Youre Public... . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
Managing Relations with Wall Street . . . . . . . . . . . . . . . . . . . . . . . . . 189

viii

Periodic Reporting and the Disclosure Obligations of

a Public Company and its Stockholders . . . . . . . . . . . . . . . . . . . . . 199
Resales of Restricted Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Section 16 and Insider Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Additional Reporting Requirements for Certain Stockholders . . . . 214
Chapter 11: Special Considerations for Non-U.S. Companies . . . . . . 217
Foreign Private Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Mechanics of the Public Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Financial Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Ongoing Reporting Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Corporate Governance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
Exemptions from Certain Provisions of the Exchange Act . . . . . . . 223

Appendices
Appendix A - The Listing Requirements of the NYSE and
the Nasdaq National Market. . . . . . . . . . . . . . . . . . . . . . . A-1
Appendix B - Sample Due Diligence Checklist. . . . . . . . . . . . . . . . . . . . B-1
Appendix C - Sample IPO Timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C-1
Appendix D - Sample Compliance Calendar. . . . . . . . . . . . . . . . . . . . . . D-1
Appendix E - Summary of Selected SEC Rules Adopted
in Response to the Sarbanes-Oxley Act of 2002 . . . . . . . E-1
Appendix F - Sample Plain English Comments from the SEC . . . . . . . F-1

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .G-1

ix

Chapter 1
Deciding to Go Public
What does it really mean to go public? Quite simply, going public
refers to the process of registering shares of a companys stock with the
U.S. Securities and Exchange Commission, or SEC, and offering the stock
for sale to the public for the first time. This is called the initial public offering, or IPO. The process of going public and the consequences of being
public, however, are anything but simple.

Brief Overview of the Legal Framework Governing the IPO

Process
The Securities Act of 1933
In General
The offer and sale of securities in the U.S. is governed at the federal
level by the Securities Act of 1933. The Securities Act has two basic
objectives:
require delivery to investors of financial and other significant
information concerning securities being offered for public sale;
and
prohibit deceit, misrepresentations and other fraud in the sale of
securities.
A primary means of accomplishing these objectives is requiring issuers of
securities to disclose important and accurate business and financial information through the registration of securities offerings.
Registration Requirements of Section 5
Section 5 of the Securities Act requires an issuer to use the registration
process for all offers and sales of its securities unless it can find an exemption under Section 3 or Section 4 of the Act. The registration process
requires an issuer to file a registration statement (generally on Form S-1)
covering the securities to be sold in the transaction before any offers are
made. The SEC must declare the registration statement effective before
any sales by the issuer can be made.

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

The Registration Process-The Pre-Filing, Waiting and Post-Effective Periods

The registration process is basically divided into three periods: (1) the
pre-filing period; (2) the waiting period; and (3) the post-effective period.
The three registration periods are discussed in greater detail in Chapter 5.
Exactly when the pre-filing period begins is not always clear; however, an issuer should consider itself as being in registration once it has
reached an understanding with the investment banking firm that is to act
as managing underwriter. The pre-filing period ends when the issuer files
a registration statement with the SEC. A common misconception is that
this period begins with the IPO organizational meeting. Typically, the
issuer has reached an understanding with the managing underwriters to
proceed with the IPO in advance of the actual date of the organizational
meeting. In general, during the pre-filing period, no offers may be
made, prospective purchasers cannot be contacted and underwriters may
not be publicly disclosed. Chapter 5 provides greater detail with respect
to what constitutes an offer for purposes of the Securities Act.
The waiting period begins when the issuer files a registration statement with the SEC and ends when the registration statement is declared
effective. During this period, offers are permitted so long as they are made
orally or by using a preliminary prospectus (commonly referred to as the
red herring). Indications of interest are allowed, but sales are prohibited. In addition, the issuer must be careful that nothing in writing
(including press releases and content posted on the issuers web site) is
construed as an illegal prospectus.
The post-effective period begins when the registration statement is
declared effective and ends when broker-dealers are no longer required to
deliver a prospectus by the Securities Act. During this period, sales are
permitted and certain communications, such as sales material or literature
(commonly referred to as free writing), are allowed and not deemed an
illegal prospectus if accompanied or preceded by a final prospectus.
The Securities and Exchange Commission and Its Role in the IPO Process
The U.S. Congress established the SEC to administer and enforce the
federal securities laws. The SEC is empowered to interpret and enforce the
federal securities laws and to propose and amend rules and regulations to
address changing market conditions.

Chapter 1 - Deciding to Go Public

The SECs role in the IPO process is to ensure that the company provides investors with the information considered necessary to enable
investors to make informed decisions about whether to purchase the companys securities.
Public offerings of securities must be made pursuant to an effective
registration statement. All companies, both domestic and foreign, must
file their registration statements electronically via the SECs EDGAR
system. The companys registration statement is then subject to examination by the SECs Division of Corporation Finance, which reviews it for
compliance with disclosure requirements. To meet the SECs requirements for disclosure, a company issuing securities must make available all
information, whether that information reflects positively or negatively on
the company, that might be deemed material and relevant to an investors
decision to buy, sell or hold the security. The registration process is discussed in greater detail in Chapter 8.
State Securities Regulation
The offer and sale of securities in the U.S. is also regulated at the state
level by each states securities laws, which are commonly referred to as
Blue Sky laws. State Blue Sky administrators typically assess not only
the sufficiency of disclosure but also the fairness of the offering. However,
the U.S. Congress enacted the National Securities Markets Improvement
Act of 1996 (NSMIA) to specifically preclude the various states from
requiring the registration of certain covered securities, which include
nationally traded securities, or securities listed or authorized for listing on
the New York Stock Exchange (NYSE) or the American Stock Exchange
(Amex) or included or qualified for inclusion on the Nasdaq National
Market. In other words, the Blue Sky requirements generally will be relevant only with respect to those companies whose securities will not be
listed on those stock exchanges or the Nasdaq National Market (for example, companies whose securities will be traded on the Nasdaq SmallCap
Market).
Self-Regulatory Organizations (SROs) and Their Role in the IPO Process
A company must also comply with applicable rules and regulations
of certain self-regulatory organizations (referred to as SROs), which
include the NYSE, the National Association of Securities Dealers (NASD),

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

and Amex, among others. The SROs require that certain listing requirements be met before listing is approved on the exchange, or included or
qualified for inclusion on the Nasdaq Stock Market.
Not every company is a candidate to list on the NYSE or the Nasdaq
National Market. The NYSE and the Nasdaq, in particular, maintain stringent quantitative and qualitative standards for their listed companies. If a
company is unable to comply with these standards, it will not qualify to
list. If a listed company falls below these standards, it is delisted. The
listing requirements for the NYSE and the Nasdaq National Market are set
forth on Appendix A.

Benefits
There are several benefits to going public, which include the
following:
Cash
A successful IPO can generate significant proceeds for a company,
and the infusion of cash offers a company an opportunity to accelerate
growth by hiring more people, building more infrastructure, conducting
more research and development and delivering more products and services. And unlike debt, there are no payments of interest or principal that
must be made.
Public offerings can range from $10 million or less to $1 billion or
more. Of the 278 IPOs, completed from the beginning of 2001 through the
end of 2003, the average deal size was approximately $316 million and the
median size was approximately $106 million.*
Liquidity for employees
Many companies, particularly technology and life sciences companies, provide incentives to employees through the use of stock options.
Underlying this benefit is the hope that someday the company will go
public (or experience some other liquidity event, such as a sale of the company) that will enable the employees to realize the appreciation in the
value of the underlying stock. Liquidity for employees generally will not
be simultaneous with effectiveness of the IPO because the companys
underwriters will insist that employees observe a lock-up, typically for
* Source: 2004 Corporate Finance Institute.

Chapter 1 - Deciding to Go Public

180 days, following the companys IPO. After the lock-up is removed,
additional restrictions under the securities laws and under the companys
insider trading policy may continue to limit the opportunities for employees, and particularly executive officers, to sell shares of the companys
stock. Nevertheless, one of the significant benefits of an IPO is the fact that
it creates a public market for the companys stock that eventually will
result in liquidity for the companys employees. The Company can use its
stock option and employee stock purchase plans to increase employee
commitment and recruiting power.
Companies that are considering going public, however, should be
aware that the landscape for the use of stock options and other forms of
equity compensation for executives and employees is undergoing significant change. Perceived excess levels of executive compensation, in
particular equity-based compensation, in the wake of the Enron debacle
and the burst of the so-called Internet bubble has led to enhanced scrutiny,
and a general negative perception, of the broad use of stock options and
other equity compensation programs. This sentiment is reflected not only
in increased rulemaking by the SEC, the NYSE and the NASD (discussed
below), but also through stockholder advocacy groups, such as Institutional Shareholder Services, which are actively recommending to their
institutional clients no votes with respect to equity compensation plans
which they determine to be too generous to executives and too dilutive to
existing stockholders. Moreover, the Financial Accounting Standards
Board has recently issued pronouncements that may result in mandatory
expensing of equity compensation. Companies should consult with
counsel in advance of the IPO process to understand the recent developments affecting equity compensation and how they will impact the way in
which companies will be able to compensate their employees once they
are public.
Liquidity for investors
Many investors in private companies invest with a view to earning a
sizable return upon a liquidity event. An IPO is one such event. A public
market for a companys stock provides an opportunity for investors to
realize appreciation in the value of their investment that is typically much
more difficult to monetize while a company is private. For example, even
if a private companys stock may be sold, the illiquid nature of private

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

company stock generally results in a discount on its valuation. Thus, the

IPO allows the investors to realize more of the accrued appreciation than
they otherwise would.
The exact timing of this liquidity depends upon a variety of factors. If
an investor has contractual registration rights entitling the investor to
include its shares in the IPO, or is otherwise permitted to participate in the
IPO as a selling stockholder, liquidity can be immediate. If an investors
shares are not included in the offering, and are subject to a lock-up restriction or are subject to holding period requirements under the federal
securities laws, liquidity may be delayed. Nevertheless, a public companys stock is generally more liquid than that of a private company.
Creation of a currency that can be used for acquisitions
Once a liquid market exists for a companys stock, the stock may be just
as valuable as cash for acquiring other businesses. In fact, it may be better.
Under certain circumstances, a stock-for-stock acquisition is eligible for
favorable tax treatment that is unavailable in the case of a cash acquisition.
Also, stock provides an acquisition currency that enables the target
company stockholders to participate in the anticipated upside of the combined company (and share in the risks related to those anticipated future
results), without having to monetize future potential benefits at the time
of closing the acquisition. It is important to note, however, that shares
issued by a company in connection with an acquisition are not automatically freely tradeable just because the company is public. If the specific
shares issued in the acquisition are not registered with the SEC, the shares
will be restricted stock under the securities laws, and the resale will need
to be registered or benefit from a specific exemption from registration.
Access to the public market for future financings
A company that has completed its initial public offering may return
to the public market to raise additional cash in follow-on offerings. A
follow-on offering often can be completed in a significantly shorter time
frame than an initial public offering. This is due in part to the fact that a
company that is already public has relationships with underwriters who
are familiar with its business, an established valuation, and a following
among analysts and investors who understand the companys business
and market.

Chapter 1 - Deciding to Go Public

A registration statement on Form S-1 is generally used for an IPO. A

company that has been public for at least 12 months and that meets certain
other requirements is eligible to register shares for a follow-on offering on
an abbreviated form of registration statement, known as Form S-3. The
Form S-3 allows the company to incorporate large amounts of information
by reference from documents previously filed with the SEC, such as the
companys recent Form 10-K and Form 10-Q filings. Using this abbreviated form significantly reduces the burden and cost of the drafting process
for a follow-on offering as compared to the drafting process for an IPO
(unless the company and the underwriters choose to include IPO-level
disclosure for marketing reasons). Even if the short-form registration
statement may not be used (for example, if the IPO was within 12 months
prior to the follow-on offering), significant efficiencies can be obtained by
being able to leverage the drafting in the IPO prospectus and subsequent
public reporting filings.
While the SEC reviews and comments on IPO registration statements
almost without exception, it sometimes chooses not to review and
comment on a registration statement for a follow-on offering, and generally does not if it has recently reviewed another filing of the same
company. Whether or not the SEC reviews the registration statement used
by a company for a follow-on public offering is entirely within the SECs
discretion. Should a company be lucky enough to receive no review from
the SEC, it can reduce the offering timetable by another five or six weeks.
In recent years, companies have increasingly used shelf registrations
as a means to raise capital in the public markets opportunistically during
perceived narrow market windows. In fact, in 2003, nearly 63% of all
equity follow-on public offerings were undertaken through the use of a
shelf registration statement. In effect, a shelf registration enables a
company which is eligible to use Form S-3 to register securities, both
equity and debt, that it does not intend to presently offer to the market.
Once effective, a company is in a position to access the markets rapidly
through a take-down of securities from the shelf and issue such securities
in a public offering without the delays and uncertainties of an SEC review
process. By way of example, it is not uncommon in the context of followon offerings involving the use of a shelf registration statement for the
offering process, from organizational meeting through pricing, to be completed in one week or less.

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Shelf registrations, however, are not without their drawbacks, principal among them being that institutional shareholders may disfavor their
use, and the perceived overhang of the securities available through the
shelf registration statement may have a depressant affect on the company's stock price. Moreover, companies should consult with counsel
early in the shelf registration process to map out a strategy for effective
due diligence in the face of offerings completed in such compressed time
frames.
Public companies are also in a better position to consider debt financing. The transparency that comes from the public reporting requirements
applicable to public companies makes them more attractive candidates for
lending, all other things being equal. Also, the cash proceeds of an IPO
make for a stronger balance sheet, which can make debt financing easier
to obtain on more favorable terms. Convertible debt financing transactions are made possible by having liquid common stock with a readily
ascertainable market value into which the convertible bonds can convert.
Enhancement of the companys stature, perceived stability and competitive position
An important consideration for many companies contemplating an
IPO is the effect that being public will have on the companys stature, perceived stability and competitive position. Private companies often face
sales resistance from potential customers who have doubts about the companys staying power. For some companies, an IPOs effect on credibility
with customers is even more important than the cash generated by the
offering. Suppliers and lenders may perceive a company to be a better
credit risk after its IPO, and therefore may be more inclined to extend
favorable terms to the company. In addition, the public offering process
itself may generate publicity that raises the companys profile with potential customers. For example, newspapers and magazines may be more
likely to cover public companies than private ones. The perceived stature
and stability that accrues to public companies may also be an advantage
in attracting top tier management talent to the organization.

Chapter 1 - Deciding to Go Public

Enhancement of the companys market value

While a company is private, investors typically apply a significant
liquidity discount in determining the price they are willing to pay for the
companys stock. A successful public offering will eliminate this penalty
for illiquidity. A successful public offering also will expose the company
to a broad base of investors who might otherwise be unaware of the
company or not suited for an investment in a private company, thereby
increasing demand for the companys stock.

Burdens
Going public has its disadvantages, too. Some of the burdens of the
public offering process and of being a public company include the
following:
Distraction of management from the operations of the company
One of the greatest frustrations expressed by executives of companies
going through the offering process is that they just cant seem to get anything else done. The offering process typically takes three to five months
and consists of many time-consuming tasks that cannot be delegated.
Investment bankers must be selected. Due diligence presentations must
be made. Drafting sessions, which can range from a few hours to multiday marathons, must be attended. SEC comments regarding disclosure
and other items in the registration statement must be addressed and
resolved. The offering process culminates with a road show, which typically consists of a multi-week, round-the-clock, national (and sometimes
international) investor presentation tour for the CEO and CFO.
Restrictions on publicity and other marketing activities
The federal securities laws restrict the manner in which stock can be
offered to the public, and any publicity that could be construed as hyping
or conditioning the market for a companys stock could cause the SEC to
impose a cooling off period to delay the companys offering. These
restrictions are discussed in greater detail in Chapter 5. Companies often
must make difficult decisions about curtailing certain marketing and
public relations activities during the offering process.

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Additionally, following the IPO, all publicity must be monitored with

an eye toward securities law requirements and potential liability. Public
statements made by company officials regarding the companys business
may result in securities fraud liability. For example, prior to an IPO, a CEO
may have few concerns about making public statements regarding the
future financial performance of the company, but as a public company all
such statements carry potential risk. There are also SEC rules relating to
selective disclosure and Nasdaq and NYSE rules requiring public disclosure of certain events, as well as other disclosure requirements and
restrictions. These rules are discussed in greater detail in Chapter 10. A
new public company should work closely with its counsel to determine
what the rules are, and put in place appropriate control structures to
ensure that inadvertent violations do not occur.
Compliance with SEC disclosure and reporting requirements, the
Sarbanes-Oxley Act of 2002 and recently adopted corporate governance
listing requirements
Once a company goes public, it becomes subject to a host of SEC rules
and regulations, including the SECs periodic reporting requirements and
Regulation FD (which is discussed in Chapter 10). For example, public
companies are required to file quarterly reports on Form 10-Q, annual
reports on Form 10-K, current reports on Form 8-K to announce certain
major events, and proxy statements in connection with their meetings of
stockholders. Preparation of these documents will consume a significant
amount of time of company personnel, particularly the CFO and his or her
staff. In addition, company insiders and large stockholders will become
subject to the reporting requirements of Section 13 or Section 16 of the
Exchange Act and will require the assistance of counsel in order to comply
with these requirements.
The rules affecting IPOs and public companies in general are changing, particularly since the enactment of the Sarbanes-Oxley Act in July
2002. The SEC, the NYSE, the NASD and the Nasdaq Stock Market have
issued new and amended rules (and listing standards) that affect public
companies and the manner in which they govern themselves and make
disclosures to their stockholders and the investment community at large.

10

Chapter 1 - Deciding to Go Public

These rules, among a variety of other matters, address the composition

and responsibilities of a companys board of directors and board committees; impose new and more stringent standards of independence on
directors and auditors; require new disclosures regarding a companys
director nominating committee and nomination process; require the
company to maintain formal disclosure controls and procedures; and
mandate CEO and CFO certifications as to the accuracy of financial statements filed with the SEC. A public companys ability to comply with these
new rules and regulations, as well as the periodic reporting requirements
and the other public company burdens, will come at a cost both in time
and money. Accordingly, a company should plan on spending more to
beef up in-house accounting and compliance staffs, more on nonemployee directors fees, more for directors and officers liability insurance
and more for fees of counsel, auditors and financial printers.
Perhaps the most significant impact of the Sarbanes-Oxley Act, and
the rulemaking that followed, are the changes it has brought in board
dynamics and the relationship between the board and its management
team. In the post-Sarbanes-Oxley world, many boards of directors have
tended to become watchdogs of management, as opposed to being partners with management, and CEOs and boards alike should be realistic in
assessing how being a public company will affect the social and cultural
aspects of the oversight and management of the company.
Reduced flexibility in corporate affairs
While a company is private and relatively closely held, many aspects
of corporate governance are conducted informally. Annual stockholders meetings may or may not actually be held on an annual basis. Board
and stockholder actions frequently are taken by written consent on short
notice. Stockholder communications may consist of nothing more than an
occasional letter from the president and periodic financial statements,
which may or may not be audited. Individual executive compensation
arrangements need not be disclosed to the companys stockholders or
other employees. Arrangements between the company and its customers
or strategic business partners can be kept secret. Company management
may discuss the companys prospects with selected stockholders and
others without restriction. Perhaps most importantly, company management can make long-term strategic decisions without worrying about
short-term effects on stock price.

11

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Once a company goes public, it becomes subject to extensive new

regulations and important strategic decisions are made under intense
public scrutiny. Periodic reports containing specified financial information, along with certifications made by the companys CEO and CFO
regarding the accuracy and completeness of such information, must be
publicly filed by legally imposed deadlines. Independent directors must
approve director nominations and executive officer compensation. Stockholders meetings must be held annually, and solicitations of stockholder
proxies may be made only by means of proxy statements that contain
specified information and that are filed with the SEC. Stockholder
approval may be required to adopt or materially amend employee stock
option or purchase plans and in connection with transactions (other than
public offerings) involving the sale, issuance or potential issuance of 20%
of more of the companys common stock. Compensation arrangements for
top management must be approved by independent directors and be publicly disclosed in detail. Certain management employment agreements
must be publicly filed as exhibits to SEC filings. Transactions in the companys stock by company insiders must be publicly disclosed and may
trigger insider trading liability claims. Important contracts with customers and others may be required to be publicly filed with the SEC for all the
world, including the companys competitors, to see (with very limited
confidential treatment for sensitive financial or trade secret terms). Casual
comments by company officials may lead to claims of selective disclosure
and insider trading. Strategic decisions which have a negative effect on
short-term financial results may be disfavored by investors and depress
the companys stock price.

12

Chapter 1 - Deciding to Go Public

Practical Tip: Consider Timing and Disclosure Impact

of Potential Acquisitions
A privately held company generally has no obligation to publicly disclose plans that it may have to acquire another business.
However, if a company is engaged in material acquisition discussions at the same time that it is engaged in the public offering registration process, the SEC may require the company to provide
detailed disclosure about the proposed transaction in the prospectus,
and may even require the inclusion of extensive pro forma financial
information to be included in the prospectus. As a result, the company may be forced to choose between premature disclosure of sensitive acquisition negotiations and delay of its public offering.
Company counsel should be consulted as early as possible if the
company is considering any acquisition activities near the time of
its IPO.
Depending on the size of the acquisition, financial statements
of the target may be required to be included in the prospectus for
the acquirers IPO. Preparation of these financial statements may
require significant time, expense and effort, and could impact the
timing of the IPO process. Also, the acquisition agreement may
need to be publicly filed as an exhibit to the IPO registration statement. If this is the case, care should be taken to ensure that sensitive
confidential information is not included in the agreement. Care
should also be taken to evaluate with the underwriters how the
accounting for the acquisition will impact the acquirers operating
results in the first few quarters following the IPO, and how that is
likely to be perceived by Wall Street and reflected in the companys
stock price.roExposure to class action securities litigation
Public companies also face increased exposure to lawsuits for securities fraud. Typically, these suits arise when a company has made a major
announcement that surprises the market (for example, financial results
that fall significantly short of expectations or the loss of a major contract)

13

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

and the stock price drops. Certain law firms specialize in bringing these
suits on behalf of the entire class of investors who traded in the companys
stock during the period leading up to the announcement of bad news. Any
recent public offering of stock by the company or sale of the companys
stock by insiders will be used as evidence that the company and its insiders knew of the bad news in advance and benefited from such information
at the expense of unsuspecting public investors. Class action securities litigation can take years to resolve, can be tremendously distracting for a
company management team and can result in multimillion dollar judgments or settlements. Chapter 4 discusses D&O liability insurance in
greater detail.
Loss of Control
One consequence of an IPO is that the founders (or other members of
senior management) of the company will lose a significant amount of the
control over the company that they exercise prior to the offering. The
public disclosure obligations, the scrutiny of the public capital markets,
the threat of potential securities litigation and the restrictive influence of
active institutional investors all serve to significantly temper the power
and flexibility that a companys senior mangement has prior to going
public. The senior management team must be prepared for this change in
its freedom to operate, and still be able to execute on the business plan.
Vulnerability to a hostile takeover
On the one hand, raising capital through an IPO may provide a
company with the financial resources that it needs to remain independent.
On the other hand, going public may increase the companys vulnerability
to a hostile takeover, particularly if insiders no longer hold a significant
percentage of the company. There are a number of defensive mechanisms
that a company can put in place to give the companys board of directors
more control in a takeover situation, some of which are discussed in more
detail in Chapter 3. This issue should be addressed with the companys
counsel and investment bankers at the beginning of the offering process,
because many defensive measures are more easily implemented while a
company is still private.

14

Chapter 1 - Deciding to Go Public

Effect on employee compensation

The promise of liquidity and the desire for a high valuation can drive
employee performance in the years and months leading up to the IPO.
However, once the event has occurred, potential new hires may feel that
the opportunity for the big score has passed, and they may therefore be
more difficult, or more expensive, to recruit. Further, a large and sudden
increase in the net worth of existing employees may result in attrition following the IPO, especially among employees who are fully vested in their
stock options. The board of directors of a company contemplating an IPO
should consider whether key employees have the proper incentives to
continue contributing to the companys success following the offering.
The company should review its option plans with counsel and consider
the adoption of additional benefit plans that are appropriate for public
companies, such as employee stock purchase plans.
Expense
The public offering process is expensive, and the costs of going public
and being public have dramatically increased in recent years, in large part
as a result of recent corporate governance reforms.

Expenses of an Initial Public Offering

The cost of going public has increased significantly since the height
of the Internet boom in 1999, a year in which 541 IPOs were completed
(versus the 87 IPOs that were completed in 2003)*:
2003

1999

Average

Median

Average

Median

$1,087,677

$725,000

$521,857

$400,000

Accounting

775,118

450,000

412,120

275,000

Printing

Legal

364,857

250,000

301,455

200,000

Transfer Agent

16,086

10,000

15,698

10,000

Total Expenses

$3,434,606

$1,745,000

$1,694,954

$1,172,500

* In 1999, over 62% of the IPOs involved issuers from computer-focused industries
(Internet, Computer Software/Services, Telecommunications, Computer Systems/
Products and Semiconductor/Electronics Components). In contrast, only a little over
19% of IPOs completed in 2003 involved issuers from those industries (none of which
involved an Internet company).
Source: 2004 Corporate Finance Institute. For more information visit www.ipovitalsigns.com,
Melissa M. Pierkowski, Executive Director

15

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Expenses of an Initial Public Offering (continued)

The following additional expenses are based on the size of the
offering (as of May 31, 2004):
Underwriters discount and
commission

Typically 7.0% of the aggregate

offering proceeds.

SEC filing fee*

$126.70 per $1 million of aggregate offering amount.

NASD fee

$500, plus .01% of the proposed

maximum aggregate offering
amount. The maximum fee is
$30,500.

The following are exchange listing fees for domestic issuers:

Nasdaq National Market

$5,000 non-refundable application fee, plus an increasing fee

that is based on the number of
shares listed (up to a maximum
fee of $150,000). The maximum
total fee is $155,000.

NYSE

$36,800, plus a decreasing marginal fee per million shares

listed ($14,750 to $1,900 per
million shares). The minimum
total fee is $150,000 and the
maximum total fee is $250,000.

Amex

$5,000 non-refundable application fee, plus an increasing fee

based on the number of shares
listed (up to a maximum fee of
$60,000). The maximum total
fee is $65,000.

* The filing fee is subject to periodic adjustment. The SEC issues a Fee Rate Advisory each
time such fees change and posts the advisory on the its web site located at http://www.sec.gov.
For example, on April 30, 2004, the SEC issued Fee Rate Advisory #1 for Fiscal Year 2005, pursuant
to which the SEC announced that, effective on the later of October 1, 2004, or 5 days after the SEC
receives its fiscal year 2005 regular appropriation, the filing fee will be reduced to $117.70 per
$1 million of aggregate offering amount.

16

Chapter 1 - Deciding to Go Public

For example, a domestic company applying to be listed on the

Nasdaq National Market selling $50 million of common stock to the
public, with 20 million shares outstanding after the offering, would pay
$3.5 million in underwriting fees, incur an SEC filing fee of $6,335, an
NASD fee of $5,500 and listing fees of $105,000.
The direct costs of an offering generally are netted against the gross
proceeds for accounting purposes and therefore do not have a negative
impact on the companys operating results. However, the ongoing
expenses of being a public company will have a direct effect on the companys bottom line.
In addition to the costs of the public offering itself, there are a host of
additional expenses that come with being a public company. These
include the costs of preparing periodic reports to be filed with the SEC, the
costs of soliciting proxies prior to each annual stockholders meeting, the
additional cost for directors and officers liability insurance, the costs of
putting into place and maintaining the corporate governance structures
that are required of public companies and the costs of dealing with the disclosure and other securities laws issues that public companies face on a
regular basis. These costs can be quite significant.

Is the Company Ready?

After a company takes into account the direct expenses of an offering,
the ongoing expenses that it will incur once it becomes a public company,
and some of the more intangible burdens of being a public company, it
may decide that an IPO is not the most desirable way to raise capital.
However, if it appears that the benefits will likely outweigh the burdens,
the companys board of directors and management team should consider
the following:
Does the company have the right stuff?
Answering this question requires a combination of soul-searching on
the part of the company and candid advice on the part of the investment
bankers. The right stuff may vary from company to company or industry to industry, but generally includes such things as a disciplined and
experienced management team, strong internal financial controls, reasonable visibility as to future financial results, a large target market, a
sustainable and scalable business model and a defensible competitive
position.
17

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Does the company meet the criteria of underwriters and the market?
The criteria for going public vary from industry to industry over time,
and the characteristics of IPOs have changed substantially over the past
few years. During the Internet boom of the late 1990s, many investors
were willing to buy concept stories, growth and market share gains at
any expense, complex or unproven business models, sector plays and
early stage Internet companies. However, the equity markets and investors seem to have returned to a more traditional (and, as many observers
would say, more balanced) approach in valuing companies and determining whether they make promising investment opportunities. Investors are
now focusing on companies that are profitable (or have a short, visible
path to profitability), driven by experienced and credible senior managers,
have proven business models and differentiated products or technologies
that present strong barriers to entry for real or potential competitors and
have large, rapidly growing market opportunities.
For example, a technology company contemplating an IPO with a
top-tier investment banking firm in this new IPO era should (ideally) be
profitable (preferably with several pre-IPO quarters of profitability), but
at a minimum should show a clear path to profitability based on successive quarters of improving top- and bottom-line performance. The typical
IPO candidate will also have quarterly revenues of at least $15 to
$20 million, a path of sequential quarterly earnings growth, a projected
post-IPO valuation in excess of $200 million, and a proposed offering size
of at least $40 million. However, the criteria used by the various underwriters will differ, with the larger underwriting banks generally requiring a
stronger financial profile. The criteria may also differ based on the industry
sector in which the company competes (for example, the financial profiles
of biotech companies going public will differ from those of software companies). Of course, exceptions to these rules of thumb abound. Thus, a
company with an unusually innovative product or an exceptionally
accomplished management team may be able to attract underwriters and
investors even if it falls short on certain other criteria. Also, for many technology companies, projected revenue and income growth have been far
more important factors than current profitability. It is also important to
keep in mind that many fund managers are restricted by certain mandated
breakpoints in terms of the size of company in which the managers can
invest. In sum, the markets appetite for particular types of companies

18

Chapter 1 - Deciding to Go Public

Four Quarters Trailing Revenue and Net Income (Loss) Leading up to the IPO
(Selected Technology IPOs Prices During 2002-2003
Q-4

Q-3

Revenue
Net Income (Loss)

8,471
(1,527)

8,903
(4,199)

Revenue
Net Income (Loss)

22,157
1,589

Revenue
Net Income (Loss)

Q-2

Q-1

TOTAL

10,633
(1,914)

11,562
(1,824)

39,569
(9,464)

18,669
699

22,094
1,287

26,076
2,505

88,996
6,080

11,802
829

11,176
4,570

11,349
1,250

13,373
1,608

47,700
8,257

Revenue
Net Income (Loss)

24,007
2,174

27,406
27,096

30,498
2,310

33,103
2,952

115,014
34,532

Revenue
Net Income (Loss)

16,479
(718)

21,540
(589)

29,249
1,213

48,545
(399)

115,813
(493)

Revenue
Net Income (Loss)

18,359
(8,001)

18,878
(5,554)

21,618
(4,465)

30,527
(4,508)

89,382
(22,528)

Revenue
Net Income (Loss)

55,538
1,832

64,362
2,346

71,903
3,424

67,706
1,612

259,509
9,214

Revenue
Net Income (Loss)

9,827
(844)

11,948
117

12,876
(615)

19,672
765

54,323
(577)

(in thousands)

varies over time, and a company contemplating an IPO should discuss

current market criteria with prospective underwriters.
Is the companys business and financial model realistic?
Predictability of results is essential for maintaining credibility with
analysts and investors, as well as for reducing stock price volatility and
the likelihood of a lawsuit. Before embarking on an IPO, company management must be justifiably confident in the companys ability to execute
on its plan. The public capital markets are unforgiving with companies
that fail to meet Wall Street financial performance expectations, especially
shortly after an IPO before the company has established a history of credible public company results.
Would the companys offering benefit from the achievement of additional
milestones?
If a companys financial situation permits, the company may benefit
from delaying its IPO until it achieves a certain milestone, such as the
introduction of a new product line or a significant increase in revenue. The

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

timing of an offering is a complex matter, and deteriorating market conditions could offset the benefits of delay. The company should discuss the
trade-offs with its investment bankers.
Can company management participate in the offering process without
jeopardizing the company's business operations?
A company will be severely penalized by the market if it loses
momentum because management was too distracted to properly run the
business during the offering process. Falling short of projections during
the first few quarters following the IPO can virtually guarantee securities
litigation.
Is the company prepared to operate under strict publicity guidelines
during the offering process?
If the proposed timing of the IPO conflicts with significant opportunities to promote the company, such as speaking at analyst conferences or
giving interviews to important publications, the company should consult
with its counsel and investment bankers. Managed carefully, certain types
of marketing and publicity are permissible during the registration process. However, if it is determined that the proposed activities would
jeopardize the timing of the offering, then the company must decide
whether the offering or the publicity is the higher priority.
Is the company prepared to make the level of disclosure required in
connection with a registration of its stock?
If sensitive negotiations, contractual restrictions, competitive factors
or other issues would prevent the company from making the level of disclosure required by the securities laws about material aspects of the
companys business, financial condition or risks, the company should reevaluate the proposed timing for its initial public offering. The company
should discuss sensitive disclosure issues with its counsel in the early
stages of planning for an IPO.

20

Chapter 1 - Deciding to Go Public

Is the company prepared to meet the ongoing obligations of being a public

company?
Chapter 10 addresses the reporting obligations of a public company.
It is common for companies to increase staffing in the finance and administration departments in contemplation of becoming subject to these
requirements.
Are the company's insiders willing to relinquish control and answer to
the public?
Depending on the amount of stock sold in the offering, insiders may
lose voting control immediately or may lose it over time as the company
issues additional stock through employee stock plans, follow-on offerings
and acquisitions. Even if insiders retain a majority of the outstanding
voting stock following the IPO, the companys directors and officers will
have fiduciary duties to the companys minority, public stockholders.
These fiduciary duties will limit the insiders ability to declare dividends
to meet their personal financial needs, to grant themselves perquisites that
may be considered by public investors to be excessive, to cause the
company to enter into business dealings with themselves or businesses
controlled by them or to engage in other self-dealing activities.
Can the company meet Nasdaq or stock exchange listing requirements?
The company should discuss with its investment bankers the appropriate place to list the companys stock. The listing requirements of the
NYSE and the Nasdaq National Market are set forth in Appendix A.
Is an IPO the best route to achieving the companys objectives?
In weighing the benefits and burdens of going public, the company
should also evaluate other alternatives to achieving its capital raising,
liquidity or other objectives, as there are a number of other paths a
company can follow. If raising a limited amount of cash is a companys
primary objective, a private financing, bank loan, lease financing arrangement or joint venture may be a faster, cheaper and less burdensome
solution.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Now or Later?
The valuation that a company receives in connection with its IPO is a
function of market conditions as well as a function of the companys
current condition and future prospects. Many companies attempt to time
their offerings to coincide with periods when the market is especially
receptive to new issues. These periods are often cyclical. For example, a
particular industry may be perceived as hot and companies in that
industry will race to complete their offerings while the market window is
open. In subsequent quarters, some of those companies will falter. Investors may then become more cautious about new issues and the market
window will begin to close, even for relatively strong companies that
easily could have sold stock at the beginning of the cycle.
Catching the market at its peak has the obvious advantage of a higher
valuation. However, the temptation to go public before the company is
ready can result in frustration for management and disappointment for
stockholders if the companys performance is not sufficient to keep the
stock price up after the market cools off.
Market windows can also be seasonal. According to conventional
wisdom, it is difficult to bring new deals to the market during the second
half of August when many professionals are enjoying the last days of
summer with their families before the school-year begins and many European countries are essentially closed for business. The Thanksgiving and
Christmas holiday seasons have been historically difficult times to bring
new offerings.
Market conditions can change between the time that a company
decides to undertake its IPO and the effectiveness of the IPO. In deciding
when to go public, a company must take into account its own readiness
and financial needs, and seek the advice of experienced investment
bankers.

22

Chapter 2
Assembling Your IPO Team
Once a company has decided to go public, the next step is to assemble
an experienced team to guide the company through the rigorous process
that lies ahead. The companys success will depend to a large extent on a
coordinated team effort among the members of the working group, which
is comprised of the companys management team and board of directors,
the companys counsel, the managing underwriters and their counsel, the
companys independent auditors, and in cases where needed, special
experts. The primary goal of the working group is to complete a successful
offering that complies with applicable laws and regulations. One of the
principal tasks of the working group is drafting the registration statement,
including the prospectus, that will be used to (1) satisfy legal disclosure
requirements, (2) market the companys stock to investors and (3) protect
the company and the members of the working group from liability with
respect to their participation in the IPO.

The Companys Management Team

The most important working group members are the companys
management team, led by the CEO and CFO. The management team acts
as a liaison between the working group and the companys board of directors and plays a critical role in all aspects of the offering process. The
market responds favorably to complete and experienced management
teams, especially those that have worked together for some time, and may
penalize a company for an inexperienced or incomplete team.
Additionally, the companys management team, and in particular the
CEO and CFO, will be the critical points of contact between the company
and the public capital markets. They will be communicating directly with
the public capital markets in the road show during the IPO process, in the
companys quarterly earnings conference calls after the IPO, and in other
public settings. How effective these management team members are at
conveying information effectively to the market, and how they respond to
questions from analysts and investors under pressure, could impact how
the companys business is perceived by the market, and could impact the
companys stock price. How the information is communicated can often
be as important as the content of the information itself. A premium is

23

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

placed on executives that can instill trust and confidence in the capital
markets. These principles are especially true in the world of relatively volatile technology company stocks. A company that is exploring a public
offering would be well served to ensure that the executive team includes
individuals that have experience communicating with the public capital
markets, and working within the complicated and changing framework of
securities and corporate governance regulation.
The company should discuss any management gaps or anticipated
turn-over with its investment bankers and counsel early in the offering
process.
Role of the companys management team
Making structural and timing recommendations to the board. The management team must make a number of structural and timing recommendations
to the board of directors that are relevant to the IPO, including recommendations regarding the size of the offering, the inclusion of selling
stockholders, the drafting schedule, and the timing and extent of the road
show. While experienced investment bankers and counsel can provide
valuable advice on many issues, most key decisions in the offering process
are ultimately made by the management team under the guidance of the
board of directors.
Preparing the registration statement and responding to SEC comments. The
CEO, CFO and, depending on the nature of the business, key engineering,
sales and marketing, manufacturing and other employees will be the most
important resources to the working group as it prepares the registration
statement and prospectus for the offering. The drafting process is a group
effort, and company management and key employees will actively participate in the drafting, reviewing and editing of key portions of the
registration statement. The management team will be the critical source of
information about the companys business and operations that will enable
the working group to accurately describe the company in the prospectus.
While one or two members of the management team may become the
primary liaisons to the working group, the availability of the entire executive staff is crucial to ensuring the accuracy of the registration statement.
When SEC comments on the registration statement are received, company
management will be integral to the preparation of responses.

24

Chapter 2 - Assembling Your IPO Team

The drafting process is a labor-intensive process. Different members

of the management team may be required to spend significant periods of
time participating in drafting and reviewing the registration statement. In
particular, the CEO, CFO, head of marketing and head of sales will play
critical roles. The CFO is usually the primary manager of the public offering process for the company, with a controller-level person carrying the
laboring oar with respect to collecting and disseminating information as
part of the due diligence and drafting processes. The CFO will also play a
key role in helping other team members understand the companys financial position and results of operations, and describe these in the financial
disclosures portions of the registration statement. The CEO and the marketing and sales executives will be invaluable in helping the working
group to quickly understand and describe the companys business. A
company should be prepared for this demand on the time and attention of
its key executives, and plan accordingly. Inadequate time and attention
from these critical players can degrade the efficiency of the offering preparation process, and can contribute to inadequate disclosure in the
offering documents.

Practical Tip: Carefully Plan for Availability

of Management Team Members to Avoid Slowing
Down the Process
One of the key challenges a company embarking upon the IPO
process will face is reconciling the competing realities that the management team is critical to the IPO process and also critical to the
successful operation of the companys business on a daily basis.
The IPO process will demand significant time from management
team members, but, of course, they cannot neglect their duties in
managing the business. If management team members are not sufficiently available to the working group, it can affect the timing of the
IPO process.

25

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Practical Tip: Carefully Plan for Availability

of Management Team Members to Avoid Slowing
Down the Process (continued)
In order to ensure that management team members can adequately participate in the process, the working group should carefully plan the working groups drafting schedule for the entire
process and ensure that this schedule is consistent with the availability of the management team members. For example, if a companys business has a seasonal characteristic so that one part of the
year is disproportionately busy or critical to the business, the company should carefully consider how that reality will be reconciled
with the demands of the IPO process if the IPO process would overlap with the busy period. roMaking road show presentations. After the registration statement is
drafted and a red herring, or preliminary prospectus, is printed by the
financial printer, the management team and managing underwriters will
conduct a road show to market the offering to investors. The road show is
the primary opportunity for the company to tell its story, showcase its
business and ultimately sell the offering to investors. While the managing
underwriters will handle the logistics of the road show and assist
company management in preparing for their presentations, it is company
management, not the underwriters, that investors are interested in meeting. During the road show, the CEO and CFO of the company are
presenting to investors, and the credibility of the CEO and CFO and the
effectiveness of their presentations will be critically important to the
success of the offering. Underwriters sometimes suggest that companies
work with outside consultants to polish the road show presentations.

The Companys Board of Directors

The companys board of directors must be involved throughout the
IPO process, from the initial decision to undertake a public offering to the
final decision to proceed with the offering. The non-employee directors
typically are not involved in the working group due diligence sessions
and drafting sessions, but they must be provided with interim drafts of
the registration statement and kept informed as to the status of the process
as the deal progresses. In addition to approving the offering itself, the
26

Chapter 2 - Assembling Your IPO Team

board will be responsible for reviewing and authorizing any necessary

corporate housekeeping matters, reviewing and authorizing the filing of
the registration statement and forming a pricing committee comprised of
directors who will have the authority to negotiate with the managing
underwriters to establish the terms and conditions of the offering (including pricing terms). SEC rules require a majority of the board to sign the
registration statement; as such, board members will be liable for material
misstatements and omissions unless they can establish a due diligence
defense, as discussed in Chapter 7. Directors should be active and diligent
in reviewing the registration statement for accuracy and in asking questions of management and the companys counsel with respect to the
registration statement and the offering process to ensure that they benefit
from the due diligence defense discussed in greater detail in Chapter 7.
Newly adopted SEC, NYSE and Nasdaq rules and regulations impose
requirements relating to the composition of the boards of directors, and
certain committees of the board of directors, of public companies. These
requirements mandate that public company boards of directors be composed of a majority of independent directors and that audit committee
members meet certain financial literacy requirements, and confer authority over certain board functions to the independent directors.
The NYSE and Nasdaq rules, as well as SEC rules, will require public
company boards of directors to comply with the following requirements:
Majority independent directors. Both the Nasdaq and NYSE rules
require that boards of directors be composed of at least a majority
of independent directors.
Executive sessions of independent directors. Both the Nasdaq and
NYSE rules require that independent directors hold regularly
scheduled meetings at which only those directors are present. The
NYSE rules require that non-management directors meet regularly, and also recommends that, if there are non-management
directors who are not independent (within the meaning of the
rules), the independent directors should additionally meet at least
once a year.
Independent audit committee. The Nasdaq and NYSE rules and securities laws require that listed companies must have an audit committee composed of at least three directors, all of whom are
independent and meet basic financial literacy requirements.

27

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Audit committee required to include one financially sophisticated member: The Nasdaq and NYSE rules and securities laws require that
least one member of the audit committee must meet more stringent
financial sophistication requirements, including prior experience
in finance, accounting or otherwise in preparing or overseeing the
preparation of financial statements.
Board nominations by independent directors: The Nasdaq rules
require that board nominations must be determined by, or recommended to the board of directors by, either a majority of the independent directors or a nominating committee composed solely of
independent directors. The NYSE rules require that board nominations must be determined by a nominating committee composed solely of independent directors.
Independent compensation committee: The Nasdaq rules require that
executive compensation must be determined by, or recommended
to the board of directors by, either a majority of the independent
directors or a compensation committee composed solely of independent directors. The NYSE rules require that listed companies
establish a compensation committee composed solely of independent directors charged with making recommendations to the
board of directors regarding compensation.
The rules for determining independence are very detailed and factspecific. The company should work closely with its counsel in determining whether its directors meet the independence requirements, especially
in questionable cases.
Depending on the composition of a companys board of directors
prior to embarking on the public offering process, these requirements may
require the company to significantly alter the structure of its board of
directors. It takes a substantial amount of time and effort to identify and
install qualified independent directors. In the past, companies were often
able to enlist new directors on the eve of the IPO. However, many director
candidates tend to be more cautious because of heightened concern over
the potential personal liability that arises in connection with the offering.
An IPO-bound company can expect new directors to conduct a thorough
review of the companys indemnification measures (for example, D&O
insurance and indemnification agreements) to ensure adequate protection
is in place and to make all inquiries necessary in connection with the IPO
process to avail themselves of the due diligence defense. The combined

28

Chapter 2 - Assembling Your IPO Team

effects of recent corporate governance reforms making the requirements

for some board positions more stringent and increasing the amount of
work required by directors promise to make for a tight market in qualified
candidates for public company directorships. As a result, it is important
to begin this process early.
Public companies will also need to have charters for their board committees. It is important for a company contemplating an IPO to work
closely with counsel to ensure that the committee charters will comply
with the applicable exchange or Nasdaq rules and securities laws.
In recognition of these timing issues, the NYSE, Nasdaq and SEC
provide newly public companies with special phase-in periods for compliance with certain independent director requirements. Companies may
initially be allowed to have only one independent director at the time of
listing, a majority of independent members within 90 days following listing, and fully independent committees within 1 year. Notwithstanding
the grace periods for newly public companies, companies may wish to
consider, as a corporate governance best practice, complying with all (or
as many as are reasonably practicable) of the requirements as of the date
of the companys IPO (or, if possible, as of the initial filing of the registration statement). Institutional investors may expect to see newly traded
companies follow best practices with regard to corporate governance matters. As a result, it is conceivable that a company that is not compliant at
the time of the IPO may be penalized in the marketing of its offering for
its failure to follow best practices in corporate governance. Companies
that anticipate taking advantage of the phase-in provisions for newly
public companies should confer with their counsel and their underwriting
team regarding the potential impact that not accelerating compliance with
these requirements before the IPO could have on the offering. A company
taking advantage of the phase in provisions will also be required to disclose that fact in the IPO prospectus.
As it prepares for its IPO, a company should review its board composition with its counsel and investment bankers, with particular thought
given to the SEC and applicable exchange or Nasdaq rules as well as marketing bringing on additional outside and independent directors with
relevant industry or public company experience, as discussed in
Chapter 3.

29

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

The Managing Underwriters

Most IPOs are made with the assistance of investment banking firms
that act as firm commitment underwriters. In a firm commitment underwriting, the company sells the IPO shares to the underwriters at a
discount from the price at which the shares will be sold to the public. The
underwriters then sell that stock, either directly or through a selling
group, to investors who have subscribed to the offering.
Structure of the underwriting group
The company typically chooses two or three investment banks to act
as managing underwriters, although the number may be smaller or larger
in any particular case, depending on factors such as the size of the offering
and the level of interest among underwriters. In most IPOs there will be
more than one manager. If more than one managing underwriter is
selected by the company, one of the managers will be designated as the
lead manager (also sometimes called the book runner) with the other
managing underwriters referred to as co-managers. In rare cases, for
particularly hot IPOs, there may be two lead managers. The lead manager
plays the dominant role with respect to the structure, allocation, timing
and pricing of the offering, the preparation of the registration statement
and the organization of the road show. In addition to establishing the roles
in managing the IPO process, the designation as a lead manager or comanager impacts the allocation of the underwriting fees and discounts.
The lead manager is listed on the bottom, left side of the cover of the prospectus, and the other managing underwriters are listed below and to the
right of the lead manager. The lead manager and co-managers are the
members of the underwriting syndicate that will actually be involved in
the IPO preparation process, attending drafting sessions and the road
show meetings.
It is up to the company to determine which bank will be the lead
manager and which bank or banks will be the co-managers. Investment
banking firms relationships with one another can be competitive or cooperative, and usually are a bit of both. There is a definite hierarchy of firm
prominence in the investment banking world, and it would not be
unheard of for a bank that is not selected as the lead manager to refuse to
act as a co-manager to the bank that is chosen, if the selected bank is the
less prominent of the two. The decision regarding the lead manager and

30

Chapter 2 - Assembling Your IPO Team

the ordering of the co-managers should be made prior to the organizational meeting to ensure that the underwriters spend their time working
together toward the success of the offering.
The managing underwriters may organize a larger group of investment banks to help distribute the stock and bear the risk of the offering.
The entire group of investment banks is referred to as the underwriting
syndicate. The underwriting syndicate may, in turn, sell part of the offering through a selling group consisting of even more investment banks and
broker/dealers. It is not necessary for the company to participate in the
selection of the syndicate or selling group members, although the managing underwriters will often take into account any preferences expressed
by the company. The syndicate and selling group members other than the
managing underwriters do not participate in the due diligence, drafting or
road show processes.
The Role of the Managing Underwriters
The managing underwriters coordinate many aspects of the IPO process, conduct due diligence on behalf of all of the underwriters, advise the
company on IPO structural issues, assist in drafting the registration statement, arrange the road show, market the offering to potential investors
and provide after-market support and analyst coverage for the company.
Selection criteria
The selection of underwriters for an IPO is a critical step in the process. When choosing managing underwriters, a company should consider
the factors listed below. If two or more managing underwriters are to be
used, the company may wish to base its decision, in part, on whether the
banks have complementary strengths. For example, if a company desires
to sell both to institutional and retail investors, it may wish to select one
bank that is particularly strong in the institutional arena and one that is
equally strong in the retail channel.
Analyst coverage. Analyst coverage is essential to maintaining investor interest in a companys stock following its IPO. Without it, the market
for the companys stock may be relatively illiquid, volatility of the stock
may be heightened and follow-on offerings may be difficult to place. This
type of analyst is known as a sell-side analyst, and is typically an
employee of the underwriting firm (though there are independent ana-

31

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

lysts that are not part of firms that underwrite equity offerings). The role
of the sell-side analyst is to research a particular industry and the companies in that industry, and to report on the results of that research and make
predictions about the anticipated performance of the industry, the companies and their securities. The sell-side analysts reporting is outward
facing, intended for the potential purchasers of securities who are brokerage customers (or potential brokerage customers) of the securities firm for
which the analyst works. Sell-side analysts are to be contrasted with buyside analysts, who typically do similar investigatory work, but whose
reporting is internally facing, intended for the financial institution
employing them in buying decisions on behalf of the institution itself. The
buy-side analysts figure into the IPO process as well by attending road
show presentations to glean information about the company to determine
whether the analysts institutional employer should purchase the IPO
securities.
Although individual sell-side analysts have a reputation for frequently moving from one investment bank to another (or from investment
banking into venture capital or business), the fact that an investment bank
currently provides significant analyst coverage of a particular industry is
generally a sign that the investment bank is committed to that industry
and will be likely to hire additional analyst talent if the current analyst
jumps ship. A good analyst will help position the company properly and
may help reduce volatility in a companys stock by setting realistic expectations for the companys performance. The company should read recent
research reports issued by analysts at each of the prospective underwriting firms and investigate the analysts experience and published industry
ratings. The company should then determine whether the reports reflect
an understanding of the companys industry and its future, and the companys position in that industry, that is consistent with the companys
understanding.
The role of analysts in the IPO process, as well as after the IPO, has
undergone intense scrutiny in recent years as a result of the analysts high
profile in the late 1990s, their increasing power to influence stock prices
and the widespread perception that analysts were tainted by a raft of conflicting interests. These conflicts included perceived entanglement of
research analysts with the investment banking/underwriting side of the
analysts firms business and perceived entanglement between the analysts and the companies on which they report. The result was a serious
undermining of investor confidence in analysts recommendations, and a

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Chapter 2 - Assembling Your IPO Team

backlash of regulatory action. These actions included the promulgation of

Regulation FD, which restricts non-public communications between
public companies and investment professionals (Regulation FD is discussed in greater detail in Chapter 10), the enactment of the SarbanesOxley Act, which required SROs to adopt rules relating to analyst conflicts, the promulgation by the NYSE and Nasdaq of rules relating to
analyst conflicts of interest, and a series of regulatory enforcement actions
against securities firms and analysts for past transgressions relating to
analyst research. Many of the enforcement actions were settled in a global
settlement that resulted in several leading investment banks agreeing to
structural and operational restrictions designed to eliminate the analyst
conflicts of interest. The result of the regulations is that research analysts
will be much less involved in the investment banking aspects of the IPO
process, and there may be some duplication of efforts as the analysts and
bankers have to essentially operate entirely separately during the process.
These analyst conflicts, the regulatory responses and the impact on the
analysts role in the IPO process are discussed in more detail later in this
chapter and in Chapter 9.
Level of interest in the company. The company should try to gauge how
important its offering will be to the underwriter. During particularly frenzied market periods, an investment bank simply may not have the
resources to staff all of its deals adequately. Even during normal market
periods, a small deal simply may not meet the criteria of bulge- or
major-bracket investment banks, in which case the company may wish to
consider regional or boutique firms. When interviewing a prospective
underwriter, a company should try to get a sense of what priority that
investment bank will place on the companys deal by, for example,
making inquiries of the banks interest in the company and its industry,
which individuals from the bank will be actively engaged in the IPO process, and whether competing transactions will enable the bank to devote
sufficient attention to optimize the success of the road show.
Track record with similar IPOs. Does the prospective underwriter have
experience marketing the stock of companies of a similar size, stage of
development and industry as the company. Underwriters that have successfully placed the stock of similar companies may be more likely to have
relationships with investors that would be interested in purchasing the
companys stock. Relationships with customers, suppliers and competitors of the company may indicate a deeper understanding of the

33

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

companys industry and a real commitment to providing analyst coverage

in that area. However, this must be weighed against the possibility of conflicting loyalties, problems in handling the companys confidential
information and an inability to provide evenhanded advice in certain
acquisition situations.
Reputation. Some investment banks are more respected than others,
either in general or for their expertise in particular market segments. For
investors whose first introduction to the company is through the IPO, the
reputation of the managing underwriters may have a significant influence
on the perceived quality of the investment and, in turn, may even influence valuation.
Distribution capabilities and focus. Among the most critical aspects of
choosing an underwriting team is ensuring that the company has underwriters who are going to be able to complete the distribution, and are
going to be able to get the companys shares into the hands of the right
investors. Companies should ascertain the banks distribution capabilities
and objectives, its key institutional accounts, whether the bank will be able
to build a quality syndicate to achieve optimum distribution, liquidity and
visibility for the companys offering.
Some investment banks sell primarily to institutions, which tend to be
more sophisticated and capable of understanding a complex business
model. However, institutions tend to take a more activist approach to corporate governance and are less likely than individual investors to accede
without a compelling rationale to management recommendations on
items such as increases in stock option pools, mergers and acquisitions
and anti-takeover measures. Retail investors tend to provide greater
liquidity for a companys stock because they contribute to the public float
and the actions of a single investor can rarely influence the prevailing
market price. Theories abound for whether it is better to be more heavily
weighted toward institutional or retail investors. The companys management team should ensure that its prospective lead managers explain their
approach and support it with empirical evidence from recently completed
deals. Most companies prefer a mix of institutional and retail stockholders. If a company has a particular international distribution objective, it
should discuss that also with prospective underwriters.
Underwriters differ based on many other characteristics as well. Different underwriters may have different strengths in terms of types of
technologies. They may also differ as to the regional strengths of their

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Chapter 2 - Assembling Your IPO Team

institutional investor relationships. For example, some firms may have

stronger connections with East Coast institutional investors. So, if a
company chooses a West Coast based lead managing underwriter for
some reason, and yet wants to make sure that East Coast institutional
investors take positions in the company, the company would be well
served to ensure that one of the co-managers (or, at a minimum, one of the
other syndicate members) is an underwriter with strong connections to
East Coast institutional accounts. Strategizing the makeup of the underwriting team with a view to leveraging their various strengths in terms of
reach to investors is a matter on which the company should work very
closely with the lead managing underwriter and the companys other
advisors.
Aftermarket support. While getting the deal sold is critical to a successful IPO, post-offering market support can be just as important. In order for
the trading price of the stock to accurately reflect the underlying business
fundamentals and not be distorted by liquidity concerns, there must be a
fluid and efficient market in the companys stock. This requires a few
strongly capitalized firms that act as market makers, and stand ready to
buy and sell the companys stock at the market prices, so that trading can
continue efficiently at all times. Aftermarket support also includes the
ability to help the company get other analysts interested in covering the
company, and attracting large institutional investors to the companys
stock after the IPO. In determining a prospective investment banks aftermarket support capabilities, a company should request that the bank
provide its track record in terms of aftermarket performance of other IPOs
it has managed.
Experience in secondary offerings, debt offerings, mergers and acquisitions,
anti-takeover measures and other investment banking functions. A company
will realize greater benefits from its investment bankers if it maintains
long-term relationships that allow the bankers to develop an intimate
understanding of the companys business, objectives and management
team. Ideally, a companys investment bankers will keep the company
abreast of market developments, make creative financing suggestions,
bring desirable acquisition opportunities to the companys attention and
assist the company in implementing appropriate anti-takeover measures.
A company should look ahead and consider whether the banks that it
chooses to manage its IPO will be able to meet the companys expanding
needs.

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References. The company should ask each prospective managing

underwriter that it is seriously considering to provide a list of the several
most recent IPOs for which it was selected as a managing underwriter. If
possible, this request should be refined to the most recent deals in the
companys industry or a related field in which the analyst or corporate
finance team that will be working on the companys IPO participated.
Company management should then contact the CEO or CFO of those
companies to find out whether, with the benefit of hindsight, they were
satisfied with their choice.
The company may also wish to ask each prospective managing
underwriter for a list of more mature companies with which it has
maintained a long-term investment banking relationship. Company
management should then contact the CEO or CFO of each of those companies and ask many of the same questions that it asks of the more
recently public companies. Company management should also inquire as
to whether the reference company did or did not use that investment bank
for all follow-on offerings or acquisitions which it has undertaken since its
IPO, and why. Has the investment bank stayed in close contact with the
company, or does it only show up when a commission is involved? Are
the individual bankers familiar with the companys developments, or are
they spread too thin or have too much turnover in the team?
The company should also consider asking each prospective underwriter to provide a list of institutional investors with which it has placed
IPO securities. When checking these references, the company should not
only inquire as to the credibility of the prospective underwriter that provided the reference, but the reputation of the other prospective
underwriters as well. These calls should be limited to their stated purpose
of checking the prospective underwriters references. For both practical
and securities law reasons, it is not appropriate to discuss other details of
the offering or the company on these calls.
Finally, the company should take into account the opinions of its
board members, counsel and others who may have first-hand experience
with the various investment banking firms under consideration.
Chemistry. When company management selects an investment
banking firm, it must be comfortable with the people from that firm who
will be responsible for providing service to the company. A successful IPO
requires teamwork, the ability to read each others signals and, quite
frankly, the ability to spend day after day together in drafting sessions and

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Chapter 2 - Assembling Your IPO Team

road show activities. A successful post-IPO investment banking relationship will be far more fruitful if the bankers are enthusiastic about the
relationship, understand the companys long-term goals and have managements trust. In considering chemistry, management should try to
distinguish between bankers that tell the company what it wants to hear
from those that are willing to provide candid advice. The company should
make sure it gets to know the broader investment banking team, not just
the deal team that pitched the business. The companys senior executives
should make a point of meeting the capital markets leads and the institutional sales leads.
Offering price and underwriting discount. Generally speaking, price is
one of the least important criteria in selecting a managing underwriter.
The final offering price will ultimately be determined by factors such as
the companys performance, market conditions prevailing at the time of
pricing and the level of interest generated during the road show. While
investment banks will discuss a ballpark valuation with the company at
the beginning of the offering process, no bank can realistically promise a
particular price in advance. Company management should be wary of any
bank whose valuation of the company is significantly out of line with the
consensus of the other prospective underwriters. Because most investment banks (and their customers) use similar valuation techniques and
will use a similar group of comparable companies for determining the
applicable earnings or revenue multiple, a valuation that is substantially
different from others may mean that the prospective underwriter does not
grasp the companys business model, does not understand the companys
industry, or is playing games in hopes of winning the companys
business.
The underwriting discount for a firm commitment IPO listed on the
Nasdaq National Market or a major exchange is typically 7%, and generally does not vary across major investment banks.

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Practical Tip: Selection of the Underwriters May Mean You

Are In Registration Be Ready for All That Entails
Not only is selection of underwriters a key decision for a companys IPO process, it is also a pivotal moment in the process. There
are a number of restrictions on a companys ability to freely speak
publicly when the company is in registration. While there are no
bright lines, it is commonly understood that selection of underwriters for a public offering with the intent of commencing the offering
process marks the beginning of this restricted period, as discussed
in greater detail in Chapter 5. The company must work closely with
counsel to ensure that it understands these restrictions and is prepared to comply with them once underwriters have been selected.oThe changing role of research analysts in the IPO process
The role of research analysts in the capital markets and the investment banking industry has received a great deal of media and regulatory
attention in recent years, particularly in the aftermath of the severe
declines in the public equity markets following the late 1990s. The SEC
investigated the role of Wall Street analysts in the securities industry in
1999 as it became apparent that the analysts were playing an increasingly
prominent and pivotal role in the industry, and in the capital raising
process in particular. The SEC reviewed industry practices and conducted
examinations of the largest full service investment banking firms on Wall
Street. The results of the SEC investigation outlined a number of conflicting pressures to which analysts had become exposed, including:
analysts had become increasingly involved in the activities of the
investment banking groups;
analyst compensation had become increasingly tied to the success
of the investment banking groups;
investment banks and analysts often held equity positions in the
companies they covered;
the disclosure of conflicts involving analysts was deemed inadequate; and

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Chapter 2 - Assembling Your IPO Team

there was suspicious timing of favorable ratings relative to the

timing of the release of the post-IPO lock-up.
The regulatory inquiry into the perceived structural problems present
in the interaction of research analysts with the investment banking business resulted in a number of responses. These regulatory actions are
described in more detail in Chapter 9.

The Companys Legal Counsel

The companys lawyers will play an instrumental role throughout the
IPO process. In particular, they will quarterback the drafting process,
provide critical advice to the company throughout the process and serve
as the primary liaison between the company and the SEC. In selecting
counsel for its IPO, the company should choose a firm that is experienced
in securities law matters generally, and the IPO process in particular, and
that has sufficient resources to perform all of the tasks required in the time
frame set by the company and the managing underwriters.
Role of company counsel
The companys lawyers will have numerous responsibilities throughout the IPO process, including:
Assisting the company with its pre-IPO corporate housekeeping
and IPO preparations;
Helping the company to anticipate potential or likely issues in the
SEC review process, and to formulate strategies and solutions for
those issues;
Helping the company to coordinate the due diligence process;
Taking the lead in drafting the registration statement;
Advising the company with respect to the registration statements
compliance as to form with the requirements of the securities
laws;
Filing the registration statement with the SEC;
Coordinating, drafting and filing responses to SEC comments on
the registration statement;

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Negotiating with the SEC regarding contentious issues;

Preparing the confidential treatment request and negotiating it
with the SEC, when applicable;
Preparing and submitting the Nasdaq or exchange listing application;
Negotiating the underwriting agreement on behalf of the company;
Advising the company with respect to directed shares program
issues;
Coordinating the selling stockholder process, when applicable;
Advising the company on publicity restrictions during the registration process;
Helping the company formulate its insider trading policy, analyst
and investor relations policies and other public company policies;
Advising the company with respect to employee benefits matters
for public companies;
Educating the company about the many legal restrictions and
reporting and other requirements faced by public companies;
Assisting the company in implementing corporate governance
structures applicable to public companies;
Advising the company regarding anti-takeover measures;
Advising the company on an ongoing basis after its IPO on securities-related matters;
Advising the board of directors regarding their duties in the IPO
process, including with respect to their due diligence defense; and
Representing the company in the event of securities litigation.
Selection criteria
A company that already has experienced counsel meeting the criteria
discussed below will have a head start on the offering process. Many companies approaching an IPO, however, discover that they have outgrown
their current counsels ability to meet their evolving legal needs or decide

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Chapter 2 - Assembling Your IPO Team

to engage counsel with more extensive IPO and public company experience. If a company is considering retaining new securities counsel in
anticipation of an IPO, it should do so sooner rather than later so that the
new lawyers will have time to familiarize themselves with the company
and to perform the many pre-IPO tasks described in Chapter 3.
Experience, experience and experience. An IPO is a highly technical, timesensitive, high-stakes event, and the companys counsel is directly responsible for the execution of the entire registration process. Counsels
experience with the IPO process and the practices of the SEC will be
invaluable in ensuring an efficient, timely and successful offering. Only
law firms with extensive corporate and securities law experience should
be considered. A law firm that regularly represents companies going
through the IPO process will be much more effective in leading the
working group and performing the many tasks described above. A firm
with an active IPO practice also will be better equipped to anticipate
problem areas and respond to difficult SEC comments. Many of the issues
that arise in the IPO process are as much lore as law, and the knowledge
and expertise to efficiently deal with the issues can generally only be adequately obtained though extensive first hand experience with the process.
Timing the effectiveness of the registration statement to coincide with
the culmination of the road show is important to the success of any offering, and the company will want to have counsel capable of offering timely,
creative solutions to outstanding issues as the desired effective date draws
near. A law firm that has experience representing underwriters, as well as
companies, will have more credibility in negotiating the underwriting
agreement and resolving due diligence and disclosure issues with the
underwriters. Finally, a law firm with a large, public-company client base
should be able to steer the company around many of the pitfalls common
to newly public companies following the IPO, and help position the
company to be well prepared to meet its public company legal obligations.
An experienced securities law firm will also likely have partners
involved in various policymaking groups and task forces that work with
the regulatory bodies to evaluate current laws, identify timely issues and
propose improvements to the system. That institutional perspective on
the process can be helpful in anticipating and addressing particular issues
that arise in the IPO process.

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IPO LEGAL REPRESENTATION

(IPO Transactions 1998 through 2003)

TOTAL IPO REPRESENTATIONS

Number
of IPOs

Law Firm

Percent
of Total
IPOs

Aggregrate
Offering Amount

Percent of
Total
Aggregate
Offering
Amount

Wilson Sonsini Goodrich

& Rosati

239

14.6%

$21,481,959,386

6.6%

Brobeck, Phleger & Harrison

148

9.1%

10,422,274,009

3.2%

Shearman & Sterling

124

7.6%

46,968,162,961

14.5%

Skadden, Arps, Slate,

Meagher & Flom

110

6.7%

52,399,011,290

16.2%

Cooley Godward

99

6.1%

6,513,777,652

2.0%

Davis Polk & Wardwell

98

6.0%

70,040,722,014

21.6%

Latham & Watkins

94

5.7%

18,047,373,669

5.6%

Sullivan & Cromwell

82

5.0%

52,504,809,491

16.2%

Cravath, Swaine & Moore

82

5.0%

30,484,100,140

9.4%

Hale and Dorr

81

4.9%

6,845,979,181

2.1%

Source: 2004 Corporate Finance Institute.

Full-service capabilities. A companys legal needs will change significantly following its initial public offering. Forming a long-term
relationship with a full-service law firm will lead to higher quality and
more efficient service. The corporate and securities lawyers from the IPO
team will be able to spot issues early, introduce the company to lawyers
within the firm who have relevant expertise, and quickly bring those
lawyers up to speed on the companys background and current situation.
Therefore, when selecting IPO counsel, the company should consider
whether a firm can serve its needs in areas such as general corporate and
securities counseling, securities litigation, employee benefits and compensation, antitrust counseling and litigation, tax and intellectual property law.

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Chapter 2 - Assembling Your IPO Team

Interest in the company. Because company counsel plays such a critical

role on the IPO team, company counsel must be motivated to help the
company jump-start the IPO process and drive it to completion. In addition to legal abilities and business judgment, selection criteria should
include enthusiasm and responsiveness. Company counsel should be
willing to roll up his or her sleeves and do whatever it takes to help the
company make the transition from a privately held company to a public
company. Company counsel also will need to be a quick study on the companys industry, operations, risks and financial condition, and be able to
explain these concepts to investors and the SEC in a prospectus.
References. Company management should ask prospective counsel to
provide contact information for CEOs and CFOs of clients which have
recently gone public, as well as clients which have been public for at least
a few years.
In checking references with newly public companies, management
should ask whether counsel adequately prepared the company for the
challenges of the IPO process. Was counsel organized or erratic? Did
counsel help the company get a running start on the numerous pre-IPO
items listed in Chapter 3? Did counsel drive the process through to the
end, or fizzle out and require pushing from the other team members? Did
counsel demonstrate good judgment on sensitive disclosure issues, negotiations with the underwriters and dealings with the SEC? Did counsel
take the time to thoroughly understand the companys business and
financial situation? How much did counsel contribute during the drafting
process, particularly in the MD&A and Risk Factors sections of the
registration statement? What has counsel done to help the company transition to life as a public company? Has it helped the company map out its
first year of reporting and annual meeting activities? Has it coached the
company on dealing with securities analysts and minimizing the risks of
a stockholder lawsuit?
In checking references with more seasoned public companies, management should ask how long the company has worked together with the
prospective counsel. Does the company value counsels business judgment and include counsel in major strategic decisions? Has counsel
provided responsive and efficient service? Has the law firm been able to
satisfy the companys growing needs? How has counsel responded in
times of crisis?

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Chemistry. Company management must not only be confident in the

capabilities of the firm it has selected, but must also trust the experience
and judgment of the individual lawyers who will be responsible for guiding
the company through the IPO process and beyond. Are the CEO and CFO
interested in counsels opinion on issues of strategic importance to the
company? Would their rapport with counsel allow them to successfully
wrestle with difficult judgment calls together? Are they comfortable sharing
the companys dirtiest laundry with counsel and asking for recommendations? Do they feel that counsel is interested in having this sort of working
relationship with them?
Fees. A companys focus should be on value for the dollar rather than
on absolute fees. In assessing value, there are several factors that a
company should take into account. A firm that is experienced in the IPO
process may be more efficient in the long run, even if its hourly rates are
higher than those of other firms. (Company management should be sure
to ask each firm it is considering what its rates are. Companies are often
surprised to find that the rates of experienced securities counsel are not
significantly higher than those of less experienced firms.) Interest on the
proceeds of an average offering can exceed $10,000 per day and market
windows are often unpredictable. Counsel that can effectively drive the
registration process and run the gauntlet of SEC comments may save the
company tens of thousands to millions of dollars just by keeping the
process on schedule. Additionally, experienced counsel that can advise
the company wisely on disclosure issues and policies regarding insider
trading and dealing with analysts may help save the company millions of
dollars in litigation exposure.

The Underwriters Legal Counsel

Role of underwriters counsel
The underwriters counsel is responsible for:
Assisting the underwriters in satisfying their due diligence obligations, including document review, factual back up of statements
made in the prospectus and negotiation of the comfort letter from
the auditors;
Participating in the drafting process;
Satisfying applicable state securities laws and regulations;
Obtaining NASD clearance of the underwriting arrangements;
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Chapter 2 - Assembling Your IPO Team

Drafting the underwriting agreement and negotiating it with the

companys counsel;
Coordinating the mechanics of the underwriting syndicate with
the lead managers capital markets department; and
Coordinating the closing with company counsel.
Selection criteria
The underwriters counsel should have extensive public offering
experience. Many of the same criteria discussed above for company
counsel are equally applicable to the role of underwriters counsel. Underwriters counsel generally is chosen by the lead managing underwriter.

The Companys Auditors

Role of the companys auditors
The companys auditors ensure that the financial information
included in the registration statement satisfies SEC financial information
disclosure requirements, which are different and in some cases more
extensive than GAAP.
In addition, the auditors are the primary liaison between the IPO
working group and the SECs accounting staff, and generally take the lead
in drafting responses to the SECs comments relating to accounting
matters.
The auditors will also be responsible for delivering a comfort letter to
the underwriters and the companys board of directors confirming that
the financial statements contained in the registration statement comply
with accounting requirements, and tying the tables, statistics and other
financial information included in the registration statement to the financial statements and other financial records of the company.
Following the IPO, the auditors will assist the company in its ongoing
financial reporting obligations.

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Selection criteria
Almost by definition, a companys auditors must become intimately
familiar with the companys financial situation and accounting practices.
Therefore, if a company is considering changing auditors in anticipation
of its IPO, it should make the decision as early as possible.
Reputation and general IPO experience. The companys auditors should
be well regarded and have extensive IPO experience. Most public companies use one of the Big Four accounting firms. In addition, issuers should
evaluate the relevant experience of the key audit partners and the partners
expected to replace them under the SECs audit partner rotation requirements. If the issuer has or expects to have operations in foreign countries,
the auditor should have offices or experience in those countries.
Specific industry experience. The companys auditors should have
extensive and ongoing experience with other clients in the companys
industry. The SEC almost always raises issues about the companys
accounting practices during the SECs review of the registration statement. As a result, it is essential that the companys auditors be current on
accounting developments specifically applicable to the companys industry and be able to effectively justify the companys position with the SEC.
Track record. The companys audit committee should consider the
audit firms recent record with respect to restatements and disciplinary
proceedings before the SEC.
Suitability for post-IPO matters. Following the IPO, the company will
rely on its auditors to audit its annual financial statements, as well as to
provide advice regarding complex issues such as tax planning or the
accounting impact of mergers and acquisitions or new business
initiatives.
References. As with the companys other service providers, the
company (under the direction of its audit committee) should carefully
check references, inquiring as to experience, judgment, responsiveness
and efficiency.
Consequences of terminating audit relationship. Once an auditor has been
hired, it is difficult to terminate the relationship. Any resignation or dismissal of the companys auditors must be disclosed on SEC Form 8-K
when it occurs, as well as in the companys periodic SEC reports for two
fiscal years following the change, along with the reasons for the resigna-

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Chapter 2 - Assembling Your IPO Team

tion or dismissal. While changes in accounting firms that occur prior to the
IPO are easily explained, changes once the company is public may be
viewed by the market as a sign of trouble at the company. Therefore, the
company should give careful thought to its choice of auditors well in
advance of its IPO.

The Companys Financial Printer

The companys counsel generally will maintain early drafts of the registration statement on its word processing system. A few weeks prior to
the initial filing of the registration statement, the companys counsel will
transfer the draft to the financial printers document management system.
The financial printer will then host the remaining drafting sessions, circulate new proofs of the document to the working group members and
provide word processing and other administrative support. Finally, once
the draft is finalized, the financial printer will transmit the registration
statement via EDGAR to the SEC, print prospectuses and promptly distribute them to the underwriting syndicate.
Role of the Company's financial printer
The companys financial printer is responsible for document management throughout the registration process, including:
Typesetting/conversion of word-processing documents into the
registration statement, including the prospectus, in the appropriate underwriter's style;
Hosting working group sessions at the financial printers facilities, utilizing conference rooms, telephone, facsimile and Internet
capabilities, administrative support and food services;
Document management, including author alterations and proof
distribution of the registration statement throughout the IPO process;
EDGARization of the registration statement, including all exhibits,
for filing with the SEC;
Electronic transmission via EDGAR to the SEC of each filing,
including correspondence with the SEC staff;

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Printing of the prospectus and distribution of it to the selected

underwriters syndicate and working group; and
Electronic conversion of the prospectus to HTML/PDF formatted
files for distribution by the underwriters and electronic posting of
the document to the companys web site.
Following the companys IPO, the financial printer often will assist
the company with its ongoing printing and filing responsibilities as a
public company, including:
SEC filing requirements, such as the companys filings on
Forms 10-K, 10-Q and 8-K, Section 16 filings and the filing and
printing of the companys annual report and proxy statement;
Other filing needs, including filings made in connection with
future follow-on public equity or debt offerings and merger and
acquisition transactions; and
Certain ancillary services, including translation services, localization/globalization services, digital and print services.
Selection criteria
Company management is responsible for selecting the financial
printer, and should do so relatively early in the IPO process. Criteria that
should be used in selecting a financial printer include the following:
Level of service. Time will be of the essence as the initial registration
statement nears completion and the underwriters and management team
gear up for the road show. Rapid and accurate service from the financial
printer can reduce the time between receiving SEC comments and filing
an amendment to the registration statement. Around-the-clock, professional work by the financial printer will be essential to keeping the
offering on schedule.
Location and facilities. The location of the financial printers office, as
well as the availability of conference rooms, private telephone rooms,
modem and Internet connections and other amenities are factors worth
considering for the convenience of the working group.
Cost. Cost is a factor, and the multiple variables that affect the IPO
process can add to the time and expense of the transaction. In evaluating
costs of the financial printing services, a company should consider these

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Chapter 2 - Assembling Your IPO Team

costs in relation to the value of the printing services received. The quality
of service will affect the time commitment and cost of other service providers during the transaction. The company may also want to consider
the importance of developing a strong, long-term relationship with its
printer in light of the future needs that the company will have following
its IPO.
To ensure that the financial printer can give an accurate and competitive proposal, the company should give the printer as much information
as possible, including the number and quality of prospectuses to be produced, a rough estimate of the number of pages, and the type and number
of photographs, artwork and other graphic elements to be included. The
company should also inquire about the financial printers pricing of variable aspects of the transaction, such as amendments to the registration
statement, authors changes, conference rooms and client accommodations (for example, meals, secretarial services, postage and delivery, and
rush, overtime or weekend service).
References. The financial printer should be able to give the company a
list of other companies for which the printer has recently performed financial printing services in connection with IPOs. Additionally, the financial
printer generally will be able to provide the company with names of some
of its long-time public company clients. These kinds of references will
reflect the quality of the financial printers long-term services to public
companies. The company may also wish to solicit the opinion of company
counsel and the underwriters, who likely will have dealt on numerous
transactions with all the major financial printers.

Special Experts
Most working groups do not include special experts. Where the
nature of the companys business requires an understanding of highly
technical information, however, it may be appropriate to involve a special
expert in the registration process. For example, if patented technology is
central to the companys business, special patent counsel may be needed
to explain the status of a patent application, the strength of the companys
patent portfolio or claims of patent infringement. If a company operates in
a heavily regulated field, such as medical devices or telecommunications,
special regulatory counsel may be helpful to the working group.

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The extent of a special experts involvement in the public offering

process can vary widely depending on the working groups requirements.
A special experts involvement may consist of a brief telephonic due diligence interview with the underwriters, an informal review and edit of
relevant sections of the registration statement, the rendering of a legal
opinion on matters of particular concern, or actual expertizing of a
portion of the registration statement. In most general terms, Section 11 of
the Securities Act describes an expert as one whose profession gives
authority to his or her statements. Section 11 of the Securities Act
describes an expertised portion of the registration statement as one that is
prepared or certified by an expert who, with his or her consent, is named
in the registration statement as having prepared or certified a part of the
registration statement, or report or valuation that is used in connection
with the registration statement. The level of special expert participation
should be decided by the company and the underwriters, with the advice
of their respective counsel, early in the IPO process. The expected extent
and purpose of an experts role should be made very clear to the expert,
who may not have much familiarity with the IPO process.

Others
Numerous other parties will be tangentially involved in the IPO
process as well. For example, the company will need to select a banknote
company to print stock certificates and a transfer agent and registrar to
administer stock issuances and transfers. Company counsel generally can
assist the company in offering recommendations on the basis of prior
experience and reputation and assisting the company in making these
arrangements. The company may also wish to retain a design firm to assist
with graphics and artwork to be used in the prospectus, and a professional to help the CEO and CFO refine their public speaking and
presentation skills for the road show. The underwriters generally can put
the company in touch with people experienced in providing these services
in the public offering context.

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Chapter 3
Gearing Up
A company will need to undertake a number of corporate housekeeping and administrative tasks to prepare itself for the IPO process and the
transition to becoming a public company. The extent and expense of the
work required will vary from company to company and will depend on a
number of factors, including the length of the companys operating
history and the quality and accuracy of the companys corporate records.
In addition to the corporate clean-up items that should be performed, the
company should address with its counsel and underwriters any desired
structural changes such as a reincorporation, a stock split, various defensive mechanisms and new equity compensation plans.
Among the issues that a company should consider in anticipation of
its IPO are the following:
Structure of entity
Most entities that go public in the U.S. are domestic C corporations. If
the business proposing to go public is a limited liability company (LLC),
a partnership, an S corporation, a foreign corporation or other form of
entity, legal and tax counsel should be consulted as to the desirability,
timing and consequences of converting into a domestic C corporation.
State of incorporation
A fundamental organizational issue that a company should address
at the early stages of the IPO process is the state in which it is incorporated
and whether the company should reincorporate in another state. Benefits
that are often sought in connection with a reincorporation include extensive legal precedent (and therefore predictability) in matters of corporate
governance and a judiciary experienced with corporate affairs and a
history of upholding stockholder rights plans, or poison pills, and other
defensive measures. The primary disadvantages are the effort and costs,
which include legal fees and additional annual franchise taxes.
Many legal practitioners recommend that companies reincorporate in
the State of Delaware prior to an IPO. More than 500,000 business entities
have their legal home in Delaware, including more than 50% of all U.S.

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public companies and 58% of the Fortune 500 companies. There are a
number of reasons why companies choose Delaware, including the
following:
The Delaware General Corporation Law is one of the most
advanced and flexible corporations statutes in the nation;
Delawares highly respected Court of Chancery dates back to 1792
and is widely recognized for its expertise in corporation law matters;
The Delaware legislature, which gives high priority to corporation
law matters and utilizes the sophistication of experienced practitioners of the Delaware Bar Association (plus, each year, the Delaware Governor and General Assembly work with their Courts
and the Delaware State Bar Association to ensure that Delawares
legal system is the most modern, flexible and responsive in the
nation); and
The highly developed body of case law created by the Court of
Chancery and the Delaware Supreme Court, with which lawyers
and judges in every state are familiar and which provides a wealth
of precedent for corporate executives and directors to utilize in
making decisions.
A reincorporation is generally accomplished by creating a new subsidiary in the state in which the company wishes to reincorporate, and
then merging the company into the newly formed subsidiary. Additional
effort and expense will be associated with assigning contracts, patents,
trademarks and copyrights from the original entity to the reincorporated
entity, and obtaining new qualifications for the reincorporated entity to
do business in various states. There is some debate among legal experts as
to whether the benefits of reincorporating outweigh the effort and
expense, and the company should discuss the matter with its counsel
before making a decision.
Capital structure
Some changes to the companys capital structure may be necessary to
complete the IPO. Often, a company needs to authorize additional shares
of common stock to have enough shares to complete the IPO and for
future needs. In addition, with the advice of its investment bankers, the
company may choose to effect a forward or reverse stock split in order to
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Chapter 3 - Gearing Up

achieve a proposed offering price in a particular target range. As a general

rule, the offering price of an IPO will be in the range of $10 to $20 per
shares. Pricing a stock too high may make the purchase of round lots of
shares too expensive, limiting the number of potential investors, and
pricing the stock too low may make the stock more susceptible to extreme
fluctuations in price and price manipulation, and may increase the risk of
falling below the listing requirements of Nasdaq or the applicable
exchange after the offering.
Because stockholder approval is required for most changes to a companys capital structure, any reasonably foreseeable changes should be
made while the company is private and the procedure for obtaining stockholder approval is still relatively simple. For example, the company may
wish to authorize even more common stock than is necessary to complete
the IPO in order to provide flexibility for future public (or private) offerings, certain acquisitions or the addition of shares to stock option pools.
The company may also wish to authorize undesignated preferred stock
that can later be used for future financings or in connection with the
implementation of a stockholder rights plan, as discussed in greater detail
in Chapter 2.
The board of directors and committees of the board
A company should consider whether changes in the composition of
its board of directors should be made prior to or in connection with the
IPO. Does the current board have sufficient depth and experience? Would
adding one or more independent directors with relevant industry experience provide additional insight and make the company more attractive to
investors? Also, does the companys board composition comply with
applicable Nasdaq or exchange listing requirements and SEC rules? For
example, the NYSE and Nasdaq require that a majority of the board of
directors of a listed company be composed of directors who satisfy their
respective independence standards. Does the company need to add one or
more independent directors? Also, are there any directors who may resign
in anticipation of the IPO?
In addition, a company should consider whether to organize additional board committees. The board of directors of a public company must
have a standing audit committee that is directly responsible for the
appointment, compensation, retention and oversight of the companys
auditors. Audit committee members must meet stringent standards of

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independence, and public companies are required to disclose whether

they have at least one financial expert serving on their audit committees. For example, pursuant to SEC Rule 10A-3, an audit committee
member may not, other than in his or her capacity as a member of the
board of directors or a committee of the board, accept any payments for
services as an officer, employee or consultant of the company. Also, SEC
Rule 10A-3 requires national securities exchanges and associations to prohibit the initial listing of any security of a company that is not in
compliance with the rule. The SEC has provided certain limited exemptions from its independence standards, including exemptions for the
newly public company such that all but one member of the audit committee may be exempt from the standards for 90 days from the effective date
of the companys registration statement and a minority of the members of
the audit committee may be exempt from the standards for 1 year from the
effective date of the companys registration statement.
In addition, the NYSE and Nasdaq have requirements with respect to
board and board committee composition. The NYSE and Nasdaq require
that a listed company have an audit committee of at least three directors
and composed entirely of independent directors (pursuant to their respective standards of independence), among other requirements, including
certain financial literacy requirements. The NYSE also requires that a
listed company have a compensation committee and a nominating/corporate governance committee composed entirely of independent
directors. Nasdaq does not mandate that its listed companies have compensation or nominations committees. However, Nasdaq does require
that the compensation of a listed companys CEO and other executive
officers must be determined, or recommended to the board of directors,
either by a majority of the independent directors or a compensation committee composed solely of independent directors. Also, Nasdaq requires
that director nominees be selected, or recommended for the boards selection, either by a majority of the independent directors or a committee
composed solely of independent directors. The NYSE and Nasdaq have
provided exemptions to new public companies from their respective governance rules for a limited transition period.
If a company cannot meet the independence or other corporate governance standards of the SEC and applicable Nasdaq or exchange listing
requirements prior to its IPO, the company should begin implementing an
appropriate process to become compliant within the permitted transition
periods. The process of identifying qualified, independent directors takes

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time and diligence. Many companies engage recruiting firms to assist in

the process. Regardless, this is an area of corporate housekeeping that
requires serious attention early in the IPO process.
Indemnification of directors and officers
The company should review, with the assistance of counsel, the adequacy of the indemnification provisions contained in its charter
documents. The company should also make sure that its form of officer
and director indemnification agreement reflects the current state of the
law, has been approved by the stockholders (to the extent necessary to
ensure its enforceability), and has actually been entered into with each
officer and director. In addition, the company should purchase appropriate director and officer liability insurance, as discussed in greater detail in
Chapter 4.
Capitalization records
The company should make sure that its capitalization records
accurately reflect all stock issuances, transfers and cancellations; all option
and warrant issuances, exercises and terminations; all convertible debt
issuances, transfers, conversions and cancellations; all anti-dilution
adjustments; and details of any other securities transactions. In order to
determine holding periods under Rule 144, the date of payment should
also be recorded. Ideally, the date of board authorization, the blue sky
exemption relied upon, and any special rights or restrictions (such as
rights of first refusal, registration rights, voting agreements or lock-up
restrictions) will also be noted in the capitalization records.

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Practical Tip: Avoiding Lost Stock Certificate Charges

While a company is private, company counsel often acts as the
companys transfer agent and lost stock certificates are relatively
easily replaced. Prior to the effectiveness of the IPO, the transfer
agent function passes to the professional transfer agent selected by
the company. Professional transfer agents typically require a fee in
connection with the issuance of a replacement certificate. The fee
represents a premium for a bond to indemnify the company and the
transfer agent in the event that the lost certificate resurfaces and is
traded in error. The bond premium fee is often calculated as a percentage of the value of the certificate being replaced, and therefore
can be quite expensive. As part of its pre-IPO preparation, a
company may wish to remind its employee-stockholders and investors to locate their certificates or promptly request replacements.oCompany counsel will need to trace the companys capitalization
history to ensure that the prospectus accurately discloses the companys
current capital structure, the dilution to new investors, and the shares that
will be eligible for sale by existing investors following the IPO. Underwriters counsel will review these records carefully during the due diligence
process. If the companys outstanding securities were not issued in compliance with applicable federal or state securities laws, a time-consuming
rescission offer may be required. The companys new transfer agent will
also require accurate records.

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True Story: Due Diligence Uncovers Potential Violations

During the IPO due diligence investigation of one technology
company, attorneys discovered that certain stock issuances and
stock option grants by the company to its employees and consultants were not made in compliance with federal and state securities
laws. This discovery was made just prior to the filing of the companys registration statement. The company and the IPO working
group were forced to consider two alternatives either delay the
IPO for several months while the company made an offer to stockholders and optionholders to rescind the earlier stock transactions
or proceed with the IPO and hope to be able to convince the SEC to
allow the company to conduct the rescission offer after the IPO.
Fortunately for this company, the SEC permitted the company
to move forward with its IPO. However, the company was required
to register the rescission offer after the IPO as a public offering on a
Form S-1 registration statement. The companys IPO was successful,
but the company spent well in excess of $100,000 in legal, accounting
and other fees to remedy the problem. oLock-up situation
The number of shares sold in an IPO is typically only a fraction of the
companys total outstanding stock. If all of the companys existing investors tried to sell their stock in the open market at the same time or shortly
after the IPO while the underwriters were trying to establish a market for
the companys stock, the market price would be severely depressed. Most
underwriters would refuse to accept the risk of bringing the offering to the
market under such circumstances. Underwriters therefore require that a
companys existing stockholders enter into contractual agreements to
refrain from selling their stock during a specified time following the IPO,
typically 180 days.
Often, lock-up restrictions will be included in existing contracts with
stockholders, such as stock purchase agreements, registration rights
agreements or option plans. Generally, underwriters are not willing to
rely on these provisions and require each existing stockholder to enter
into a lock-up agreement with the underwriter on its standard form. The

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company should analyze which of its stockholders are already bound by

lock-up agreements with the company and have this information available for the underwriters early in the registration process. Underwriters
typically require that all or a large percentage of the companys outstanding shares are locked-up before the preliminary prospectus is
printed. Accordingly, it is important for the company to get an early start
on obtaining lock-up agreements from its stockholders.
In May 2003, the NYSE/NASD IPO Advisory Committee issued a
report in which it made several recommendations for the SEC and the selfregulatory organizations (such as the NYSE and the NASD) to enhance
public confidence in the integrity of the IPO process. In particular, the IPO
Advisory Committee concluded that investors reasonably expect that the
companys directors, officers and large pre-IPO stockholders who agree to
lock-up their shares will be bound by those agreements for the stated
period. Accordingly, the IPO Advisory Committee recommended that
underwriters be required to notify the company prior to granting a lockup exemption and to announce the exemption through a national news
service. The Committee also recommended that companies be required to
file a report on Form 8-K with the SEC concerning any exemptions
granted by underwriters to such persons. As of the date of this edition of
the guidebook, the NYSE and NASD had proposed amendments to their
rules to implement these recommendations, but the rules had not yet been
adopted.
Analysis of registration rights
The company may have granted some of its stockholders the right to
include their shares in a public offering of the companys stock. The company, together with its counsel, should analyze these rights, including the
number of shares subject to them, whether the rights apply in the case of
the companys IPO, whether the underwriters can reduce or eliminate the
number of such shares to be sold if marketing considerations so require,
the order of priority among registration rights holders in the event of a
cutback, the steps required to obtain an amendment or waiver of the registration rights and applicable notice periods. The company should have
this information available for the underwriters early in the registration
process.

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Overhang analysis
Closely related to an analysis of the companys capitalization records,
lock-up situation and registration rights is the overhang analysis. This
analysis, which will be summarized in the section of the prospectus entitled Shares Eligible for Future Sale, reflects the interplay of required
holding periods under the securities laws, lock-up restrictions and registration rights. The analysis shows the maximum number of shares held by
existing securityholders that may be sold at various intervals after the
effective date of the IPO.
Analysis of other rights
During the companys financing history, it may have granted various
rights to certain investors, including the right to receive advance notice of
certain events, such as an IPO, or rights of first refusal to purchase stock
in new rounds of financing. The documents containing these rights should
be reviewed carefully to ensure that, to the extent that such rights apply
to an IPO, they are satisfied or properly waived, and to analyze whether
it is appropriate to seek to terminate these rights upon effectiveness of
the IPO.
Minute books
The company should make sure that its minute books contain final
minutes of all board, board committee and stockholder meetings, as well
as actions of the board or stockholders taken by written consent. Not only
is this good corporate practice, but both company counsel and underwriters counsel will insist upon reviewing a complete set of all minutes and
consents as part of the due diligence process.
Due diligence materials
The company can begin assembling the many documents that the
underwriters and their counsel will want to review in the course of their
due diligence. This includes capitalization records, minute books, material contracts and many other documents. Once underwriters have been
selected, the company can obtain due diligence checklists from them and
their counsel. The company can obtain a sample due diligence checklist
from its counsel or use the one in Appendix B to begin collecting materials
in anticipation of the underwriters request. This topic is discussed in
greater detail in Chapter 7.
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Stock plans
The company will need to review its existing stock plans with its
counsel. Once the company is public, certain provisions of the federal
securities laws will become applicable to the companys stock plans, while
certain provisions of state securities laws may no longer apply. As a result,
the companys existing plans may be inadequate or inappropriate for a
public company. Many companies also use the IPO preparation process as
an opportunity to add shares to the pool of options available for future
grant. The company should authorize a sufficient number of shares for its
anticipated needs for the foreseeable future. Finally, new types of plans
which were not practical prior to the companys stock becoming publicly
traded, such as employee stock purchase plans (ESPPs), will become
available following the IPO. Because most of these plans require board
and stockholder approval and must be described in the prospectus, it is
advisable to finalize them as early in the IPO process as possible.
Audit and review of material accounting issues
The prospectus must contain audited statements of operations, cash
flows and changes in stockholders equity for the three most recently completed fiscal years and audited balance sheets as of the end of the two most
recently completed fiscal years. While there is no requirement that the
period since the end of the prior fiscal year be audited, some underwriters
will request an audit of such interim period, particularly where the
companys financial situation has changed rapidly and the offering will
go effective late in the current fiscal year. The company should keep its
auditors apprised of its IPO plans to give them sufficient time to complete
their audit work. The company should also discuss with its underwriters,
auditors and counsel any accounting practices that may deviate from
the industry norm, which involve unusual facts or which may otherwise
cause concern or confusion for the SEC or investors. Common problem
areas historically include revenue recognition, deferred charges, accounting for business combinations, goodwill amortization periods,
capitalization policies for intangible assets, reserves, related-party transactions and stock-based compensation. The company will also need to be
prepared to comply with new SEC rules relating to the use of non-GAAP
financial measures, critical accounting policies and off-balance sheet
arrangements, as well as have a roadmap for compliance with rules relating to management reports on internal controls (and required auditor
attestation), disclosure controls and procedures, certifications regarding
the accuracy of financial statements and periodic reports filed with the
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SEC following the IPO. It will be particularly important for the company
to ensure that it has the right internal accounting and control team and
that its systems have been designed to ensure the company can satisfy its
disclosure requirements as a public company.
Cheap stock analysis
One issue that emerging growth companies have long encountered in
the IPO process is the cheap stock issue. The cheap stock issue revolves
around a debate between the SEC and companies concerning how equity
compensation should be reflected in the companys financial statements.
This issue is prevalent for emerging growth companies because they typically rely heavily on equity compensation (stock options in particular) to
provide incentives to their employees and consultants.
Historically, accounting standards have allowed companies to avoid
recording a compensation expense on their income statements when they
grant stock options to employees if the exercise price of the stock option is
equal to the fair value of the underlying stock on the date that the option
is granted. If the option exercise price is less than the fair value of the
underlying stock at the time of grant of the option, the company must
record compensation expense on its income statement in the aggregate
amount of that differential over the vesting period of the option. However, the SEC, in examining the financial statements of a company in the
context of the IPO, often disagrees with the companys determination that
the exercise price of options was equal to the fair value of the underlying
stock at the time of grant of the options and requires the company to add
compensation expense to its financial statements. This can materially
affect the companys results of operations for the historical periods
reflected in the financial statements included in the registration statement,
as well as in future periods as stock options continue to vest. The added
expense is not a cash expense, and so it does not negatively impact the
companys capital resources. However, it is hotly debated whether the
non-cash expense negatively impacts the market price of the companys
stock.
The issue arises as a result of the fact that private companies, by definition, do not have a liquid market for their stock that can efficiently
determine the value of the companys stock based on third party, armslength transactions. Also, there are no clear rules regarding valuation of
private company equity for purposes of determining compensation
expense in connection with equity compensation arrangements. As a result,
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boards of directors, in determining a fair value of their stock for purposes of

establishing an exercise price for stock option grants, must exercise their
own judgment in an environment of significant uncertainty. In the past,
many private companies have been somewhat lax in the methodologies
they have employed in making these determinations. It has not been
uncommon for venture capital-backed companies to employ informal discount approaches to reflect junior liquidation and other rights, lack of
marketability and minority interest discounts. For example, in the emerging
growth company practice, a 90% discount is often taken in valuing common
stock (this approach values the common stock of a private company at 10%
of the price at which the company most recently sold preferred stock to
investors). The across-the-board 90% discount has largely been dismissed in
recent years as a valid method for determining the fair value of common
stock, in large part because the accounting profession has become more
aggressive in requiring private companies to justify fair value determinations for purposes of financial reporting. Nevertheless, it is typical for
venture-backed companies to price the common stock at a discount at anywhere from 50% to 90% to the price of its convertible preferred stock
because of the superior rights held by the holders of preferred stock (for
example, liquidation preferences, dividend preferences, protective voting
provisions and registration rights). As an IPO draws near, this differential
approaches zero, since a typical venture capital preferred stock converts
into common stock in connection with an IPO, and often the companys valuation at the time of the IPO is such that the liquidation preferences of the
preferred stock are often essentially worthless.
The SEC has long been critical of the option pricing techniques used
by private companies. The SEC, in the context of its review of initial public
offerings, often finds (in hindsight) that the option exercise prices were
too low. Support for the companys option prices must be based on specific facts relating to the companys business and transactions in its stock.
The SEC will also typically reject arguments based on a statistical analysis
of other companies pre-IPO option price increases.
It appears that the SECs view on the role of third party valuations in
determining fair value of common stock has evolved somewhat in recent
years. In the past, the SEC has given little weight to valuations obtained in
connection with public offering cheap stock analyses, considering them to
be somewhat suspect and self-serving. However, in the August 31, 2001
version of the Division of Corporate Finance Current Accounting and Disclosure Issues outline prepared by the SEC Staff (the SEC Accounting Issues

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Outline), the Staff indicates that it encourages companies to obtain independent valuations from competent professionals contemporaneous with
the issuance of equity instruments. The Staff also cautions issuers in the
outline that there are a number of specific concerns that the SEC has had
with valuations and encourages issuers to avoid these issues in future valuations. Among the listed concerns are the use of rule of thumb
discounts from recent financing transaction prices and rule of thumb
lack of marketability discounts and minority discounts.
The SEC provides guidance in the SEC Accounting Issues Outline
regarding the type and quality of the information that it expects the equity
valuation analysis to be based upon. The SEC has indicated that valuations should be based on objective, verifiable evidence that has been
documented contemporaneously with the issuance. The SEC further indicated that company-specific information will strengthen the valuation
determination and noted that the following analyses should be included
in a valuation:
a discussion of the companys operating performance, both in the
past and as anticipated in the future;
a quantitative reconciliation of the fair value of the options and
the IPO price;
a discussion of the valuations of the company performed by underwriters who have been approached with respect to the IPO; and
a discussion of contemporaneous transactions in the companys
securities with independent third parties, including a discussion
of the nature of the transactions and the securities sold.
An interesting point to note is that historically the SEC Staff has taken
a dim view of discounting option exercise prices significantly from contemporaneous preferred stock financing prices as a general matter. In part, this
viewpoint was based on the SECs strong feeling that the rights and preferences of preferred stock in private companies (most notably, the liquidation
preference) did not justify significant discounts because the investment was
made principally with a view to a future public offering, at which time the
preferred preferences would terminate in connection with the conversion of
the preferred stock into common stock. Following the substantial decline in
the stock markets beginning in 2000, valuations of many public and private
companies have plummeted, and the liquidation preferences of preferred
stock have proven to create an enormous disparity in relative value
between preferred stock and common stock on an actual basis. The value of
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preferred stock liquidation preferences has been demonstrated in multiple

ways and in transactions, even for companies that were close to embarking
upon initial public offerings (and, indeed, may have been in registration)
prior to the precipitous decline in the stock markets.

Practical Tip: Adopt Best Practices for Common Stock

Valuation to Proactively Minimize the Cheap Stock Issue
Long before its IPO, the company should be proactive in minimizing the possibility or size of cheap stock charges and should work
closely with its auditors and counsel to determine a proper option
pricing strategy. Regardless, in making fair value determinations, the
board of directors should analyze all relevant factors. A preliminary
draft of a proposed practice aid on valuation of private company stock
published by the American Institute of Certified Public Accountants
sets forth a list of factors relevant to a valuation determination that
serves as a good guide:
The achievement or failure to achieve significant development or business milestones;
The state of the companys industry, and the economy in
general;
The experience and competence of the management team
and other key employees, and whether the key team members are in place;
The companys share of its market;
The presence or absence of barriers to entry in the market;
Competitive forces, including potential competition, substitute products, buyers bargaining power, suppliers bargaining power and current competition;
The existence of proprietary technology, products or services;
The quality of the companys workforce;
Characteristics of the companys customers and vendorstheir number, health, profitability, etc;

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Practical Tip: Adopt Best Practices for Common Stock

Valuation to Proactively Minimize the Cheap Stock Issue
(continued)
Strategic relationships with major suppliers or customers;
The nature of the major investors in the company;
The companys cost structure and financial condition;
The attractiveness of the industry segment; and
General risks, conditions and developments in the industry
in which the company operates (as well as company-specific
risks, such as failures to ship product, delays in product
development, etc.).
The companys board of directors should also consider analyzing the following factors:
The companys performance, both historically and prospectively and the ability to generate sufficient revenue or to
raise necessary capital;
The companys stage of development and associated risks
(for example, product development risks, manufacturing
risks, lack of backlog, etc.);
Valuations of the company performed by a third party, if
any; and
Significant arms-length transactions in the companys
securities between the company and third parties.
It is important that the board of directors create a record of its
valuation deliberations, particularly as the company approaches the
point in time when a public offering is a realistic possibility within
an 18 to 24 month horizon. The record will serve to support the companys position that its valuation determinations are based on
concrete analyses rather than unprincipled rules of thumb, and it
will also make it easier for the board and company counsel to
respond in a detailed fashion to the SECs cheap stock comment(s).

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In cases where the SEC has asserted that exercise prices were below
the fair market value of the stock, the SEC will require the company to
record a compensation expense equal to the difference between the
deemed fair market value of the underlying stock at the time of grant and
the exercise price, typically amortized over the vesting periods of the
applicable options. The SEC conducts its cheap stock analysis for a period
of time preceding the effective date of the offering. Typically this period is
from 12-18 months prior to the offering, though there are occasional
instances in which the SEC will look back over a longer period of time. The
SECs positions have become increasing strict over the past few years. In
addition to becoming more aggressive on the period of time leading up to
the IPO over which option grants are examined, the SEC has also changed
from comparing option exercise prices to the low point of the proposed
offering price range to the mid-point of that range. Depending on the level
of option activity at a given company, compensation charges resulting
from SEC cheap stock scrutiny can materially change the companys
reported financial results and negatively impact valuation in the IPO.
Charges have ranged from de minimus to over $160 million.
The cheap stock issue is sometimes the most significant issue debated
between the company and the SEC during the offering process, and can
require many communications between the company and the SEC before
resolution. Since this review cycle takes time, a company may want to
consider ways to shorten the process. One approach is for the company to
acknowledge that options were granted with an exercise price lower than
the fair value of the common stock and proactively recognize a compensation charge prior to the initial filing of the registration statement. The theory
underlying this approach is that the company will have taken a reasonable
proactive step to address the SECs potential concerns, and that the
resulting compensation charge represents a more defensible position.
As an alternative or complementary strategy, the company can
consider preemptively filing with the SEC simultaneously with the initial
filing of the registration statement or shortly thereafter (in any event prior
to receiving the SECs first round of comments) a detailed analysis that
describes how the company has determined the fair value of its common
stock over the 12-18 months prior to the commencement of the offering, and
defends those determinations with references to company-specific credible
evidence. One factor that could delay the ability to file a preemptive
analysis letter is that underwriters often want a company to file the initial
registration statement without a price range for the offering. Without this

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price range, the SEC cannot effectively analyze the cheap stock issue. Notwithstanding the lack of a price range in the initial filing, a cheap stock
analysis filed by letter can assure a broad price range.

Practical Tip: Avoiding the Cheap Stock Timing Trap with

the Preemptive Strike
A company may choose to accelerate the determination of
whether there is a cheap stock issue, and if so, the magnitude of the
issue. Companies often wish to print their preliminary prospectus
based on the prospectus included in the first pre-effective amendment of the registration statement, which is the amendment
including the responses to the SECs first round of comments to the
registration statement. Absent an acceleration of the cheap stock
dialog, as described in the text above, at the time a company desires
to print preliminary prospectuses, its only indication of the SECs
comfort with the companys cheap stock position is a generic initial
comment regarding the exercise price of stock options (the comment
would simply ask the company to explain its cheap stock position).
The SEC would not be commenting based on an understanding
of the analysis that the company had undertaken (because the SEC
would not have received that analysis yet).
If a company accelerates the process, as described in the body of
the text above, it could cause the SECs first comment letter to
include a specific reaction by the SEC to the companys cheap stock
analysis. This means that, at the time of the companys decision
whether to print preliminary prospectuses, the company will have
the benefit of having some indication of how far apart the company
and the SEC are on this important issue. The risk of printing without
this information is that it may turn out that the SEC will require a
material additional compensation charge after the printing of preliminary prospectus, which could require the company to reprint
and re-circulate the preliminary prospectus, which is expensive and
could delay the timing of the offering.
Regardless of whether or not the company believes that its option
pricing history is defensible, the cheap stock issue is a complicated one in
which the companys legal and accounting advisors should be deeply
involved in the analysis and strategy.
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It is worth noting that the accounting treatment of option grants is

likely to change in the not-too-distant future. There have been several significant developments relating to accounting for stock options. In March
2004, FASB issued an exposure draft of a proposed Statement of Financial
Accounting Standards Share-Based Payment, which proposes to
amend FASB Statements No. 123 and 95 and addresses a wide range of
equity-based compensation arrangements. Under the proposal, all forms
of share-based payments to employees, including stock options, would be
treated the same as other forms of compensation by recognizing the
related cost in the income statement. The expense of the award would
generally be measured at fair value at the grant date and, in effect, results
in a compensation charge that will lower a companys net income or net
income per share. Current accounting guidance requires that the expense
relating to most stock options only be disclosed in the footnotes to the
financial statements. The final rules are expected in late 2004, which
would be effective in 2005 for publicly traded companies and 2006 for
privately held companies.
In anticipation of the FASB proposal, two separate legislative proposals were introduced in the U.S. Congress that could trump FASBs efforts:
the Broad-Based Stock Option Plan Transparency Act of 2003 (the Transparency Act) and the Stock Option Accounting Reform Act of 2003 (the
Reform Act). The Transparency Act is designed to ensure that stockholders and potential investors have accurate and meaningful financial
information and yet enable companies to continue granting stock options.
The Transparency Act proposes a three-year moratorium of any new standard while the SEC conducts a study of the economic impact of any such
accounting change. The Reform Act, which was applauded as a reasonable compromise by the National Venture Capital Association (NVCA)
and a large number of emerging growth companies in the U.S., proposes
a limit on stock option expensing to options granted to a companys top
five executives. However, the Big Four accounting firms sent a letter to the
U.S. Congress urging members to refrain from blocking FASBs proposals.
There are several schools of thought regarding what privately held
companies should do before the FASB proposal rules take effect. While
many companies may retain their existing equity compensation practices,
other companies are taking measures to adopt alternative equity award
programs or modifying existing programs to reduce the potential impact
of the proposed rules.

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Deemed dividends; discount on sale of equity to strategic partners

In recent years, the SEC has extended the cheap stock concept to sales
by the company to outside investors. Under this type of analysis, the SEC
takes the position that sales of stock during the time preceding an IPO
(usually within six months of filing the registration statement) were made
at a price less than the fair value of the stock and requires the company to
record a one-time deemed dividend charge in essence, saying that the
company paid a dividend to the investors in an amount equal to the difference between the price paid and the deemed fair market value.
The SEC looks most closely at rounds of financing led by existing
investors in the company under the theory that the transaction may not
have been at arms length and that the investors may have used their position to buy stock at a discounted price. However, the SEC has required a
deemed dividend charge even with respect to some transactions in which
a company has no discernible incentive to sell its stock to investors at a
reduced price. For example, one company recorded a charge of over $65
million in connection with its first registration statement filing. The charge
related to the sale of preferred stock three months before the filing to a
group led by outside financial investors. Unfortunately, for both the
investors and the company, the eventual IPO price was significantly less
than the price paid by these investors, but the charge remained on the
books.
The SEC also closely scrutinizes sales to investors who also have a
commercial relationship with the company (for example, customers and
suppliers). The assumption is that the negotiated price does not represent
the true fair value of the stock because the strategic partner is otherwise
transferring value to the company in exchange for a reduced purchase
price. If the relationship with the strategic partner yields revenue for the
company, the SEC may require the company to reduce revenue in an
amount equal to the deemed discount. In other cases, the charge will
increase the cost of revenue or an operating expense line item. The charge
is usually amortized over the life of the contract.
Defensive measures
Once a companys stock becomes publicly traded, the company can
be vulnerable to unwanted takeover attempts. Some of the lessons to be
learned from hostile transactions (or attempted transactions) during

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recent years include: size alone is no defense; stock may be used in hostile
takeover attempts; aggressive agitators can become catalysts for stockholder action and can provoke corporate change; foreign companies are a
threat; and cross-border issues will not deter a buyer coveting a strategic
asset at a compelling value. The goal of defensive measures is to enable
the company to control the timing and process of unsolicited takeover
bids and to encourage bidders to negotiate with the companys board of
directors. A defensive measure is not intended to, and will not, preclude
all unsolicited takeover bids.
There are numerous defensive measures that can give the company
procedural advantages in ensuring that the stockholders are not subject to
abusive takeover tactics and that make a hostile takeover more difficult
and costly to complete. These measures include undesignated preferred
stock, stockholder rights plans (also known as poison pills), certain
charter and bylaw amendments, option acceleration provisions, golden
parachutes, elimination of cumulative voting, a classified board of directors, a dual class stock structure (with one class of stock, which is not
publicly traded, having super voting rights) and many others. Several of
these measures are discussed below.
Classify the Board of Directors. A corporation can divide its board of
directors into two or three classes of directors, with the term of office (in
years) for directors equal to the number of classes, and the election of each
class to occur in staggered years (for example, the term of directors in the
first class to expire at the next annual meeting following the adoption of
the classified board, the second class one year thereafter and the third
class two years thereafter). By so dividing the board into classes, only the
members of one class of the directors are up for re-election in any given
year. In connection with the classified board, the company may also
provide in its charter documents that directors may only be removed by
stockholders for cause (in some states, this automatically results from
opting for a classified board). Classifying the companys board of directors may increase continuity of board membership, make it harder for a
stockholder to acquire control of the board in one election, give time for a
long-term strategic plan to be implemented, and prevent some types of
unfriendly creeping acquisitions or partial bids for control or other
abusive takeover tactics. Critics of classified boards argue that it is more
difficult to hold directors accountable for their actions when they are up
for election only every two or three years.

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Board Size and Vacancies. A company may amend its charter documents to vest solely in the board the power to change the size of the board
of directors and to fill any vacancies (other than following removal by a
vote of stockholders). These provisions, together with supermajority
requirements to amend such provisions in the charter documents (discussed below), protect against expansion of the board by a simple majority
stockholder vote and allow the board to control who fills all vacancies
other than those created by a stockholder vote.
Eliminate cumulative voting. Where cumulative voting by stockholders
is required or permitted in the election of directors, a stockholder can cast
a number of votes equal to the product of the number of directors to be
elected multiplied by the number of votes to which the stockholders
shares are entitled, and allocate those votes all to a single candidate or distribute the votes among as many candidates as the stockholder thinks fit
(not to exceed the number of board seats up for election). This type of
voting can allow a minority stockholder to gain board representation.
A company should consider the benefits of eliminating cumulative voting,
if possible.
Eliminate ability of stockholders to act by written consent. A company may
provide in its charter documents that stockholders may not act by written
consent. As a result, stockholders of the company would only be able to
act at a meeting duly called and held in accordance with the companys
charter documents, the applicable state corporation law and the proxy
rules under the federal securities laws. These amendments help to prevent
a small number of investors that hold a majority of the outstanding shares
of the company from acting quickly to take corporate action that may
or may not be in the best interests of the company or the minority stockholders. In addition, these amendments ensure that all stockholders are
entitled to consider and vote upon a stockholder proposal.
Eliminate right of stockholders to call special meetings. A companys
charter documents can eliminate the ability of the stockholders to call
special meetings. This would mean that a stockholder would have to wait
until an annual meeting or a special meeting called by the board of directors to bring a proposal for stockholder approval. This is likely to prevent
a majority stockholder or proxy contestant from forcing stockholder
consideration of a proposal before the board has had an opportunity to
review the proposal.

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Require specific advance notice for director nominations and stockholder proposals. A lengthy advance notice provision for director nominations and
stockholder proposals for consideration at stockholder meetings allows
a company and its board of directors an adequate amount of time to
prepare before these nominations or proposals come before the other
stockholders.
Create a class of undesignated preferred stock. A company may authorize
in its certificate of incorporation a class of undesignated preferred stock
(often referred to as blank check preferred). This class of undesignated
preferred stock enables the board of directors, without any action by the
stockholders, to create one or more series of preferred stock, to establish
the terms of each such series and to issue (or reserve for issuance) the
shares of each such series. This gives the company a high degree of flexibility to rapidly issue securities with terms different than those of
common stock. This flexibility can be very important in acquisitions, in
financing transactions and in other strategic transactions where a
company wishes to issue securities to one or more parties.
Blank check preferred also enables the board of directors to implement a stockholder rights plan (often referred to as a poison pill)
without stockholder approval. The primary goal of a stockholder rights
plan is to encourage potential bidders to come to a companys board of
directors with an acquisition proposal and negotiate, rather than going
directly to stockholders with a tender offer. The existence of a stockholder
rights plan helps to discourage inadequate bids, and gives the board the
opportunity to adequately evaluate an acquisition overture and take steps
to maximize stockholder value. A rights plan can have this effect because
of its potential to make it financially unattractive for someone to acquire
the company without approval of the board of directors. A stockholder
rights plan is usually implemented through the issuance of a pro rata
dividend of rights to acquire a newly designated series of preferred stock
of the company or, under certain circumstances, another company
involved in a business combination with the target at a designated price.
Supermajority vote for certain amendments to the companys certificate of
incorporation and bylaws. Most of the defensive measures discussed above
are implemented through the companys charter documents. The certificate of incorporation and bylaws generally can be amended with a vote of
stockholders holding a majority of a companys outstanding stock. To
provide the company with additional protection, the company may
amend its charter documents to include a supermajority (often 66-2/3% or
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some other percentage in excess of a simple majority) vote requirement for

any proposed future amendments to the sections of the charter documents
that implement the defensive measures discussed above. The absence of
super-majority voting provisions could make it easier for a hostile third
party to eliminate defensive protections.
Statutory anti-takeover measures. In addition to the protections discussed above, depending on a companys state of incorporation, the
company may be subject to the protection of a state anti-takeover statute.
These provisions generally prohibit mergers, sales of material assets and
certain other specified transactions between the company and a holder of
a threshold percentage of the companys outstanding voting stock for a
number of years following the date on which the stockholder became a
holder of the significant percentage of the outstanding stock, subject to
certain qualifications. The ban typically does not apply if (1) the proposed
transaction by which the stockholder became a significant stockholder is
approved by the companys board of directors prior to the date on which
the stockholder became a significant stockholder, (2) the transaction
involves a business combination approved by the board of directors of the
company or by holders of the outstanding voting stock not owned by the
significant stockholder, or (3) the company elects under certain circumstances to exclude itself from the coverage of the anti-takeover statute.
These statutes vary from state to state, and companies should consult with
counsel about whether the companys state of incorporation has an antitakeover statute and how it works.
Most defensive measures can be implemented at any time, provided
the company can obtain the required corporate approvals. However,
adopting them while the company is private has certain advantages. Any
necessary stockholder approval can be obtained more easily before the
company becomes public and has institutional stockholders and before it
is required to comply with the proxy solicitation rules applicable to public
companies. Many institutional investors vote against the implementation
of additional defensive measures because they believe such measures may
deprive them of a change in control premium for their shares. In addition,
a court is more likely to enforce a mechanism that is implemented following careful and orderly consideration by the board, rather than one that is
hastily adopted in the face of a particular threat.

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The existence of, or absence of, defensive measures could in theory

have an effect on the success of an IPO. After all, the institutional investors
who typically vote against the implementation of defensive measures are
often the same institutional investors to which the companys underwriters are attempting to sell shares in the IPO. However, as a general rule the
existence of most typical, middle-of-the-road defensive measures such as
a classified board and blank check preferred at the time of an IPO will not
have an adverse effect on the marketing of the IPO. An exception to this
rule is the stockholder rights plan; conventional wisdom has been that the
existence of a stockholder rights plan at the time of an IPO generally does
have an adverse effect on the marketing of the IPO.
Each of the defensive measures mentioned above are highly specialized topics, and the formulation of an effective package of defensive
measures should be discussed in detail with the companys counsel and
investment bankers. Additionally, the implementation of defensive measures requires analysis of and advice regarding the fiduciary duties of the
companys board of directors.
Review and amendment of charter and bylaws
The companys certificate of incorporation and bylaws may have
been adopted many years prior to the IPO and may contain a number of
artifacts from early rounds of financing or other provisions that are obsolete and no longer appropriate for a public company. The company and its
counsel should review these charter documents and amend them as necessary as part of its pre-IPO corporate housekeeping.
Third-party consents
The company may have lines of credit with banks or other agreements with third parties that require consent to certain actions
contemplated in connection with the IPO. For example, even if the IPO
itself does not require any third-party consents, a reincorporation might
require approval under certain bank covenants, or naming a customer in
the prospectus might require the customers approval. Also, a company is
often required to file its customer, strategic partner, distributor and other
agreements with the SEC because of their materiality to the company.
These agreements often contain confidentiality provisions that require the
consent of the other party. The company will also need to obtain consents
from customers to include their logos or case studies in the companys

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prospectus. If the company decides to include statements and statistical

data from market research firms, it will need consents from those parties
as well. In seeking such consents, the company should request that the
third parties keep the companys IPO plans confidential.
Settlement of claims
If a company has outstanding disputes, it should consider how the
IPO might change its negotiating position and what steps can be taken to
resolve the disputes before the companys IPO plans become known. Litigants may be less likely to settle for a reasonable amount once the
company has large cash reserves. Disputes regarding ownership of stock,
intellectual property or other significant rights may create marketing
problems for a company in the IPO, lowering its valuation or making a
successful IPO impossible. Material unresolved disputes generally must
be disclosed in the prospectus.
Qualifications to do business
The company should confirm that it and all of its material subsidiaries
are qualified to do business and are in good standing in all jurisdictions
where their respective activities require that they be so qualified.
Although this is primarily an administrative task, getting everything in
order can take a significant amount of time, especially if foreign country
jurisdictions are involved, and may involve the payment of back-taxes or
late fees in the event required qualifications were neglected. The underwriters will expect certificates of good standing from each applicable
jurisdiction to be delivered at the closing of the IPO.
Income and sales tax
Another corporate housekeeping item that may require some lead
time is confirming that the company is current in the payment of all of its
income and sales taxes.
Draft of the registration statement
Having a good first draft of the registration statement available for
the working group early in the registration process can shave many days,
and sometimes weeks, off of the drafting timetable. Although the final
version may bear little resemblance to the initial draft, the information
contained in a good first draft will give the group something to react to
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and will make subsequent due diligence meetings and drafting sessions
more productive. Sections that are particularly useful to have available
early in the process are the financial statements and Business, Risk Factors and MD&A.
Confidential treatment
The company may be required to file with the SEC certain of its contracts as exhibits to its registration statement. SEC rules require a
company to file all contracts not made in the ordinary course of business
which are material to the company and are to be performed in whole or in
part at or after the filing of the registration statementor was entered into
not more than two years before such filing. If the contract is such as ordinarily accompanies the kind of business conducted by the company, it will
be deemed to have been made in the ordinary course and need not be filed
with the SEC unless it falls within one of the following categories, in which
case it must be filed except where immaterial in amount or significance to
the company:
any contract to which directors, officers, the underwriters, stockholders named in the registration statement and certain others are
parties, subject to certain exceptions;
any contract upon which the companys business is substantially
dependent (for example, continuing contracts to sell the major
part of the companys products or services or to purchase the
major part of the companys goods, services or raw materials or
any license agreement to use a patent, trade secret or other intellectual property right upon which the companys business
depends to a material extent);
any contract calling for the acquisition or sale of any property,
plant or equipment for a consideration exceeding 15% of the fixed
assets of the company (on a consolidated basis); or
any material lease under which a part of the property described in
the registration statement is held by the company.
Regardless, any management contract or any compensatory plan, contract
or arrangement in which any director, the CEO or any of the other four
most highly compensated executive officers of the company participates

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is deemed material and must be filed. Other such management contracts

or compensatory plans must be filed unless immaterial in amount or significance to the company.
Once the company files a contract with the SEC, the contract is publicly available on the SECs EDGAR web site. However, the company may
request confidential treatment for certain portions of exhibits, particularly
financial and technical details, so long as the disclosure of the information
would be harmful to the company and is not necessary for the protection
of investors. The process of obtaining confidential treatment can be time
consuming and should be started as early as possible to ensure that the
initial request can accompany the initial filing of the registration statement (or shortly thereafter). This process is discussed in greater detail in
Chapter 8.
Mezzanine and other financing considerations affected by an IPO
Some companies raise additional equity capital as they are nearing
the IPO, either to bolster the balance sheet or to bring in strategic investors. During the late 1990s, some companies had to raise capital before
filing their registration statements to avoid a qualification in the audit of
their financial statements as to the companys ability to finance its future
operations, and obviously it is important that the company make a determination regarding its capital (or strategic financing) needs early on in the
process and ensure that it conducts any such fund-raising activities carefully so as to avoid violation of SEC rules.
The SECs integration doctrine. In general, a company may only offer
and sell securities either (1) pursuant to an effective registration statement
filed with the SEC or (2) pursuant to a valid exemption from the registration requirements (typically, a private placement exemption). In
determining whether a private placement of securities has a valid exemption from registration, the SEC will review not only the private placement
at issue but also any offering of securities that occurs within six months
before and after the private placement. In the event of multiple offerings
occurring within six months of each other, the SEC may view the offerings
to be integrated. In other words, the SEC may consider the offerings as
one, single offering for purposes of determining securities law compliance. The integration of multiple offerings can have the effect of
destroying the availability of a valid exemption for the current transaction
but also of retroactively invalidating the exemption upon which the

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earlier offering relied. This issue took on increased importance for companies caught in the IPO market slowdown that began in late 2000. Some of
these companies, after beginning the IPO process, find themselves
needing to raise money from private sources.
The integration question arises most often in three public offering
contexts: (1) where the company wishes to make a private offering contemporaneously (or nearly contemporaneously) with the IPO; (2) where
the company wishes to make a private offering after it has abandoned its
IPO; and (3) where the company wishes to proceed with its IPO after it has
abandoned a private offering.
Private offerings completed before registration statement is filed. Companies that complete a private financing prior to filing their registration
statements can benefit from the safe harbor protection from integration
offered by Rule 152 of the Securities Act.
Contemporaneous private and public offerings Black Box. Absent a sixmonth interval, the question of whether two offerings should be integrated is generally a fact-based analysis using five factors outlined by the
SEC in 1962. These five factors are whether: (1) the offerings are part of a
single plan of financing; (2) the offerings involve the issuance of the same
class of security; (3) the offerings are made at or about the same time; (4)
the same type of consideration is being received; and (5) the offerings are
made for the same general purpose. Rule 152 of the Securities Act provides a safe harbor from the subjective application of these five factors
relating to the potential integration of certain completed private placements with a companys subsequent IPO, even though the offerings may
be nearly contemporaneous in time.
Most private offerings to investors while a company is in registration
to go public would fail a straightforward application of the five-factor test.
However, the SEC provided significant relief to companies with the issuance of the Black Box and Squadron, Ellenoff line of no action letters. Among
other important guidance given, the SEC in Black Box expanded the safe
harbor for private offerings completed prior to the initiation of an IPO by
stating that a private offering will be deemed completed (even if not
closed) if the only closing conditions that remain are ones beyond the
control of the investors.
The Black Box no-action letter, as supplemented by Squadron, Ellenoff,
also provides a means of effecting a contemporaneous private placement
transaction (which can be initiated and closed during any part of the
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registration process) to qualified institutional buyers (QIBs) and no

more than three large institutional accredited investors. Therefore, companies have relied on the Black Box approach to issue securities to up to
three strategic partners who represent that they are QIBs or institutional
accredited investors either during the registration process or concurrently
with the closing of the IPO.
Private offering following an abandoned IPO. Once the IPO market began
to deteriorate in late 2000, and valuations of numerous companies fell,
many companies that were in the process of going public were forced to
postpone those plans indefinitely and withdraw their registration statements. Many of those companies still needed to raise money but faced
significant integration concerns. Companies were required to wait for up
to six months before initiating a private offering following an abandoned
public offering. In response, the SEC adopted Rule 155, which allows a
company to pursue certain types of private offerings following an abandoned public offering without fear of integration with the abandoned
public offering so long as certain specific conditions set forth in the rule
are met. The intent behind these conditions is to ensure that investors in
the private offering fully understand that the abandoned public offering
was separate and distinct from the private offering and that the protections of Section 11 of the Securities Act that would have been available to
them in the abandoned public offering will not be available to them in the
private offering.
Abandoned private offering followed by an IPO. Rule 155 also provides
integration relief for companies wishing to begin the public offering
process after abandoning a private offering. A private offering will not be
integrated with a public offering in this situation so long as certain specific
conditions set forth in the rule are met. The intent behind these conditions
is to ensure that investors in the public offering fully understand that any
offers to sell securities in the abandoned private offering are withdrawn
and are distinct from the offer to sell stock in the public offering. Rule 155
permits most companies to commence their IPOs immediately following
the abandoned private offering subject to satisfying the conditions of the
rule.

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80

Chapter 4*
D&O Liability Insurance
When a company considers an initial public offering, a question that
will be in the forefront of the minds of current and potential board
members will be: What is the nature of the companys director and
officer (D&O) liability insurance? During the period leading up to an
IPO, board members will be particularly concerned with D&O insurance
because the chances that a company will be sued by its stockholders
increases substantially once the companys shares are publicly traded and
because there is a chance that the directors will be personally named in
such a lawsuit. One way to recruit and retain board members, especially
independent directors, is by offering them the best possible D&O insurance available.

The Need for D&O Liability Insurance

D&O liability insurance is a form of insurance that will respond when
a company and/or its directors and officers are named in a lawsuit for
certain alleged actions or omissions. Federal securities class action litigation is the main type of suit that is brought against a company and its
directors and officers. Officers and directors of companies undertaking an
IPO have particular reason to be concerned about this type of lawsuit: a
securities class action lawsuit is more likely to be filed within three years
of an IPO than at any other time. This type of suit is most likely to occur
when there is a precipitous decline in a companys stock price. The
average stock price drop of companies against which all federal shareholder class action lawsuits have been filed since the passing of the
Securities Litigation Reform Act in 1995 has been 58.8%.
These lawsuits are of great concern for companies because the trend
in average cash settlements has been upward. The average cash settlement
in 1996 was $6.4 million, compared to $22.9 million in 2003. One way to
avoid paying a settlement in these types of cases is by having the case
* The authors wish to thank Priya Cherian Huskins for preparing the initial draft of this
chapter. She was an associate at Wilson Sonsini Goodrich & Rosati from 1997 to 2003, and
is currently a Vice President at Woodruff-Sawyer & Co., an insurance brokerage that specializes in D&O liability insurance. The authors also wish to thank Woodruff-Sawyer & Co.
for making their database available for use in preparing this chapter.

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dismissed. Lawsuits brought in the months following an IPO tend to be

brought under Section 11 of the Securities Act and they have a lower dismissal rate because the pleading standards under Section 11 are easier for
plaintiffs to satisfy as compared to other civil liability provisions of the
federal securities laws. (Section 11 is discussed in greater detail in
Chapter 7.) Another reason these lawsuits are of great concern to companies is that they often take years to settle, resulting in legal defense fees in
the millions of dollars.
An increasingly common type of suit being brought against officers
and directors is the derivative suit. Derivative suits are brought in state
court by a stockholder on behalf of a corporation. In these suits, the stockholder alleges that the officers and directors who are the subject of the suit
have breached a fiduciary duty owed to the company and its stockholders, and must disgorge their wrongful gains back to the company. Like
federal securities class action lawsuits, these suits can be extremely expensive for a company to defend.
Most companies have indemnification agreements with their directors and officers that obligate the company to indemnify them in the case
of securities litigation. Nevertheless, directors and officers usually require
the company purchase D&O insurance as a form of balance sheet protection as well as to protect themselves if, during the midst of a long-running
lawsuit, the company itself becomes financially unable to indemnify its
directors and officers.

Outline of a D&O Insurance Policy

Most D&O liability insurance policies are claims made policies, as
opposed to occurrence policies. When a policy is a claims made policy, the
policy that responds is the one that was in effect at the time the claim was
made; in contrast, with an occurrence policy, the policy that responds is
the one that was in effect at the time the occurrence took place. Despite
being claims made policies, D&O insurance policies often have a past acts
clause, which means that when a D&O insurance policy has a past acts
date, the policy will not respond to a claim that is made during the policy
period if the claim relates to an occurrence that took place before the past
acts date. It is important to keep this in mind as a company assesses its
potential exposure and the timing of any claims that may arise.

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Practical Tip: Past Acts Date

A common mistake that can be made in obtaining D&O insurance coverage for a company undertaking an IPO is to have a past
acts date that is the effective date of the IPO registration statement.
While such a past acts date ought to result in a lower premium, the
result of such a past acts date would be to exclude from coverage
anything relating to the preparation of the IPO prospectus. This is
because the prospectus was prepared before the date of the IPO
effective date.
To understand the coverage provided, one must keep in mind that
each D&O insurance policy is divided into three parts. Side A Coverage is
that part of a D&O policy that protects directors and officers directly by
responding to those claims for which a company cannot indemnify its
officers and directors. This circumstance can arise as a matter of law (for
example, in the case of derivative lawsuits or because a company is in
bankruptcy).
Side B Coverage is that part of a D&O policy that protects directors
and officers indirectly by reimbursing the company for those claims for
which the company is obligated to indemnify its directors and officers.
This is typically the case with federal securities class action litigation.
Side C Coverage (also known as Entity Coverage) in a D&O policy
responds to securities claims made against the company. This coverage
fills what might otherwise be a gap created by Side B Coverage. Side C
Coverage was created because in a typical federal securities class action
lawsuit, the company is a named defendant along with the directors and
officers. If an insurance policy does not have Side C Coverage, the insurance carrier and the company have to negotiate what portion of defense
costs and the settlement is to be allocated to the company and what
portion is to be allocated to the directors and officers. This will be a contentious negotiation because any portion of the suit that is allocated to a
company without Side C Coverage is a portion the insurance company
does not have to pay. Purchasing Side C Coverage eliminates this area of
dispute.

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The inclusion of Side C Coverage carries with it a risk, however, that

if a company were ever to enter bankruptcy, the bankruptcy trustee may
seize the insurance policy proceeds for the bankruptcy estate and leave
the directors and officers without coverage. Although there is no controlling case law on this point, legal experts agree that there is a higher
probability that that a bankruptcy judge will allow a bankruptcy trustee
to seize all the proceeds of an insurance policy if the policy includes Side
C Coverage. This is because the now-bankrupt company paid for the
insurance policy and is an insured party under the policy. Therefore, the
insurance policy may be viewed by the bankruptcy court as an asset of the
now-bankrupt company and not an asset of the directors and officers.
Although not yet settled in case law, it is widely held that deletion of Side
C Coverage from the D&O policy will decrease, if not entirely remove, the
possibility of the policy being seized in a bankruptcy and therefore preserve coverage for the directors and officers in a bankruptcy.
Typically, bankruptcy is not a concern of a company that is about to
embark on an IPO. Thus, most companies planning to undertake an IPO
would purchase an insurance policy with Side A Coverage, Side B Coverage and Side C Coverage.
To further understand the policy, one must examine the policy exclusions carefully. These are items that the insurance policy will not cover,
notwithstanding that the item might otherwise seem to be covered by an
insuring agreement. One exclusion that will appear on all D&O insurance
policies is an exclusion for fraudulent or dishonest conduct. This exclusion exists as a matter of public policy, so no insurance carrier can insure
for these items. The critical concern here, however, is the point at which
conduct becomes excluded. For example, if the conduct can only be
excluded after a final adjudication, then clearly all defense costs will be
advanced by an insurance company until the final adjudication is made.
Other typical exclusions are those for which other types of insurance can
be purchased. Examples of these are ERISA claims and pollution claims.

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Another area for critical analysis in a D&O insurance policy is the definitions. Often the definitions that are provided by an insurance company
in its policy form can be beneficially amended by endorsement. For example, since an insurance policy covers claims, it is helpful to the company if
the claim is defined as broadly as possible. An experienced D&O insurance broker will be able to provide guidance on the types of definition
modifications that are available from each insurance carrier.

Selecting the Right Broker

When selecting a D&O insurance broker, a companys management
team must keep in mind that the market for D&O insurance is complex.
Each companys policy is a highly customized, heavily negotiated contract, and the pricing for D&O insurance is similarly specialized. As a
result, to get the best advice possible, a company will often choose a D&O
broker with specific expertise in the D&O markets, thereby using a different insurance broker for its D&O insurance than for its other lines of
insurance.
A good D&O insurance broker should be able to give the company
specific recommendations for limits of liability that are based on historical
data and provide guidance on the important terms and conditions in a
D&O insurance contract. A companys D&O insurance broker should also
be able to provide a company with information and advice on alternative
vehicles to D&O insurance that can help control cost. At the same time, a
companys D&O insurance broker should offer loss control and risk management consulting that can drive down a companys overall D&O
insurance premium. Finally, a D&O insurance broker should supply the
company with information about each potential insurance companys
claims history, financial stability and rescission history. A good place to
start for recommendations for D&O insurance brokers is the companys
legal counsel.

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Practical Tip: Avoid Sending Multiple D&O Insurance

Brokers Into the Insurance Market
In an effort to obtain the best price for a companys D&O insurance, some companies will consider a strategy of asking multiple
D&O insurance brokers to place the D&O insurance. However,
insurance companies will only give quotations for a specific company
to a single broker. D&O insurance is heavily market driven, insofar
as the broker approaches multiple insurance companies and tries to
build their interest in insuring the company. The greater the number
of interested insurance companies (that is, the more competition for
the companys insurance risk), the lower the premium and the better
the terms and conditions of the insurance contract will be for the
company. If a company asks more than one broker to go into the
market, each broker will necessarily be limited in his or her ability to
drive down costs as effectively as a single broker with quotations
from all of the insurers. Accordingly, to obtain the best price for
D&O insurance, a company should avoid asking multiple brokers to
place its D&O insurance.

The Insurance Process

A company should select its D&O insurance broker at least a couple
of months prior to the initial filing of the registration statement for the
IPO. During the time leading up to the IPO, the broker will work with the
company and its counsel to develop an appropriate D&O insurance
program for the company. This work includes providing the company
with guidance on items of corporate governance about which D&O insurance company underwriters are particularly sensitive, such as corporate
communications policies and insider trading policies, and the adoption of
controls and procedures in compliance with the Sarbanes-Oxley Act of
2002. Also during this time, the D&O insurance broker in conjunction with
the companys management team should give a companys board of
directors a presentation on the companys plans for its D&O insurance.
The majority of the work taking place during this time, however, is done
behind the scenes by the D&O broker who is using this time to build a
companys insurance program, usually with multiple insurance compa-

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nies. For example, a company that seeks to obtain $20 million in liability
limits might put together its insurance program with as many as four different insurance companies.
Other items that should be considered during this time are concepts
such as coinsurance and setting high self-insured retentions. Coinsurance
refers to a companys sharing a portion of all losses with the insurance
company. Self-insured retentions are dollar thresholds under which an
insurance policy would not pay. Having coinsurance and a high selfinsured retention are two ways to bring down the cost of D&O insurance.
It is also during this time that management and its board of directors
would want to consider alternatives to traditional D&O liability insurance, such as Side A only insurance and independent director liability
insurance. Side A only insurance can be a way to save money for a
company that does not seek balance sheet protection in the case of an
indemnifiable lawsuit such as federal securities class action litigation.
Independent director liability insurance polices are insurance policies that
are designed specifically to cover independent directors and no one else.
Part of the process of building the final form of the insurance program
often involves members of a companys senior management team speaking directly with insurance underwriters. These telephone calls or inperson meetings, which are all conducted under strict non-disclosure
agreements, allow insurance underwriters to get a better feel for management as well as to obtain detailed information that may not be available in
the IPO prospectus. These telephone calls and meetings also give management the opportunity to explain to insurance underwriters why the
company is a good risk for the insurance company.
The entire insurance program should be completed except for the
actual binding of policies before the CEO and the CFO leave for the roadshow. This work includes the completion of all insurance applications,
which are long forms that will be time consuming to complete.
The D&O liability insurance application for a company about to go
public will contain a number of representations and warranties that are
the basis of the insurance companys decision to issue the insurance contract at the agreed-to premium. Misrepresentations or omissions in the
application can lead to the rescission of an insurance contract, which
would leave all directors and officers without insurance coverage. Therefore, the application process must be taken seriously. Companies will

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often poll members of the senior management team, the entire legal and
finance departments, and all the members of the board of directors in
advance of completing the application to make sure that the application is
as complete and thorough as possible. In addition, between the date on
which the application is signed and the date of the IPO, the company has
a duty to update its insurance companies on any changes to the application, such as any new litigation against the company.
The final order to bind a companys D&O insurance will be placed
immediately prior to pricing. This timing ensures that there is D&O insurance coverage from the moment a companys directors and officers have
public company liability exposure, but also that the company is not
paying for D&O liability insurance before it is needed.

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Chapter 5
Managing Publicity during
the Offering Process
The federal securities laws are designed to ensure that a public offering is made only by means of a prospectus that contains disclosure
required by SEC rules and that is subject to review by the SEC. When a
company engages in other publicity near the time of its public offering,
there is a concern that the company may be using other means to draw
attention to itself and encourage the sale of its stock. The boundaries of
what is permissible vary according to the stage of the offering.

The Pre-Filing Period; Gun Jumping Concerns

Overview
Prior to the time that a company has filed a registration statement
with the SEC in connection with a public offering of its stock, any offer to
sell or solicitation of an offer to buy the companys stock is forbidden
(with narrow exceptions for offers such as grants of employee stock
options). The Securities Act definition of offer is broad, is not intended
to be exclusive, and includes every attempt to offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value. In
addition, the SEC has further broadened the definition by including activities that condition the market for the securities to be sold in the offering.
Therefore, publicity that may increase public interest in an offering of the
companys stock is forbidden during the pre-filing period.
Exactly when the pre-filing period begins is not always clear. At the
latest, a company should consider itself as being in registration and
subject to the SECs pre-offering publicity rules when the company has
selected the managing underwriters and has reached an understanding
with them to proceed with the IPO; this may be well in advance of the
organizational meeting. As soon as a company begins to seriously contemplate its initial public offering, it should meet with its counsel to
establish appropriate publicity guidelines, since press releases, presentations, advertising and interviews can all lead to potential problems
discussed in greater detail below.

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Exceptions to the definition of offer and the Rule 135 press release
There are two generally applicable exceptions to the definition of
offer. The first applies to preliminary negotiations with underwriters. The
second exception is found in SEC Rule 135, which permits the company to
announce its proposed IPO so long as it contains only the information permitted by the rule. However, there is no legal requirement for a company
to make a pre-filing announcement of its intention to make a public offering. In fact, such an announcement is rarely made unless it becomes
necessary to end inquiries and conjecture. If a pre-filing announcement of
a proposed offering is made, Rule 135 requires that the announcement
state that the offering will be made only by means of a prospectus; it must
not contain anything more than the specific items of information enumerated in the rule; and it must not identify the underwriters or describe the
companys business. Any such announcement should be prepared with
the assistance of counsel to ensure compliance with the rule.
Guidelines for managing publicity during the pre-filing period
Where does a company draw the line between publicity about a proposed offering and legitimate marketing and public relations activities
necessary to carry on the companys business? Most companies cannot
afford to eliminate communication with the outside world during the registration process, and this is not what the securities laws require. On the
other hand, a company cannot condition the market for its securities by
dressing up hype as legitimate business news.

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Practical Tip: Striking a Balance

The SEC has provided guidelines for striking a balance between
impermissible hype and legitimate business communications.
Under these guidelines, a company may continue to issue press
releases with respect to factual business and financial developments, continue to advertise products and services and continue
stockholder communications, provided that:
such disclosures are consistent with prior practice;
such disclosures are in customary form;
such disclosures do not contain projections, forecasts or valuations; and
the content, timing and distribution of such disclosures do
not otherwise suggest that a selling effort with respect to the
companys stock is underway.
The first three points noted above are relatively easy to follow. The
fourth point involves subjective determinations and an examination of
motive. Companies sometimes attempt to time their offerings to coincide
with major corporate events, such as the launch of a new product by the
company or one of its largest customers. There is nothing wrong with a
company delaying its offering until it has achieved a new milestone and
can take advantage of a corresponding increase in its valuation. However,
timing an offering to take advantage of publicity surrounding a highly
visible event may prove to be a risky strategy if the SEC determines that
the publicity was actually an attempt to generate interest in the companys
IPO. The SEC has stated that the prohibitions on offers of a companys
stock during the pre-filing period are equally applicable whether or not
the issuer or the surrounding circumstances have, or by astute public relations activities may be made to appear to have, news value.

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Practical Tip: Avoiding Publicity Foul-Ups During the IPO

Executives do not always find the securities laws restrictions on
publicity to be intuitively obvious. A company will likely run afoul
of the rules unless affirmative steps are taken to control publicity
during the offering process and guidelines are communicated to all
employees. To avoid inadvertent foul-ups:
As soon as the company has decided to proceed with a public offering, the company should have its counsel visit the
company and make a presentation explaining the restrictions on publicity;
Executive officers should attend this tutorial, as should all
other personnel or outside consultants responsible for public
relations or marketing activities;
The company should designate one person, usually the CFO
or general counsel, to pre-approve all press releases, speaking engagements, interviews and major public relations and
marketing activities occurring at any time during the offering process;
Generally, all interviews with newspapers and business or
financial magazines, and all speeches to groups covering the
companys business or financial condition or outlook,
should be prohibited after the decision to proceed with the
IPO is made and prior to the effective date of the companys
registration statement;
The company should purge its web site of any information
(including information on third-party web sites to which the
company hyperlinks) that is inconsistent with its publicity
policy and the company should also designate a person,
usually the CFO or general counsel, to pre-approve all new
content prior to its posting on the web site (all web site communications should be reviewed regularly, dated, evaluated
for continued accuracy and relevance, and removed as they
become stale or irrelevant); and

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Practical Tip: Avoiding Publicity Foul-Ups During the IPO

(continued)
When the company announces to its employees that a public
offering is being undertaken, it should also announce that all
non-routine inquiries, including any inquiries from reporters, analysts or brokers, must be referred immediately to the
designated publicity clearance person.
The SEC has long been concerned about companies conditioning the
market prior to a public offering by generating publicity about the
company or its financial prospects. Impermissible public announcements
or disclosures during the registration process (referred to as gun jumping) are considered illegal offers in violation of the securities laws. As a
practical matter, statements made in the early stages of the offering
process may have little impact by the time the company is ready for its
registration statement to be declared effective. Nevertheless, a company
should be careful about its publicity activities during all stages of the
offering process. Interviews given early in the pre-filing period may
appear in print shortly before the desired effective date. Regardless, gun
jumping concerns at the SEC have intensified since the late 1990s.
Internet web sites
The company is responsible for the accuracy of its statements that reasonably can be expected to reach investors or the securities markets
regardless of the medium through which the statements are made, including the Internet. For example, information posted on a companys web site
will be deemed published in the same way as information contained in a
press release, and the information will be considered continually republished so long as it stays posted on the web site. In other words, the federal
securities laws apply in the same manner to the content of the companys
web site as to any other statements made by or attributable to the
company while in registration, including information on a third-party
web site to which the company has established a hyperlink. The SEC staff
has indicated informally that a company may archive old information,
such as press releases, on its web site so long as the company indicates
clearly that the information speaks only as of a certain date and that the

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company will not update such information. Whether third-party information will be attributable to the company depends upon whether the
company has involved itself in the preparation of the information or
explicitly or implicitly endorsed or approved the information. Ideally, the
companies in registration would not link to any site where it has no
control over the content, but most companies would find this advice
impractical.
To ensure compliance with the federal securities laws, the company
must be vigilant in regards to the content on its web site, including hyperlinks to third-party web sites and information. The company and its
counsel should carefully review the companys web site and any information on third-party web sites to which the company hyperlinks to ensure
not only that there are no gun jumping concerns, but also that the information is consistent with the disclosure contained in the registration
statement. For hyperlinks that are retained on the web site, the company
should add a clear and noticeable disclaimer indicating that the user is
leaving the companys site. The company may also want to consider displaying hyperlink addresses as inactive text (rather than as hot links) or
adding a pop-up window notifying the user that he is leaving the companys web site.
Consequences of a gun jumping violation
The consequences of a gun jumping violation can be severe. In many
cases, the SEC has forced the company to repeat the statements made in
the registration statement, which subjects the company to strict liability
for its accuracy. In other cases, the SEC has disciplined companies by
imposing a cooling off period. In other words, the SEC may delay the date
of effectiveness of the companys registration statement until the impact
of the premature publicity has faded. This type of discipline can destabilize the entire marketing effort of a company and its underwriters and can
result in a company missing an IPO window. In still other cases, the
company has been forced to include a risk factor in its prospectus stating
that the company may have violated securities laws and describing the
risk of recission (that is, a purchaser of shares in the IPO may have the
right to rescind his or her purchase or be entitled to damages if he or she
no longer owns the securities). Pre-filing publicity can also result in
heightened SEC scrutiny of the entire transaction. If an underwriter is
involved in a violation, the SEC may require that the underwriter be
excluded from the deal. In egregious cases, the SEC may bring formal
enforcement action, and may seek an injunction as well as other sanctions.
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True Story: Teddy Bears and the SEC

A toy company that was conducting a public offering was contacted by the SEC concerning hundreds of newspaper and magazine
articles that had appeared in the months leading up to the offering.
The company explained to the SEC that most of the articles were
about the companys top-selling product, a talking teddy bear, that
had been the hit of the Christmas season. The company argued that
the publicity had nothing to do with conditioning the market for its
stock. The company was able to establish that as soon as the decision
to proceed with the offering had been made, the company had
instructed its public relations firm to halt all publicity activities and
the companys officers had declined all requests for interviews. In
the end, the SEC permitted the offering to proceed without imposing a cooling off period.
Is the moral of this story that a company wont get into trouble
if it can establish legitimate business reasons for extensive publicity
while it is in registration?
Maybe. More likely, the lesson to be learned is that even if a
company follows the rules, high-profile publicity will attract SEC
attention and may jeopardize the timing of the companys offering
while the SEC evaluates the situation.
Directed shares program
The company may consider requesting that the underwriters set aside
a certain number of IPO shares to be sold to individuals specifically designated by the company. Depending on the number of the IPO shares to
be reserved for this purpose, a formal program may need to be implemented, with corresponding disclosure in the companys registration
statement. These programs are referred to as directed shares or friends
and family programs, and they are a fairly common feature of IPOs. Most
underwriters offer some type of directed shares programs. A majority of
the IPOs completed since 1996 involved some form of directed shares program, and in most of those deals, 5% or less of the IPO shares were
reserved for the program.

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Generally, directed shares are freely tradeable once the companys

stock begins trading on the market, and they are not subject to the underwriters lock-up agreement. As a result, directed shares can prove quite
valuable in IPOs in which the price rises quickly after trading in the stock
commences.
However, there are a number of burdens that accompany the use of
these programs. For example, after announcing IPO plans, many companies find that they have more friends than they ever realized, and the
demands for directed shares can become overwhelming. The companys
CEO and CFO (and sometimes other officers) must then deal with the distraction of numerous telephone calls from participants or would-be
participants. Participants do not get a discount to the price that is offered
to the public; they pay the same offering price as other IPO investors. As
a result, if the companys stock price drops after trading in the stock commences, participants quickly forget the benefits of participation and the
CEO and CFO soon find themselves dealing with disgruntled friends and
family; in fact, in some situations, participants have attempted to refuse
settlement of the purchase price, which can create severe tension among
the underwriters, the company, and the participants. Also, if directors and
officers of the company decide to participate in the program, they must be
careful that they do not violate the Section 16 short-swing trading liability
provisions discussed in Chapter 10.
Administering a directed shares program necessarily involves communicating with the participants prior to the effectiveness of the
companys registration statement. Such communications are likely to be
considered offers subject to the securities laws. The SEC closely scrutinizes these types of programs. Also, as discussed in Chapter 9, the NYSE/
NASD IPO Advisory Committee has recommended, and the NASD has
proposed, rules that would require any lock-up agreement applying to
shares owned by officers and directors to include any shares purchased by
those individuals in the companys directed shares program.
If the company is contemplating a directed shares program in connection with its IPO, it should carefully weigh the potential advantages and
disadvantages before moving forward. If the company decides to conduct
such a program, it should work closely with its counsel and the underwriters to ensure compliance with applicable securities law requirements
in the administration of the program.

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True Story: Directed Shares Programs Can Be Dangerous

Caution should be used in administering directed shares programs, as potential violations of the securities laws have led to
undesirable consequences for some companies and underwriters. In
certain offerings in which the SEC believed that the company or its
underwriters may have violated securities laws, the SEC required
the company to include a risk factor in its prospectus informing
investors of a potential violation of securities laws and describing
the resulting potential liability for recission. The following risk
factor from one such companys IPO prospectus illustrates this
unpleasant result:
Some shares in this offering may have been offered or sold in violation
of the Securities Act of 1933
Prior to the effectiveness of the registration statement covering
the shares of common stock being sold in this offering... an underwriter of this offering provided written materials to approximately
80 employees of [the company] that we had designated as potential
purchasers of up to 300,000 shares of common stock in this offering
through a directed share program. These materials may constitute a
prospectus that does not meet the requirements of the Securities Act
of 1933. No employee who received these written materials should
rely upon them in any manner in making a decision whether to purchase shares of common stock in this offering.
If the distribution of these materials by [the underwriter] did
constitute a violation of the Securities Act of 1933, the recipients of
these materials who purchased common stock in this offering would
have the right, for a period of one year from the date of their purchase
of common stock, to obtain recovery of the consideration paid in connection with their purchase of common stock or, if they had already
sold the stock, sue us for damages resulting from their purchase of
common stock. These damages could total up to approximately $4.5
million plus interest, based on the initial public offering price of
$15.00 per share, if these investors seek recovery or damages after an
entire loss of their investment. If this occurs, our business, results of
operations and financial condition would be harmed.

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True Story: Directed Shares Programs Can Be Dangerous

(continued)
Other companies have had to make similar disclosures in their
IPO prospectuses. For example, a risk factor in one prospectus disclosed risks of potential securities laws violations related to the fact
that certain information regarding its directed shares program had
been posted on an internal bulletin board and that certain executive
officers had sent e-mails to potential participants in the program.

The Waiting Period

Overview
The waiting period is the period between the filing of the registration statement with the SEC and the time that the SEC declares the
registration statement effective. The purpose of the waiting period is to
give investors time to become acquainted with the information in the prospectus and arrive at an informed investment decision, as well as to allow
the SEC time to review and comment on the registration statement.
During the waiting period, offers (but not sales) of the companys
securities are permitted. However, the methods for making offers during
the waiting period are highly regulated. With a few exceptions, publicity
relating to the companys offering is limited to oral offers and written
offers made by means of the preliminary prospectus. The term prospectus is broadly defined and includes any written offer (including offers
made via television, radio or the Internet) or a confirmation of a sale.
Anything in writing (for example, press releases and articles quoting the
company or its officers) that conditions the market for the companys
securities will be construed by the SEC as an offer. Accordingly, the prefiling guidelines for determining whether an announcement is legitimate
business news or impermissible hype are also applicable during the
waiting period.
Because oral offers are permitted during the waiting period, the
company and the underwriters can commence the selling effort and
conduct the road show during this period. However, the distinction

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between an oral offer and a written offer is not always intuitive, and
issuers must recognize a number of limitations on their activities during
the waiting period, including:
Offers by means of radio or television broadcasts or by audio or
video recordings are not permissible during the waiting period
(however, the SEC has permitted companies to conduct some of
their road show activities via the Internet subject to specific conditions);
Misleading statements, whether written or oral, are never permissible; and
Written materials other than the preliminary prospectus, such as
copies of slide presentations which accompany an oral presentation, may not be distributed during the waiting period.
The company must be careful to avoid making statements or projections during the road show or in interviews that could be deemed to be
factually inaccurate or misleading or to speak of material items or developments that are outside the scope of the prospectus. The best method for
avoiding these pitfalls is to limit the content of statements during the road
show or in interviews to only the information contained in the prospectus.
Emails are considered writings, and any email communication
during the offering process could be considered a written offer. During
the waiting period, telephone calls should not be supplemented by email.
The company should hold telephonic conference calls or in-person meetings to keep employees or other constituencies informed of the progress
of an offering rather than using email.
Rule 134 press release
A public announcement is allowed during the waiting period so long
as the press release contains only the limited amount of information permitted by SEC Rule 134 and states from whom a prospectus can be
obtained. Although there is no requirement that such a post-filing
announcement be made, most companies issue such a press release
shortly after the registration statement is filed with the SEC. The contents
of such a press release are limited by SEC rules, and any such press release
should be reviewed in advance of its publication by counsel.

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Consequences of violations
The consequences for violations during the waiting period are the
same as those for violations during the pre-filing period and include delay
in effectiveness, expulsion of offending underwriters from the syndicate
and injunctions. Because the desired effective date is closer at hand, the
effect of an SEC-imposed cooling off period at this stage can be more detrimental to the proposed timing of the offering. For the offending parties,
it can also be very embarrassing.

True Story: The SEC Goes Online Grocery Shopping

In October 1999, the SEC required Webvan Group, Inc. to take a
three-week cooling off period and to include certain statements
made to the public to be included in Webvans registration statement because of concerns about publicity surrounding the company,
certain statements that were reportedly made to prospective investors
during the companys road show that had not been included in its
prospectus and comments reportedly made by Webvans CEO during
an interview with Forbes magazine. As one commentator put it, the
SEC put Webvans IPO in the frozen-foods section.
Ironically, the Webvan controversy generated only more media
attention regarding the company and its offering, which several
observers claimed only helped to push the offering price of the stock
to $15 (much higher than the $11 to $13 range initially projected) and
the aggregate offering proceeds from $300 million to $375 million.
Regardless, the SEC could have imposed more severe penalties.
It is difficult for a company to remain quiet during such an exciting time, especially when employees, journalists and investors are
seldom satisfied to learn the details of the companys offering from
its registration statement filed with the SEC. Nonetheless, the
important lesson in the Webvan IPO case is that a company in registration should err on the side of caution rather than try to test the
boundaries of the rules. The company should approach the IPO
process with the assumption that the SEC will find any statement
that is published, either on its own or with the aid of the internet or
interested parties, including competitors.

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The Post-Effective Period

The post-effective period begins when the SEC declares the companys registration statement effective and it continues until the
distribution of the companys securities is completed (a 25-day period in
the case of an IPO conducted on Nasdaq or on an exchange).
Once the registration statement has been declared effective, offers
and sales of securities are permitted. A final prospectus must precede or
accompany any delivery of the security. During this period, a communication (for example, sales material or literature) is not deemed a
prospectus so long as it is preceded or accompanied by the final prospectus. These types of communications are commonly referred to as free
writing.
Following the pricing of the IPO, the company will typically issue a
press release announcing the pricing of the deal. The content of the press
release is governed by SEC Rule 134 discussed above. As a result, most
pricing press releases look similar they include the number of shares
offered, the price, the names of the managing underwriters, a very short
description of the company's business and instructions as to how to
contact the managing underwriters to obtain a final prospectus.
While the rules for publicity during the post-effective period are substantially less restrictive than the rules applicable to the waiting period
and the pre-filing period, caution is still advisable. Statements made
during the post-effective period are subject to general antifraud rules and
may serve as the basis for liability.
After the twenty-fifth day following the pricing of the IPO, research
analysts who are employed by underwriters in the IPO can publish
research reports regarding the company. An extensive discussion of the
role of research analysts in the IPO process is included in Chapter 2.

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Chapter 6
Hosting the Organizational Meeting and
Management Presentations
Purpose
The registration process formally commences with the organizational
meeting, which is usually held at the offices of the company, or sometimes
at the offices of company counsel. The purposes of the organizational
meeting are to allow the working group members an opportunity to meet
each other and to consider the IPO issues at a high level. This portion of
the organizational meeting typically lasts for a few hours. Management
due diligence presentations are often combined with the organizational
meeting, although they may be held separately. If management presentations are included, the organizational meeting will be a full-day event.

Agenda for the Organizational Meeting

Review the working group list
The managing underwriters will distribute a draft working group list
that contains office and home address, telephone and other contact information about each member of the working group. The list should be
reviewed and any changes should be noted and returned to the managing
underwriters.
Review the proposed time schedule
The working group will outline a proposed schedule at the organizational meeting. The schedule will cover drafting sessions, the SEC review
process and the road show. Time should be allowed for any necessary
corporate housekeeping, stockholders meetings or financial audits.
Appendix C is a sample IPO timetable.

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Actual or contemplated acquisitions by the company during the offering process could significantly affect the timing of the offering due to the
related disclosure requirements. Any proposed acquisitions should be
discussed with company counsel prior to the organizational meeting.
Structure of the offering
Topics to be discussed at the organizational meeting are listed below.
While all of these issues are typically discussed at the organizational meeting, most of them are not finally resolved until later in the offering
process.
Size of the offering. The size of the offering will be determined by the
company and the underwriters, taking into account the amount of proceeds the company is interested in raising, the level of dilution the
company is willing to accept, the amount of shares (or float) needed to
ensure a liquid trading market after the offering and the appetite of the
market.
Price of the offering. Although the price will not be determined until
after the road show is complete, the company should advise the underwriters of any price-related parameters, such as price thresholds for the
automatic conversion of preferred stock into common stock.
Participation of selling stockholders. Often, the IPO will not only include
shares issued and sold by the company but also shares sold by existing
stockholders of the company. Who is allowed to participate as a selling
stockholder and how much they are allowed to sell in the offering will be
influenced by several factors. Contractual registration rights must be considered, although these are often amended or waived. If the company
intends to sell a large amount of stock for its own account, there may be
little room for selling stockholders. If there is a large stockholder which
could flood the market with stock after the lock-up is released (or worse
yet, which is not subject to a lock-up), the company and the underwriters
may wish to include that stockholders shares in the IPO in order to reduce
this unpredictable overhang. The underwriters will advise the company
as to the marketing implications of a particular stockholders participation
in the offering. For example, potential investors may be alarmed if the
companys CEO sells most of his or her stock in the IPO, but may be
understanding of an early investors desire to achieve liquidity.

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Over-allotment option. The over-allotment option, also known as the

green shoe, virtually always consists of an additional 15% of the stock
being offered and can be exercised by the underwriters within 30 days of
the initial closing to cover over-allotments of the companys stock. The
company and the underwriters should discuss whether the over-allotment shares will come from the company, selling stockholders or a
combination of the two.
Desirability of a directed shares program. The company may request that
the underwriters set aside a certain number of IPO shares to be sold in a
directed shares program. To ensure compliance with applicable securities
law requirements, the company should closely coordinate any directed
shares program with the underwriters and company counsel. This topic is
discussed in greater detail in Chapter 5.
Overhang analysis and lock-up situation. The trading price of a companys stock following its IPO is a function of supply and demand. The
post-IPO performance of the stock can be adversely affected if large quantities of stock flood onto the market. At the organizational meeting, the
underwriters will want to discuss the number of the companys outstanding shares that can be sold in the public market following the IPO in
reliance on Rule 701, Rule 144 or otherwise, and the dates that these shares
will become eligible for sale.
In order to reduce downward pressure on the stock, the underwriters
will likely insist that most, if not all, of the stock outstanding prior to the
IPO be subjected to contractual lock-up restrictions prohibiting the sale of
the stock for a specified period following the IPO. The company should
alert the underwriters if it expects to have difficulty obtaining a lock-up
with respect to any significant block of shares.
Distribution objectives. The company and the underwriters will briefly
review the proposed allocation between retail and institutional investors,
as well as any international distribution objectives.
Listing on Nasdaq or an exchange. Company counsel should be prepared to discuss the applicable listing requirements and any concerns
about the companys ability to satisfy them. The working group may also
briefly discuss proposed ticker symbols.

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Use of proceeds
The companys intended use of the IPO proceeds must be disclosed
in the prospectus, as must the fact that management will have broad discretion over the use of the proceeds if no definitive use is contemplated at
the time of the IPO. If the proceeds are to be used for the repayment of
existing debt or specific acquisitions of other businesses, extensive disclosure, including pro forma financial statements, may be required in the
prospectus. The underwriters will need to understand the intended use of
proceeds in order to understand its effect on the companys future business and financial projections.
Legal issues
Company counsel will review the important legal issues and concerns
relating to the offering. Although the working group members will not
expect an extensive report, they will expect a brief summary of the status
of most of the items addressed in Chapter 3. Company counsel should
identify and the working group should discuss any issues that will have a
significant impact on disclosure or timing.
Accounting issues
The timing of the offering may be significantly dependent upon the
ability to quickly close the companys books, prepare financial statements
and complete an audit. Therefore, the working group members should
use this opportunity to clarify any accounting-related timing issues. When
will the audit for the most recently completed fiscal year be completed?
Will financial statements for the companys most recent quarter be
required for the initial filing? When will they be available? Will financial
statements for the following quarter need to be included in an amendment
to the registration statement? When will these financial statements be prepared? Will financial statements for the stub period since the last annual
audit need to be audited?

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Practical Tip: Identify Need For Special Accounting Work

As Early As Possible
If the company has a significant stub period for financial
statements (6 or 9 months) the underwriters may want the stub
period financials to be audited. Often this will occur if the issuer
company does not have a long history of operations, and the stub
period represents a significant part of the positive financial results
trend in which investors will be investing. Because the trend is not
preceded by a significant history of audited financial results that is
consistent with the trend, the underwriters may want the audit as a
matter of due diligence. This audit could require a significant
amount of time to complete and could prove to be a rate-limiting
step in the IPO process. It is important to highlight this issue as soon
as possible in the process so the audit can be started, and the entire
working group can properly factor its timing into the overall timing
for the IPO. Even if the underwriters do not require the company to
audit stub periods, the company and the underwriters may wish to
include financial statements for those stub periods in the prospectus
(whether or not SEC rules require inclusion). In addition, the underwriters may advise the company to include in the prospectus
summary quarterly financial information for some number of quarters (typically at least 4 but not more than 10) prior to the time of the
IPO, even though the SEC does not require such quarterly information. It is typical in these circumstances for the underwriters, as part
of their due diligence, to require the company's auditors to perform
a limited review of the quarterly financial statements. While the procedures performed by the auditors when reviewing interim
financial information is more limited than the procedures performed in an audit, it is important to highlight this issue early in the
process so that the review can be started and any issues associated
with the review can be identified.

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The CFO and the companys auditors should identify for the working
group any significant accounting issues, such as controversial revenue
recognition or other accounting methods used by the company, unusual
reserves, the need for restatement of financials, or anticipated cheap stock
problems.
Finally, the auditors and the managing underwriters counsel may
briefly discuss the auditors comfort letter and any potential points of contention that may arise.
Due diligence
If the working group members have not already done so, they can
begin exchanging due diligence requests and materials with the company.
The company should alert the working group if there have been any major
recent developments.
Publicity policy
At the organizational meeting, the underwriters will want to confirm
that the company has its pre-offering publicity policy in place. If the
company is aware of any upcoming product announcements, press
releases, third party research reports or other publications involving the
company, it should alert the IPO team at the organizational meeting.
Additional issues
The working group may also briefly discuss the status of the companys decisions regarding the financial printer, the registrar and transfer
agent, the bank note company and the custodian for the selling stockholders, if any.

Management Presentations
Management presentations are essential for the group that will be
conducting due diligence, drafting the registration statement and marketing the companys stock. In preparing presentations, the company should
bear in mind that the audience members may vary widely in their understanding of the company and its industry. The investment bankers may
already be quite familiar with the company and may ask fairly sophisticated questions. For other members of the team, such as the underwriters
counsel, the organizational meeting may be the first introduction to the
company.
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Each executive officer of the company typically speaks for one-half to

a full hour, although more or less time may be appropriate depending on
the scope of the officers responsibilities. Follow-up meetings may be
requested by the IPO team at a later date.
The CEO. The CEO typically begins by discussing the history of the
company and giving a general overview of the companys industry,
overall operations, culture and organizational structure, including board
composition. The CEO will also discuss the companys short-term and
long-term goals and plans for achieving those goals. Any foreseeable
roadblocks to the companys success should also be discussed at this time.
Other Executive Officers. The working group typically expects to hear
from the head of each principal function/division, such as sales and marketing, engineering, manufacturing and customer service, as applicable.
Each executive officer should describe his or her professional background,
the activities and personnel for which he or she is responsible, and significant factors influencing his or her area of responsibility. The vice
president of sales may discuss the companys sales and distribution strategies and programs, sales channel, customers and strategic relationships,
sales force and compensation policies, product sales trends, market share
and competitive pressures on sales and pricing, pricing and selling terms,
and forecasting methodology. The head of engineering or chief technology officer may discuss product development activities and strategy,
technology and skills, and intellectual property position. The head of
manufacturing may discuss the companys current manufacturing operations, capacity for growth, sole source components and relationships with
suppliers.
The CFO. The CFO is responsible for presenting historical financial
information as well as projections. Because the working group members
often have a limited ability to absorb new information by the end of a full
day of management presentations, the CFO often limits his or her initial
presentation to a brief overview of the companys financial status, projections, accounting controls and financing requirements. A more in-depth
review of the companys financial situation and projections is then given
in a separately scheduled financial due diligence session. Prior to the organizational meeting, the CFO should discuss with the underwriters their
preference for the timing and format of a detailed financial presentation.

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Practical Tip: Effective Management Presentations

The task of coordinating the management presentations typically falls to the CEO or CFO. To ensure an effective meeting, the
coordinator should consider taking the following steps:
Schedule the date of the presentations far enough in advance
to ensure that each presenter will be available;
Ensure that each presenter understands the purpose of, and
audience for, the presentation;
Ensure that each presenter is prepared;
Find out how many people will be attending and make sure
the conference room is large enough for the entire group;
Have a writing surface available for all attendees;
Make sure all audio-visual equipment is set up properly;
At the meeting, distribute hard copies of any slides BEFORE
the presentation so that the attendees can focus on what the
presenter is saying rather than trying to transcribe all the
information from the slides;
Mark all slides and hand-outs CONFIDENTIAL;
Allow time for questions;
Schedule regular breaks and re-convene on schedule;
Try to stay on schedule and arrange for follow-up meetings
as necessary; and
Have food and beverages available at the beginning of the
meeting and at appropriate intervals.

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Potential Liability and the Role of Due Diligence
By the end of the initial public offering process, most executives
would rather hear underwriters counsel drag their fingernails over a
chalkboard than ask another due diligence question. Still, due diligence is
an essential part of the offering process. Due diligence is a small price to
pay for the liability protection that it provides, and in most due diligence
matters the interests of all of the working group members will be aligned.

Potential Liability for Violations of Federal Securities Laws

It has become an unfortunate fact that a sharp drop in a public companys stock price is often closely followed by a securities class action
lawsuit. This results from a variety of factors including the structure of the
securities laws and the financial incentives for the plaintiffs and their
counsel (especially shortly following a public offering when there are
underwriters and other potential defendants who have substantial financial resources).
The federal securities laws impose special disclosure obligations (and
concomitant liabilities) on a company and others involved in the IPO
process when the company avails itself of the securities markets. There are
three principal securities law provisions that create potential civil liability
in connection with a companys IPO: Section 11 and Section 12 of the Securities Act, Section 10(b) of the Exchange Act and SEC Rule 10b-5.
Section 11 of the Securities Act
Section 11 of the Securities Act creates an obligation of candor in the
context of a public offering specifically relating to the contents of the registration statement. It provides securities purchasers with an express right
of action for damages if any part of the companys registration statement
(when it is declared effective by the SEC) contains an untrue statement of
a material fact or omit[s] to state a material fact required to be stated
therein or necessary to make the statements therein not misleading.
Section 11 does not require a plaintiff to establish a culpable state of mind
in the defendant as a requirement of recovery, nor does it require a
showing of reliance by the plaintiff on misstatements in the registration
statement.
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The parties who can be sued pursuant to Section 11 are limited.

Section 11 gives the plaintiff the right to sue:
every person who signed the companys registration statement
(SEC rules require the registration statement to be signed by the
companys principal executive officer, principal financial officer,
principal accounting officer and a majority of the directors of the
company);
every person who was a director of the company at the time of the
filing of the registration statement;
every expert (for example, accountants, engineers, appraisers)
whose profession gives authority to a statement made by him,
who is named as having prepared or certified any part of the registration statement, or as having prepared or certified any report
or valuation used in connection with the registration statement,
with respect to the statement in such registration statement,
report, or valuation, which purports to have been prepared or certified by him; and
every underwriter in the offering.
Section 11 also provides a plaintiff with three alternative methods for
computing damages. A successful plaintiff may recover the difference
between the amount paid for the securities (not to exceed the IPO offering
price) and (1) the value at the time of the lawsuit, (2) the price at which the
plaintiff sold the securities prior to the lawsuit, or (3) the price at which the
securities were sold by the plaintiff after the lawsuit was brought but
before judgment so long as the damages computed under this third alternative would be less than those based on the difference between the price
paid for the security (not to exceed the IPO offering price).
The company is strictly liable for material misstatements or omissions
contained in its registration statement. However, Section 11 provides each
potentially liable party other than the company a due diligence defense as
an escape from liability. The due diligence defense is discussed in greater
detail later in this chapter, but it is worth noting that an officer or
employee director who signs a registration statement containing a material misstatement will find it difficult to prove that he or she had
reasonable grounds to believe the statement was true. The closer the
involvement of a defendant in the IPO process (or in the companys busi-

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ness and operations generally) and the higher his or her position within
the company, the more a court will expect of the defendant and the more
difficult it will be for him or her to establish the due diligence defense.
Section 12 of the Securities Act
Section 12(a)(2) of the Securities Act supplements liability pursuant to
Section 11 by providing securities purchasers with an express remedy for
material misstatements or omissions in connection with the offer or sale of
the companys securities by means of a prospectus or oral communication.
Unlike Section 11, Section 12(a)(2) is not limited in scope to the statements
made in the companys registration statement but extends to oral statements (for example, statements made during the companys road show
and other meetings with potential investors). Also, liability pursuant to
Section 12(a)(2) extends beyond the persons enumerated in Section 11
(for example, it is possible that directors or stockholders who actively
participate in the IPO process may be deemed sellers for purposes of
Section 12(a)(2)). However, Section 12 liability is narrower than Section 11
liability in regards to privity - the plaintiff must have purchased the
securities directly from the defendant. Similar to Section 11, a plaintiff is
not required to establish a culpable state of mind in the defendant as a
requirement of recovery, nor does it require a showing of reliance by the
plaintiff on misstatements.
A successful Section 12(a)(2) plaintiff is entitled to rescission to
recover the purchase price paid for the companys securities plus interest,
less any income received on the securities, upon tender of the securities to
the company or to damages if the plaintiff no longer owns the securities.
However, if a defendant proves that any or all of the amount otherwise
recoverable by the plaintiff pursuant to Section 12(a)(2) arose from something other than the misstatement or omission, then such amount is not
recoverable.
Section 12(a)(2) expressly provides that a defendant is not liable if he
or she did not know, and in the exercise of reasonable care could not have
known, of the misstatements or omissions. Accordingly, a proper due diligence investigation in connection with the preparation of the companys
registration statement can be effective in minimizing potential liability.

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Section 15 of the Securities Act liability of controlling persons

In addition, Section 15 of Securities Act provides that any person who
controls a person liable pursuant to Section 11 and Section 12 will be liable
jointly and severally with and to the same extent as the controlled person.
It is important to note that the term controls is broadly defined for purposes of Section 15 and the concept of control in this context can include
directors, officers and principal stockholders depending on the specific
facts and circumstances. There is one exception to Section 15 liability - the
controlling person will not be held liable if such person can prove that he
or she had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is
alleged to exist.
Section 10(b) of the Exchange Act and SEC Rule 10b-5
Section 10(b) of the Exchange Act makes it unlawful to use or
employin connection with the purchase or sale of any securityany
manipulative or deceptive device or contrivance in contravention of such
rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors. Based on the
authority granted to it by Section 10(b), the SEC adopted Rule 10b-5 to
prohibit fraudulent devices and schemes, material misstatements and
omissions of material facts, and acts and practices that operate as a fraud
or deceit upon any person in connection with the purchase or sale of a
security. Unlike Section 11 and Section 12 of the Securities Act, neither
Section 10(b) nor Rule 10b-5 provides an express private right of action to
securities purchasers injured by a violation. However, an implied private
right of action has developed over time in the federal courts based on basic
common law principles used in fraud cases.
Unlike Section 11 and Section 12 claims, a plaintiff in a private
damages action brought under Section 10(b) and Rule 10b-5 must demonstrate that the defendant had a culpable mental state with respect to the
misstatement or omission (for example, that the defendant made a misrepresentation with the intent to deceive). The courts have interpreted
Section 10(b) and Rule 10b-5 to extend liability to defendants who were
reckless with respect to the statements (for example, where the defendant
had reasonable grounds to believe material facts existed that were
misstated or omitted, but nonetheless failed to obtain and disclose such
facts). Stated differently, a completely innocent misstatement may not

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result in Rule 10b-5 liability, but if the companys registration statement

is drafted with a reckless disregard for its accuracy there will likely be
liability exposure. Presumably if the working group takes reasonable
steps to ensure the accuracy of the registration statement, liability under
Section 10(b) and Rule 10b-5 can be avoided. Accordingly, one reason why
due diligence is important in the IPO process is that a thorough due diligence effort will go a long way to undermining any claim that there was
recklessness if it turns out that the registration statement contains a material misstatement or omission. The diligence effort will also reduce the risk
that the registration statement will contain a misstatement or omission in
the first instance.
In a Section 10(b) case, the plaintiff ultimately must show actual
damages caused by the misstatement or omission. In most of these cases,
an appropriate measure is the out-of-pocket loss caused by such statement
or omission. However, the courts have not always agreed on what constitutes an appropriate measure of damages in these cases.
The IPO process exposes the company and certain other participants
in the process to potential liability. However, there are a number of things
that the working group can do to mitigate the risk of liability. This is why
due diligence takes on enormous importance for the participants in the
IPO preparation process.

What is Due Diligence?

Due diligence is the process of ensuring that the information in the
registration statement is accurate, that the registration statement does not
omit any required information, and that the registration statement does
not omit any information necessary to prevent the statements in the registration statement, taken as a whole, from being misleading. Due diligence
is an iterative, fact-findind investigation.

What is the Due Diligence Defense?

Section 11 of the Securities Act provides a special defense against liability for certain participants in the IPO process. This defense is called the
due diligence defense. If this defense is established by a defendant, it
will effectively shield the defendant from Section 11 liability.

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In order to establish a due diligence defense and avoid liability for a

misleading registration statement, a working group member must prove
that:
the working group member made a reasonable investigation regarding the contents of the registration statement; and
the working group member had reasonable grounds to believe,
and did believe, at the time the registration statement became
effective, that the statements in the registration statement were
true, that there was no omission to state a material fact required to
be stated in the registration statement, and that there was no omission to state a material fact necessary to prevent the statements in
the registration statement from being misleading.
The due diligence defense is available to working group members but
not to the company itself.
As noted above, the due diligence activities that create the defense
pursuant to Section 11 are also useful in mitigating potential liability pursuant to Section 12 and Rule 10b-5.

Why is Due Diligence Important to the Company, the

Board of Directors and Management?
As noted above, the company does not have the benefit of a due diligence defense to claims regarding the contents of the registration
statement. As a result, a companys only real defense against a lawsuit
brought in connection with a public offering of its stock is to avoid the
misstatement or omission that causes a lawsuit. Specifically, the company
must ensure that the registration statement was materially accurate and
that the registration statement did not omit any material information
required to be contained in the registration statement or necessary to
prevent the registration statement from being misleading to a potential
investor. A material inaccuracy or ommission, regardless of how innocent,
will give rise to potential liability. Accordingly, the most important reason
for due diligence is that it significantly decreases the likelihood that the
registration statement will be deficient.
The second reason that due diligence is important to the company is
that the companys officers and directors do have a due diligence defense.
Under the federal securities laws, directors of the company and officers of
the company who sign the registration statement may be personally liable
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to a purchaser of the companys stock if the registration statement is materially defective. However, the federal securities laws provide that if a
director or officer can establish that he or she conducted a reasonable due
diligence investigation, such person can escape personal liability even if
the registration statement is materially misleading.

Why is Due Diligence Important to the Underwriters?

Underwriters also have a due diligence defense. Of course, underwriters would rather avoid the need to rely on the due diligence defense
by simply making sure that the registration statement is accurate. Regardless of whether a court determines that the managing underwriters made
a reasonable investigation in connection with the offering, a managing
underwriters reputation in the financial community may be tarnished if
it appears that the underwriter failed to uncover a critical issue in connection with the companys business. In other words, the underwriters have
a business motive, as well as a legal motive, to conduct thorough due diligence. In todays environment, underwriters and their counsel will do
all that they can to perform a careful and conscientious diligence
investigation.
In addition to the underwriters general diligence investigation relating to the registration statement, underwriters and their counsel will
interview the companys auditors and the companys audit committee
regarding their respective roles in auditing and reviewing the financial
statements and disclosure in the registration statement. The underwriters
will likely insist on holding these meeting without management being
present. The underwriters will focus on the companys critical accounting
policies, accounting controls and systems (and whether such controls and
systems will be adequate to enable the company to meet its disclosure
requirements as a public company following the IPO) and the trends in
the companys business.
The underwriters will conduct due diligence regarding the companys officers and directors. Underwriters counsel will review resumes
and responses to detailed directors and officers questionnaires. The form
of questionnaire is generally prepared by the companys counsel, and the
responses enable the company to make certain required disclosures in the
registration statement and to the NASD and to provide an efficient way
for the underwriters to formalize a part of their due diligence
investigation.

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True Story: Its OUR Prospectus

In a drafting session for a telecommunications equipment companys public offering, the CFO and one of the representatives of the
managing underwriter were arguing over some proposed language
for the Risk Factors section of the prospectus. The conversation
went something like this:
CFO: I do not want to discuss this risk in the prospectus. Its
ridiculous. Its just going to scare people off. I hired you to sell my
stock, not to tell people why they shouldnt buy it.
Underwriter: Its not ridiculous. Our due diligence investigation
revealed that this risk has been a real problem for the company in the
past and theres a real probability that these problems could crop up
again. If it does scare people off, then by definition its material and
were all going to get sued if something blows up and we didnt disclose it.
CFO: This is MY prospectus and Im not letting YOU people tell
me how to write it.
Underwriter: The prospectus has our fingerprints on it too.
The underwriter was right. Underwriters, as well as the company, have liability if the prospectus is false (unless, of course, the
underwriters can establish their due diligence defense).
In this case, the CFO begrudgingly allowed the risk factor language into the document and the offering passed without incident.
Unfortunately, the companys fundamental disregard for public disclosure didnt change, and a few years later the companys auditors
abruptly resigned, the SEC commenced an investigation of the company, and a criminal investigation was commenced against
members of the management team.

Whats the Standard?

Under the federal securities laws, the standard for reasonable investigation and reasonable ground for belief is defined as that required of a
prudent man in the management of his own property. This is a negli-

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gence standard as long as the members of the working group are not
negligent in their efforts to confirm the material accuracy and completeness of the registration statement, the due diligence defense should be
available to working group members other than the company. So, the
investigation need not be perfect, just reasonable under the circumstances.

Examples of Bad Due Diligence

Understanding what constitutes a reasonable investigation and a reasonable ground for belief lies partly in understanding what does not
constitute adequate due diligence.
Escott v. BarChris Construction Corporation, decided in 1968, is the landmark case on this topic. To make a long story short, BarChris failed to
disclose certain unusual accounting policies, related-party transactions,
accounts receivable collection problems and an assortment of other financial irregularities in its public offering prospectus.
Shortly following the public offering, BarChriss precarious financial
position collapsed and BarChris was forced to file for bankruptcy. A
stockholder lawsuit was filed against the company, the underwriters, the
principal officers, the non-employee directors and the auditors (that is,
most of the working group). The case involved over 60 plaintiffs and 10
law firms, and took nearly 5-1/2 years to reach a final decision.
BarChris was found liable because the prospectus was materially misleading; as discussed above, as the issuer of the securities in the offering,
the due diligence defense was not available to it. Most of the other
working group members asserted that they had satisfied the due diligence
standard. The court, however, ruled in favor of the plaintiffs. The BarChris
case is illustrative of the types of behavior that will not satisfy the due diligence obligation of IPO working group participants. The court made the
following points regarding the due diligence standard:
An officer will not be held to a lower standard just because it is the
officers first time to be involved in a public offering;
An officer may not rely exclusively on its attorneys and auditors
to determine what the prospectus should contain, especially if the
officer is aware of factual misstatements and omissions in the prospectus;
An officer will not be excused of his or her due diligence obligations due to a lack of formal education, or a lack of understanding
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of the issues. An officer should make an effort to investigate matters which he or she does not understand;
An officer may not rely on its auditors to expertize sections of the
prospectus when the officer knows or has reason to believe that
those sections are partially untrue;
An officer may not rely on other members of the management
team to ensure that the disclosure in the prospectus is accurate;
A director cannot satisfy his or her due diligence obligations by
briefly glancing at a preliminary draft of the prospectus in a board
meeting. A director may not rely exclusively on managements
general assurances that everything is all right to ensure that the
prospectus is accurate and not misleading;
A director may not satify his or her due diligence obligations by
relying on general inquiries about the company that are not specifically related to the contents of the prospectus;
A director will not be excused of his or her due diligence obligations just because he or she joined the companys board shortly
before the offering;
A director should not be satisfied with a prospectus that is a scissors and paste-pot job from a prospectus used by the same company in connection with an earlier offering where the companys
business has changed significantly between the two offerings;
A director should insist that minutes of executive committee
meetings that he or she did not attend be written up and made
available for the directors review prior to the filing of the registration statement;
It may be appropriate for a director to have a discussion with the
companys auditors if the director is aware that the company has
from time to time in the past entered into unusual financial
arrangements with the companys officers;
When a prospectus takes many months to prepare, a director
should investigate whether statements in an early draft are still
accurate or need to be updated before the filing of the final version;

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The underwriters may not be able to establish their due diligence

defense if they fail to thoroughly follow up on potential problems
and missing records identified by their counsel;
The underwriters may not be able to establish their due diligence
defense if neither they nor their counsel review copies of the companys material contracts, especially where such documents are
necessary to substantiate important figures such as backlog;
The underwriters may not rely solely on assurances from the companys officers that the prospectus is accurate;
If the underwriters delegate due diligence tasks to their counsel
and their counsel performs those tasks inadequately, the underwriters will suffer the consequences of their counsels failure;
A failure to follow-up on facts that would cause a reasonable person to engage in further inquiry or merely accepting a general
indication that there is no problem without a reasonable attempt
to verify the answer, may be evidence of a lack of due diligence;
A director who is actively involved in the preparation of the registration statement may be required to do more to satisfy the due
diligence defense than a director who is not so involved; and
The failure to make a check of easily verifiable matters is evidence
of a lack of due diligence.
Of course, these are only examples from one particular case. The due
diligence review necessary in connection with any particular offering will
be very fact-specific and will vary depending on the unique facts and circumstances surrounding the particular company that is going public.
Another important lesson that BarChris teaches is that it is important
to create a record of diligence. Those members of the working group who
are entitled to rely on a due diligence defense must bear the burden of
proving that they in fact satisfied that duty of care. This is a sensitive area
though, that must be reconciled with the document retention policies of
the company and the underwriters. Officers and directors should work
closely with their counsel in determining how to create a reasonable and
effective record of diligence.

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Examples of Good Due Diligence

For years, BarChris was the leading authority on due diligence (or the
lack thereof), leaving working groups to wonder just what sort of investigation would meet the standard necessary to establish a due diligence
defense. In two important cases, In re Software Toolworks, Inc. Securities Litigation (decided in 1992) and In re International Rectifier Securities Litigation
(decided in 1997), the court went to great lengths to describe good due diligence. In both cases, the underwriters asserted that they were entitled to
rely on the due diligence defense. In both cases, the court agreed. The following actions were helpful to the underwriters in establishing their due
diligence defense:
Interviewing company officials, exploring all aspects of the companys business;
Reviewing trade journals and other industry-related publications
to ascertain industry trends, market trends and competitive information;
Contacting major customers to verify managements representations;
Contacting major distributors to verify managements representations;
Contacting major developers and licensees to verify managements representations;
Contacting major customers of the companys OEM partners;
Contacting an industry organization regarding the health of the
companys market;
Inspecting the factory in which the companys product was being
manufactured;
Subjecting the companys annual budget to line-by-line scrutiny;
Reviewing the companys financial statements with the companys auditors;
Reviewing the companys internal financial model with the companys management;
Obtaining a comfort letter from the companys auditors;

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Obtaining written representations from the company that the prospectus was accurate;
Obtaining written representations from the selling stockholders
that the prospectus was accurate;
Confirming with customers the companys return policy;
Surveying retailers to confirm that no price cutting on the companys products was occurring;
Contacting officials at an industry organization in order to follow
up on negative information about the health of the companys
market appearing in an article in a financial magazine;
Following up on information discovered during the due diligence
process that appeared to contradict the disclosure in the prospectus;
Repeatedly asking the company about the current quarters
expected financial results;
Discussing the current quarters preliminary financial results with
the companys auditors;
Relying on financial statements expertised by the companys auditors;
Confirming the companys OEM revenue recognition policy with
other accounting firms;
Reviewing confirmations and reconfirmations from each OEM;
Questioning company personnel about the development and
scheduled availability of products;
Employing an analyst who is knowledgeable about the issuer
companys industry;
Interviewing consultants and other service providers to the company;
Interviewing outside counsel on specialized matters such as patents and environmental issues;
Having underwriters counsel review the companys contracts,
board minutes and similar documents;

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Having entire working group review the prospectus line by line;

and
Maintaining involvement by the companys management throughout the drafting process.
Other examples of good due diligence techniques can be derived
from the securities regulators occassional forays into proposing formal
due diligence requirements upon underwriters. While these rule proposals have not been adopted, they serve as a good suggestion of diligence
processes to consider. In 1973, the SEC requested that the NASD consider
establishing appropriate standards of underwriter due diligence, as a
result of SEC findings that there was significant differnce among underwriters relating to due diligence practices (including disagreement as to
which parts of the prospectus must be verified, the extent to which verification should be carried and the methods of such verification). As a result,
the NASD proposed requiring the following minimum diligence standards for underwriters of public offerings:
Review by underwriters counsel of the issuers corporate charter,
bylaws, and corporate minutes;
Examination of the audited and unaudited financial statements of
the issuer, including footnotes, for the preceding 10-year period or
for the entire period of the issuers existence if less than 10 years;
Review of all changes in auditors by the issuer within the preceding 10-year period, if applicable, and the reasons therefor;
Review, with the issuers auditors, of the financial statements that
will appear in the prospectus;
Review of the issuers budgets, budgeting procedures and order/
backlog figures;
Review of internal projects of the issuer, including the intended
use of the proceedings of the offering;
Review of all pertinent marketing, scientific or engineering studies or reports concerning the issuer or its products during the previous 10-year period or for the term of the issuers existence, if less
than 10 years;
Consideration as to the necessity of third party review of appropriate portions of the inquiry if the issuer is a promotional organi-

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zation or engaged in marketing high technology or previously

unmarketed products;
Investigation of the issuers current and past relationships with
banks, creditors, suppliers, competitors and trade associations;
Communication with key company officials and appropriate marketing and operating personnel regarding the nature of the
issuers business and the role of each of the above individuals in
the business operation;
Inspection of the issuers property, plant and equipment;
Examination of business protection devices and related data such
as trademarks, patents, copyrights and production obsolescence,
among others;
Review of available information with respect to the issuers position within its industry;
Review of pertinent management techniques, organization of
management and the background of the management personnel
of the issuer; and
Preparation and maintenance of memoranda pertaining to all
meetings or conversations regarding the issuer held during the
members performance by it of its obligation of adequate inquiry.
In addition to the lessons of recent cases and the NASD proposal,
there are many other due diligence investigation steps that underwriters
and their counsel will typically follow. These include (in part) the
following:
Review communications between the company and its stockholder;
Confirm the capitalization of the company (tying it to the board
authorizations, as well as to the paper records of the stock ledger
and agreements relating to the issuance of stock);
Confirm that securities issuances complied with applicable securities laws;
Confirm contractual rights relating to securities (including voting
agreements, participation rights and registration rights);

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Perform analysis of outstanding shares which were issued pursuant to exemptions from the registration requirements of applicable
securities laws, including the ability of the holders to re-sell those
shares;
Review of material contracts and standard forms of contracts;
Review of registered intellectual property of the company and
other intellectual property protection strategies;
Analyze outstanding litigation matters;
Understand the companys principal sales channels and the structure of agreements relating to those channels;
Review benefit plans for employees, including all equity compensation plans, agreements and arrangements;
Circulate comprehensive directors and officers questionnaire;
Review recent publicity regarding the company;
Investigate the companys relationships with its material suppliers (identify limited source suppliers; identify actual or potential
problems regarding suppliers);
Examine management letters issued by the companys accounts;
Review any recent appraisals or valuation reports;
Review disclosure documents of comparable companies;
Review industry sector reports for the companys industry; and
Obtain report of recorded liens.
The foregoing is not a comprehensive list. Rather, it is representative
of the types of inquiries that underwriters and their counsel will typically
pursue in the IPO process.

Different Diligence Standards for Different Participants

It is important to note that all of the foregoing procedures are not
required. The investigation does not have to be perfect. However, the
process must be reasonable. Notwithstanding the cases discussed above,
members of the working group are not prohibited from relying on statements made by the companys management. On the contrary, reliance on

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management representations is acceptable, as long as it is reasonable. The

reasonableness will depend on the facts and circumstances, including the
materiality of the information, the difficulty of verifying the information
and the absence or presence of information that calls into question the
accuracy of the management representations.
Is the same level of due diligence required of every member of the
working group? No. The due diligence required of the different working
group members will vary according to their situations. As noted by the
court in Feit v. Leasco Data Processing Equipment Corporation in 1971:
[w]hat constitutes a reasonable investigation and a reasonable ground
to believe will vary with the degree of involvement of the individual, his
expertise, and his access to pertinent information and data[and] [w]hat
is reasonable for one director may not be reasonable for another by virtue
of their differing positions. The Leasco court indicated that underwriters
might be held to a higher duty than some other members of the working
group. The court noted that, since underwriters are expected to assume an
opposing posture with respect to that of the issuers management in an
offering, the courts must be particularly scrupulous in examining the
conduct of underwriters. The court further noted that the adverse
posture of the underwriters requires that they must be alert to exagerations and rosy outlooks put forth by management and must play the role
of devils advocate in the transaction. On the other hand, in Weinberger v.
Jackson, a non-employee director was able to defeat a lawsuit by demonstrating that, after reviewing six drafts of the registration statement and
discussing certain aspects of the registration statement with management,
he saw nothing suspicious or inconsistent with the knowledge he had
acquired as a director. In BarChris, the court made it very clear that the
chief financial officer of a company cannot rely on the report of the companys auditors to the same degree as other members of the working
group who are not as intimately familiar with the financial records, processes and performance of the company. In Software Toolworks, the court
noted that underwriters cannot be held to have the same intimate knowledge of a companys affairs that inside directors have, and so the
underwriters duty must be considered in light of this more limited access.
It is an important part of the role of both company and underwriters
counsel in the IPO process to educate the working group on the potential
liabilities from the transaction for their respective clients, and the steps
that they may take to satisfy their due diligence duty obligations.

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Practical Tip: Helping the Outside Directors

Build a Due Diligence Defense
Outside directors (non-employee directors) typically do not
have the same opportunities as the other working group members
to participate in the due diligence and drafting processes. To assist
the outside directors in building a due diligence defense, the
company should include the outside directors on the distribution
list for drafts of the registration statement, copies of SEC comments,
responses to SEC comments and amendments to the registration
statement. Shortly before the initial filing of the registration statement is made with the SEC, the board should hold a meeting at
which it reviews the registration statement in detail with the companys officers, counsel and auditors.

The Use of Experts

Section 11 of the Securities Act describes an expert as every accountant, engineer, or appraiser or any person whose profession gives
authority to a statement made by him, who has with his consent been
named as having prepared or certified any part of the registration statement, or as having prepared or certified any part of the registration
statement or report or valuation used in connection with the registration
statement. An expertised portion of the registration statement is one that
is prepared or certified by such an expert who, with his consent, is named
in the registration statement as having prepared or certified a part of the
registration statement, or report or valuation that is used in connection
with the registration statement. The most common example of an expertized section of a registration statement is the report of the companys
auditors and the accompanying audited financial statements. Other examples of expertization include opinions of special counsel, reports of
engineers and reports of appraisers.
Courts take a narrow view in determining whether a portion of a registration statement has been expertized. For example, the involvement of
auditors in the preparation of a registration statement will not result in the
unaudited figures being expertized. Similarly, the participation of
company counsel in preparing the registration statement will not result in
expertization, even if company counsel is the primary drafter.
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Each potential defendant, other than the issuer, has a due diligence
defense to the potential liability imposed by Section 11 of the Securities
Act. The burden of proof associated with each due diligence defense
varies with the class of the potential defendant (for example, expert or
non-expert) and whether the portion of the registration statement giving
rise to the potential liability has been expertised.
Non-expert defendant sued for non-expertised portion of registration
statement. To invoke the due diligence defense, a non-expert facing
potential liability for statements contained in a non-expertised
portion of a registration statement must demonstrate that he or
she had, after reasonable investigation, reasonable grounds to
believe and did believe, at the time the portion of the registration
statement giving rise to the potential liability was declared effective by the SEC, that statements in the portion of the registration
statement were true and that there was no omission to state a
material fact required to be stated therein or necessary to make the
statements therein not misleading.
Expert defendant sued for expertised portion of registration statement.
To invoke the due diligence defense, an expert facing potential liability for statements made upon his or her authority as an expert
or as a copy or extract from his or her report or valuation as an
expert contained in a portion of a registration statement must
demonstrate that either (1) he or she had, after reasonable investigation, reasonable ground to believe and did believe, at the time
the portion of the registration statement giving rise to the potential liability was declared effective by the SEC, that the statements
in such portion of the registration statement were true and that
there was no omission to state a material fact required to be stated
therein or necessary to make the statements therein not misleading or (2) such portion of the registration statement did not fairly
represent such experts statement as an expert or was not a fair
copy of or extract from his or her report or valuation as an expert.
Non-expert defendant sued for expertised portion of registration statement. To invoke the due diligence defense, a non-expert facing
potential liability for statements contained in an expertised portion of a registration statement must demonstrate that he or she
had no reasonable ground to believe and did not believe, at the
time the portion of the registration statement giving rise to the
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ments therein were untrue or that there was an omission to state a

material fact required to be stated therein or necessary to make the
statements therein not misleading, or that such part of the registration statement did not fairly represent the statement of the
expert or was not a fair copy of or extract from the report or valuation of the expert.

Practical Tip: A Few Ways to Minimize the Disruption

Caused by Due Diligence
Due diligence is inherently a laborious and disruptive process
for the company. To keep due diligence running smoothly and in
parallel with other aspects of the offering process, keep the following tips in mind:
1. Anticipate. Reduce the number of interruptions later in the
process by obtaining due diligence checklists from the
underwriters and their counsel prior to the organizational
meeting. Assemble the requested materials as early as possible (and make a second copy, so that large copying projects
are minimized during the busier parts of the process). If the
checklist is not yet available, assemble materials based on
the list at Appendix B and then supplement them as necessary. In addition, as factual information is added to the registration statement (for example, industry size data or
industry growth rates) obtain copies of supporting sources.
Failure to provide the underwriters with backup for statistics or other factual information may result in important
marketing or other factual information being pulled from
the registration statement on the eve of filing. It is a good
practice to create a binder of backup materials that is
indexed to the prospectus, so you have an organized and
easily referenceable source for all of the factual statements in
the prospectus.

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Practical Tip: A Few Ways to Minimize the Disruption

Caused by Due Diligence (continued)
2. Control the flow of documents. Do not allow the due diligence
process to get out of control. Designate a single person at the
company as the primary contact for due diligence materials.
Often the controller or another member of the CFOs staff is
well suited for this job. A relatively new employee who is
unfamiliar with the companys records and history is not a
good choice. The companys counsel should similarly designate one person to take primary responsibility for due diligence document matters. Requests for documents such as
company contracts, stock option records or minute books
should then be made through the designated company and
legal contact persons. Obviously, company officers still will
need to make themselves available to discuss key aspects of
the business. It is also very helpful if the company coordinates diligence production through its counsel. This way, the
companys counsel can be sure that it is seeing everything
that is provided to the underwriters counsel.
3. Be cooperative. While due diligence requests rarely come at a
convenient time, everyone benefits from the improved disclosure and liability protection resulting from thorough due
diligence. Due diligence responsibilities often fall on the relatively junior members of the team, who are simply doing
their jobs when they ask for backup information. Cooperating with these team members will avoid last-minute crises.
4. Stay organized. Many companies find it helpful to create a
master set of indexed binders containing all requested due
diligence materials. Responding to multiple due diligence
requests then becomes a simple photocopying exercise.
Also, if these materials are indexed based on the diligence
request list, it is easy to determine what has, and has not,
been provided and it is easy to refer back to previously produced materials when the inevitable follow-up questions are

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Practical Tip: A Few Ways to Minimize the Disruption

Caused by Due Diligence (continued)
asked throughout the process. It is helpful not only to organize the materials in accordance with the diligence list, but
also to annotate the list with a brief description of each individual piece of diligence material provided so that it may
become a useful guide to the assembled materials.
5. Resolve issues early. If a due diligence request is unclear or
seems unreasonably burdensome or disruptive, the company and its counsel should discuss the issue with the
underwriters and their counsel. Often the scope of a request
can be clarified or narrowed. Invariably, issues will arise during the due diligence process. The company and its counsel
should address these issues as quickly as possible.

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Timeline
From the date of the organizational meeting until the closing, the IPO
process takes roughly from three to five months. An illustrative timeline
is contained in Appendix C.

The Drafting Process

Drafting a registration statement is a group effort. Active participation without pride of authorship generally leads to the best result.
Company management and counsel should work together to prepare
a draft of the registration statement for distribution to the working group
several days prior to the first drafting session. The initial draft is primarily
intended to get the drafting process started by giving the working group
something to react to. Inevitably, the registration statement will go
through many revisions before being filed with the SEC.
Preparing the initial draft of the registration statement will be a more
productive exercise if done with input from the underwriters as to the
general marketing positioning of the company. All members of the
working group should review prospectuses (or other SEC filings) for comparable companies, including the companys competitors, that can be
used as examples or counterpoints. Business plans, private placement
memoranda and marketing brochures previously prepared by the
company may provide material for the registration statement, although
care should be given to making a balanced presentation.
The most effort and detail initially should go into the Risk Factors,
Business and MD&A sections. The financial statement pages also
should be made available to the working group as soon as possible. The
balance of the prospectus, which contains management biographies, compensation data, descriptions of option plans and certain other information
generally can be added to a later draft.

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Company counsel typically runs the master draft of the registration

statement and is responsible for processing changes from the working
group. During the early drafting sessions, comments from the working
group are likely to be broad, structural comments, such as draft a new
section to explain, rearrange this section to emphasize or condense
these sections. Turn-around time will be slow for the first few drafts, but
can be improved if other members of the working group help draft or
revise certain sections. For example, the CFO and the companys auditors
might make certain requested revisions to MD&A, while the underwriters might bring their marketing expertise to bear on certain parts of the
Business section, particularly the Industry Background and Strategy sections. The ultimate drafting burden, however, tends to fall
squarely on company counsel (because it typically has experience drafting
registration statements) and the management team (because it has the
company-specific knowledge).

Practical Tip: Drafting Schedule

An overly ambitious schedule for turning drafts of the registration statement can be counterproductive. Enough days should be
allotted between each drafting session to allow company counsel to
collect all comments, draft revisions and circulate the new draft.
Time also should be allowed for the working group to read the new
draft carefully prior to the next drafting session.

As the registration statement takes shape, the working groups comments should become more focused, and company counsel can make
specific changes with the working group during the drafting sessions. At
this point, the size of the working group often shrinks to a core of representatives of each working group member. Not only is this cost-effective
for the company, but it also makes the drafting process more efficient. The
last few drafting sessions typically are held at the financial printer, where
pages marked with changes can be submitted for revision as the group
continues to work.

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Contents of the Registration Statement

Form S-1 is the registration statement form most commonly used by
companies selling securities to the public for the first time. Forms SB-1 and
SB-2 are available to small business issuers (which is defined as a U.S.
or Canadian issuer having annual revenues and a public float of less than
$25 million) but are used far less frequently. Form F-1 is available for
certain non-U.S. issuers, as discussed in more detail in Chapter 11.
The principal SEC regulations affecting the Form S-1 registration
statement are Regulation S-K and Regulation S-X. Regulation S-K dictates
the content of the registration statement exclusive of the financial statements. Regulation S-X states the requirements applicable to the form and
content of financial statements included in the registration statement.
There are additional SEC regulations guiding the mechanics of the filing
(such as fees and signatures) and the SECs electronic filing system
(EDGAR).
The Form S-1 registration statement consists of two parts. Part I contains most of the information about the companys business and financial
condition. The prospectus, which is the portion of the registration statement delivered to investors, is Part I of the registration statement without
the Form S-1 cover page. Part II of the registration statement contains supplemental information not required to be included in the prospectus, such
as information regarding offering expenses, indemnification of officers
and directors of the company, recent sales of unregistered securities,
undertakings and exhibits and financial statement schedules. Part II is not
required to be delivered to investors, although it is publicly available.
The prospectus portion of the registration statement is typically comprised of the following sections.
Front and back cover pages
The front and back cover pages of the prospectus contain certain
information required by Regulation S-K, such as the companys name and
the number and type of securities being offered. The company may elect
to include additional information and color graphics or photos on the
back cover page or inside cover pages to increase the marketing appeal of
the document. The company should work closely with the financial
printer if graphics or photos are to be used, as a certain amount of lead

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time will be required to prepare them for inclusion on the cover. The
content of graphics and photos is subject to SEC review and can serve as
the basis of liability. Therefore, graphics and photos included in the cover
pages should not make claims or imply information that would be inappropriate to include in the body of the prospectus.

Practical Tip: Get Artwork Started Early

Many prospectuses include artwork on the inside cover page.
The company should discuss this artwork very early in the drafting
process to develop a consensus from the working group regarding
the artwork. Depending upon the companys internal graphics capabilities, designing the artwork, and the iterative process of review/
redesign, can be a time consuming process. The SEC will want to see
the artwork (or at least a nearly final draft of it) with the initial registration statement filing, or soon thereafter. If the artwork is
delayed, it could slow down the registration statement review
process.

Summary
The Summary section, which comprises the first few pages of the prospectus, is the first substantive information about the company that
investors will see. For many investors, it is the only section that they will
read before making an investment decision. The Summary contains a brief
description of the company and its business, typically consisting of a few
paragraphs. It also sets forth the type and amount of securities being
offered, the number of shares that will be outstanding following the offering, the use of proceeds and the proposed listing symbol. Condensed
financial statement information is also included, generally consisting of a
table showing information for the prior three or five years (or such shorter
period as the company has been in existence), as well as information for
the current year stub period and the corresponding prior-year period. A
summary version of the most recent balance sheet, as well as a corresponding balance sheet adjusted to reflect the receipt and application of
the offering proceeds, is also included. Companies also include their
mailing address and telephone number, as well as their Internet home
page address. Other interesting or useful information may also be
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included. The Summary section is often one of the last sections to be

drafted due to the fact that it is a condensed version of the other portions
of the prospectus.
Risk Factors
Material risks faced by the company or that may cause investments in
the companys stock to be risky should be disclosed in the Risk Factors
section. To maximize protection from liability, risk factors should be specific and disclose enough information to place the risk in context and
enable an investor to assess the magnitude of the risk. Each individual risk
must be disclosed under a descriptive heading that clearly and concisely
describes the risk and several different (even though related) risks should
not be grouped under a single risk factor heading, but rather should be
separated into different risk factors.
Risk Factors customarily are listed in the approximate order of importance and likelihood of occurrence. Although SEC regulations do not
specify any particular required order, they do require that risk factors be
organized logically. The exact order should be decided among the
working group members. However, the SEC has provided some guidance
with respect to the manner in which the risk factors should be categorized
to make that section more readable. The SEC has noted that risk factors
generally fall into three broad categories, and the risks should be specifically identified to the applicable category. These three categories are risks
faced by companies in the industry, risks that are specific to the company
and risks related to investing in the companys securities.
The SEC also indicates that companies should not use boilerplate risk
factors copied from the prospectuses of similar companies or companies
in the same industry. Rather, a company should provide disclosure that
enables readers to understand the specific risks applicable to the
company.

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Practical Tip: Risk Factors A Cheap Form of Insurance

During the process of drafting the companys registration statement, management will no doubt hear from company counsel or
underwriters counsel that good risk factor disclosure may be the
companys cheapest form of insurance. There are certainly plenty
of examples in securities litigation where risk factor disclosure led to
the dismissal of multi-million dollar securities class action lawsuits.
A company should strive to prepare thorough and thoughtful disclosure of each material risk faced by the company.
Use of Proceeds
The registration statement must disclose the proposed use of the net
proceeds of the offering or, if the company has no specific plan for the use
of the proceeds, a discussion of the principal reasons for the offering.
Examples of uses of offering proceeds include capital expenditures,
working capital, debt repayment and acquisitions. If debt repayment is a
use of proceeds, the company must make specific disclosures regarding
the debt to be repaid. If the company identifies acquisitions as a use of proceeds, the SEC will require the company either to represent that it has no
current plans, arrangements or intentions concerning specific acquisitions
or to include certain detailed information about any proposed acquisition,
including pro forma financial information if the acquisition is probable
within the meaning of the accounting rules and would meet certain materiality thresholds. Therefore, the company should discuss any thoughts
about acquisitions with its counsel as early in the IPO process as possible.
Dividend Policy
This section addresses the companys current and anticipated dividend policy, including the frequency and amount of dividends. If there
are any legal, contractual or other restrictions on the ability of the
company to pay dividends, such as negative covenants in the companys
bank line of credit, the nature of those restrictions should be disclosed.

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Capitalization
The companys capitalization information, including short- and longterm liabilities and stockholder equity, is included in tabular format both
on an actual basis and on a pro forma basis reflecting the offering.
Dilution
When new investors will be diluted immediately following the offering due to a difference between the IPO price and the net tangible book
value per share, the prospectus must disclose (i) the net tangible book
value per share before and after the offering, (ii) the increase in net tangible book value resulting from the offering and (iii) the amount of dilution
from the public offering price which will be absorbed by the new
investors.
Selected Financial Data
In order to highlight trends in the financial condition and results of
operations of the company, SEC Regulation S-K requires that selected historical financial data for at least the last five fiscal years (or since
incorporation, if the company has not been in existence for five full fiscal
years) be included in the registration statement. If financial statements for
the interim period since the end of the last fiscal year are included in the
registration statement, then the Selected Financial Data section should
also set forth selected financial data for such period and the corresponding prior-year period.
Managements Discussion and Analysis of Financial Condition and
Results of Operations (MD&A)
Overview and Results of Operations
The MD&A section of the prospectus analyzes the companys operating results, capital resources and other relevant financial information.
MD&A focuses particularly on year-to-year comparisons of the companys prior three fiscal years and a comparison of any subsequent
interim period against the corresponding prior-year period. In a number
of interpretative releases, most recently in Commission Guidance
Regarding Managements Discussion and Analysis of Financial Condition
and Results of Operations (Release Nos. 33-8350 and 34-48960, dated

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December 29, 2003), the SEC has stated that the purpose of MD&A is to
provide readers with the information necessary for them to understand
the companys financial condition and results of operations and should
satisfy the following principal objectives:
provide a narrative explanation of the companys financial statements that enables investors to see the company through the eyes
of management;
enhance the overall financial disclosure and provide context
within which financial information should be analyzed; and
provide information about the quality of, and potential variability
of, a companys earnings and cash flow, so that investors can
ascertain the likelihood that past performance is indicative of
future performance.
Accordingly, a well-drafted MD&A does more than state the obvious
about whether a line item has gone up or down. Good MD&A will help
investors gain insight into the reasons behind the trends and will identify
material events or uncertainties that could affect the companys future
operating results or financial condition. Careful thought should be given
to signaling anticipated changes from historical trends experienced by the
company.
The SEC has suggested that companies provide an introductory
section or overview to the MD&A that facilitates the readers understanding of the companys financial condition and operating performance. The
SEC has cautioned that this overview should include the most important
matters on which a companys executives focus in evaluating such matters. The SEC has suggested that a good introduction or overview should:
include economic or industry-wide factors relevant to the company;
inform the reader about how the company earns revenues and
income and generates cash;
to the extent necessary or useful to convey this information, discuss the companys lines of business, location or locations of operations, and principal products and services (but an MD&A
introduction should not merely duplicate disclosure in the Business section of the prospectus); and

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provide insight into material opportunities, challenges and risks

such as those presented by known material trends and uncertainties, on which the companys executives are most focused, both
short- and long-term, as well as the actions they are taking to
address these opportunities, challenges and risks.
Liquidity and Capital Resources
In its MD&A, the company also must assess its liquidity and capital
resources. Specifically, MD&A must include an assessment of the companys cash requirements, sources and uses of cash and debt instruments,
guarantees and related covenants.
Critical Accounting Policies
MD&A must discuss the significant implications of the uncertainties
associated with the methods, assumptions and estimates underlying the
companys critical accounting measurements. MD&A must disclose the
companys accounting measurements if:
the nature of the estimates or assumptions is material due to the
levels of subjectivity and judgment necessary to account for
highly uncertain matters or the susceptibility of such matters to
change; and
the impact of the estimates and assumptions on financial condition or operating performance is material.
This disclosure should supplement, not duplicate, the description of
accounting policies that must be disclosed in the notes to the companys
financial statements.
Off-Balance Sheet Transactions
The SEC also requires that MD&A provide the following disclosure
with respect to certain off balance sheet transactions that have, or are reasonably likely to have, a material current or future effect on the companys
financial condition, changes in financial condition, revenues or expenses,
results of operations, liquidity, capital expenditures or capital resources:
an identification and critical analysis of the arrangement; and
an assessment of the likelihood of the occurrence of any known
trend, demand, commitment, event or uncertainty that could
affect the arrangement.

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Related-Party Transactions
The SEC has stated that transactions involving related parties will not
be presumed to be transactions carried out on a market basis due to the
potential lack of arms-length dealings. Accordingly, the SEC has advised
companies that MD&A should discuss material transactions with related
parties to the extent necessary for an investor to understand the companys current and prospective financial position and operating results,
financial statements and the business purpose and economic substance of
such related-party transactions. These disclosures are likely to include:
the business purpose of the arrangement;
identification of the related parties;
a description of how the transaction prices were determined;
a description of the terms or other transaction arrangements that
differ from those which would likely be negotiated with clearly
independent parties;
a description of the methodology for the evaluation, if disclosures
represent that the transactions have been evaluated for fairness;
and
a description of any ongoing contractual or other commitments as
a result of the arrangement.

Practical Tip: High-Level Attention to MD&A

Delegating the primary drafting of the MD&A section to less
experienced team members is a mistake. The MD&A, more than any
other section of the prospectus, is the companys forum for setting
investor expectations and helping financial analysts understand the
companys financial model. Although it often lacks the marketing
impact of the Summary or Business sections of the prospectus, the
MD&A section is important to sophisticated investors. If thoughtfully prepared, the MD&A section can go a long way toward
protecting the company in the event of securities litigation.

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Business
SEC Regulation S-K requires a comprehensive narrative discussion of
the companys business during the previous five-year period (or such
shorter period as the company has been in existence). Specifically, this
section of the prospectus should include a discussion of the companys
industry segment, the companys products and services, capital equipment purchases, seasonality of the companys business, intellectual
property, foreign operations and export sales, properties, sources and
availability of raw materials, inventory practices, customer concentration,
backlog, competition, research and development expenditures, regulatory environment, legal proceedings involving the company and number
of employees. The Business section has evolved over time into a very stylized format incorporating this information. Variations of the following
categories are used, roughly in this order: Industry Background,
Company Solution, Strategy, Products, Sales and Marketing, Customers,
Manufacturing, Competition, Research and Development, Intellectual
Property, Employees, Properties and Legal Proceedings. Of course, the
exact layout and content of the information to be included is determined
according to the companys specific business and the preferences of the
working group, particularly the underwriters.

Practical Tip: Anticipating the Comment Regarding

the Customer List
For obvious marketing reasons, companies and their underwriters often like to include a list of the companys representative
customers in the Business section. Care should be taken to ensure
that the customers named are truly representative and are not
selected simply for their name recognition. The SEC frequently
requires companies to justify their selections or revise their lists. The
company should be prepared to defend its choices on the basis of
revenues generated, units purchased or some other relevant
criterion.

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Management
The prospectus must state the names, ages, business experience and
certain other information for each of the companys directors and executive officers. For the chief executive officer and the four other most highly
compensated executive officers of the company, extensive compensation
data must be presented in the format specified by Regulation S-K. The
management section also describes committees of the board of directors,
employment contracts, the companys stock plans and indemnification of
directors and officers.
Certain Transactions
The company must disclose certain transactions in which any director, executive officer or 5% stockholder (or any of their family members)
had a direct or indirect interest. Examples include purchases of stock by
these individuals, transactions between the company and another entity
in which these individuals have a substantial interest or loans between the
company and these individuals.
Principal and Selling Stockholders
The prospectus must disclose the total number of the companys securities owned by (1) any person known to the company to be the beneficial
owner of more than 5% of the companys stock, (2) the companys chief
executive officer and each of the other four most highly compensated
executive officers, (3) all directors (and director nominees), and (4) directors and executive officers of the company as a group, without naming
them. The prospectus also must state what percentage of the total number
of outstanding securities each such individual owns. If there are selling
stockholders, information regarding the number of shares owned and the
number of shares being sold by each selling stockholder also must be disclosed. The information presented must reflect not only stock currently
held by such persons, but also stock which such persons have the right to
acquire within 60 days.

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Description of Capital Stock

This section provides a description of the important rights and characteristics of the securities being sold in the offering. Where the security
being offered is common stock, this section of the prospectus can be fairly
simple. Provisions of the companys certificate of incorporation or bylaws
that would have the effect of discouraging a takeover attempt also must
be described.
Underwriting Arrangements
SEC Regulation S-K requires a list of the underwriters involved in the
offering and the respective amounts of stock each underwriter is allotted.
This section also includes a description of the principal terms of the underwriting arrangements, any material relationship between the company
and any underwriter involved in the offering, any conditions to the obligations of the underwriters to sell the securities, an analysis of restrictions
on resale of the companys unregistered securities and the factors considered in determining the offering price of the securities. Each investment
banking firm typically has its own preferred format for this section.
Financial Statements
Generally, the prospectus is required to present (1) audited balance
sheets as of the end of the companys two most recent fiscal years, (2)
audited statements of operations, statements of cash flows and statements
of changes in stockholders equity and footnotes for each of the companys
three most recent fiscal years and (3) depending on the length of time
between the end of the prior fiscal year and the date of filing or effectiveness, an unaudited balance sheet as of the end of the interim period and
statements of operations, statements of cash flows and statements of
changes in stockholders equity for the interim period and for the corresponding prior-year period.

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A Word about Words: Plain English Disclosure

Prospectus - disclosure document or protective document?
One of the central means by which the securities laws protect investors is through rules requiring that a prospectus provide adequate
information regarding the issuer and the offering to prospective investors.
Key to the protective effect of these disclosure requirements is the clarity
and accessability of the disclosure the most detailed description of a
business is of little value to investors if it is conveyed in inpenetrable language or if its presentation discourages investors from reading it in the
first place. SEC rules have long required that prospectuses be clear,
concise and understandable.
The prospectus, which was conceived as a means of providing information to investors (in part as a selling document and in part to protect
investors), gradually came to be viewed by issuers as largely a defensive
document. Increasingly, the driving force behind the language in the prospectus was the tenet that an issuer cannot be liable for something it has
truthfully told the investors in the prospectus. This notion led to the
natural corrollary that more is better (that is, that more information, more
detail and more repetition equates to more protection from potential liability). Once these defensive doctrines gained control of the drafting
process, it became increasingly a legal document the focus was the protective needs of the issuer more than the informational needs of the
investors. The result was that, over the years, quantity supplanted quality,
the prospectus became increasingly highly stylized and a great deal of
non-specific boilerplate disclosure crept in, resulting in an incredibly
dense and repetitive document.
The Plain English Disclosure requirements
In 1997, the SEC adopted the Plain English Disclosure rules in
response to these trends in disclosure. The Plain English requirements
apply to the cover page and the Summary and Risk Factors sections of the
prospectus, and are designed to make these sections more accessible to the
average reader. Specifically, these sections must use the following six
basic principles:
Short sentences;
Definite, concrete, everyday language;

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Active voice;
Tabular presentation or bullet list presentation of complex information wherever possible;
No legal or business jargon or highly technical terms; and
No multiple negatives.
In addition, the rules require the company to design and format the
cover page and the Summary and Risk Factors sections to make them easy
to read and to highlight important information for investors. The rules
permit companies to use pictures, charts, graphics, and other design features to make the prospectus easier to understand.
Appendix F contains sample comments that were released publicly by
the SEC in its June 1999 Staff Legal Bulletin regarding Plain English disclosure (originally issued in September 1998 and updated in June 1999).
A copy of the SECs Plain English Handbook: How to Create Clear SEC
Documents is available on the SECs web site at www.sec.gov.

Filing the Registration Statement with the SEC

Once in its final form, the registration statement will be electronically
filed with the SEC. The financial printers routinely provide the service of
converting the registration statement into the electronic format required
by the SEC, known as EDGARizing, and transmitting the document to
the SEC.
Prior to filing, the company must obtain an EDGAR ID number,
deposit an amount sufficient to cover the SEC filing fee in a special SEC
bank account established for this purpose, obtain signature pages to the
registration statement from the company, its principal executive officer,
its principal financial officer, its controller or principal accounting officer
and at least a majority of the board of directors, and obtain an executed
auditors report and consent. Although these originally executed signature pages, reports and consents are not filed with the SEC, they must be
obtained prior to the EDGAR filing, must be kept on file by the company
for at least five years and must be provided to the SEC upon request.

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Filing Exhibits with the SEC and Requesting Confidential

Treatment
Regulation S-K requires that certain documents, including the underwriting agreement, the certificate of incorporation, bylaws and other
documents affecting the rights of security holders and certain material
contracts be filed with the registration statement as exhibits. (See
Chapter 3 Confidential Treatment for a discussion of the SECs rules
regarding the filing of material contracts.) All exhibits must be filed electronically with the SEC via its EDGAR system, absent a hardship
exemption. Preparing the exhibits for filing can require significant lead
time, particularly when an electronic version does not exist and must be
created. (Yes, this means that those lengthy leases, lines of credit and other
contracts may need to be scanned or re-typed by hand if electronic versions do not exist.)
As discussed earlier in Chapter 3, exhibits filed with the SEC are not
included in the prospectus, but they are publicly available when filed. Disclosure of the companys material contracts may be harmful to the
company, especially where the contracts contain sensitive technical or
financial information that would be useful to the companys competitors
or hinder the companys future negotiations with its customers or suppliers. As a result of these hardships, the SEC will consider requests for
confidential treatment of limited portions of material contracts.
To request confidential treatment of sensitive information, the
company must prepare two versions of its exhibits. One version, which is
filed via EDGAR and becomes publicly available, should have the sensitive portions redacted (that is, eliminated and replaced with a placeholder
such as *****). The other version, which is submitted to the SEC in paper
format only, should have the sensitive portions bracketed. This paper
version of the exhibits should be submitted to the SEC with an accompanying letter identifying each item of information for which confidential
treatment is sought and explaining in specific detail for each item the companys position as to why such confidential treatment should be granted.
Generally, the SEC will grant confidential treatment only if the
request meets the following requirements:

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Type of information entitled to protection. The information to be

granted confidential treatment must be entitled to protection
under an exemption from the disclosure requirements of the Freedom of Information Act. Most confidential treatment requests rely
on the exemption covering trade secrets and commercial or financial information.
Information not publicly disclosed. Confidential treatment will not be
granted if the information has been publicly disclosed already,
either in the prospectus or elsewhere. The SEC will deny confidential treatment of publicly disclosed material, even if the disclosure
was inadvertent, such as an erroneous EDGAR filing of unredacted exhibits.
Information not necessary for protection of investors. The SEC must be
persuaded that disclosure of the information is not necessary for
the protection of investors. The SEC will not grant confidential
treatment if withholding the sensitive information would obscure
a material risk faced by the company.
Narrow request. The request should be as narrow as possible. A
common mistake is to request confidential treatment for an entire
sentence or paragraph where only a few words or numbers are
truly sensitive. The SEC will require that a request be amended if
it is too broad.
Duration of request. The company must state the specific term for
which confidential treatment for a specific item is requested, along
with an analysis that supports the period requested. The term
should be as short as is necessary to protect the company.
Consent to release. The confidential treatment request must contain
the companys consent to the release of the information to other
governmental agencies, offices or bodies and Congress.
The SEC examiner will review the companys confidential treatment
request and respond with a comment letter. The company may respond
by giving the examiner additional information to support the companys
request, or may file an amendment to the registration statement in which
exhibits are re-filed to include those portions of information for which the
SEC is unwilling to grant confidential treatment. This process continues
until the only redacted items are those for which the SEC has agreed to
grant the companys request for confidential treatment.
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Practical Tip: Begin the Confidential Treatment

Process Early
The confidential treatment review process has its own timeline
which is separate but parallel to the registration statement review
process. In order to prevent the confidential treatment process from
delaying the effectiveness of the companys registration statement,
the company should submit its initial confidential treatment request
as soon as possible after the initial filing of the registration
statement.
Confidential treatment requests present a number of logistical
challenges. For example, the agreement required to be filed may
include confidential information of the companys major customer
or strategic partner. Companies often must obtain consent from customer or partner legal departments, which can take weeks in large
organizations. Moreover, concessions required by the SEC may
require disclosure of confidential information of the companys customer or partner and resolution can require disclosure of
information that can be damaging to the relationship. In summary,
companies should plan early and strategize with counsel to ensure
that the confidential treatment request process does not delay the
offering or harm the companys business.

Exchange Act Registration

While the IPO registration process focuses on preparing and filing a
Form S-1 registration statement under the Securities Act, the company
also must register its common stock pursuant to the Exchange Act if it
plans to be listed on Nasdaq or an exchange. Even if the company did not
plan to initially list on Nasdaq or an exchange, the IPO would eventually
cause the company to trigger certain numeric thresholds requiring
Exchange Act registration under the federal securities laws. Exchange Act
registration is accomplished by filing a short registration statement on
Form 8-A, which contains basic information about the characteristics of
the companys stock (dividend rights, voting rights, etc.) and which identifies anti-takeover provisions in the companys charter documents. The

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working group generally does not focus on Form 8-A, which is not distributed to investors. Rather, company counsel usually prepares the
document, which is reviewed briefly by underwriters counsel prior to
filing.
Care should be taken to avoid the Form 8-A becoming effective,
which occurs automatically 60 days after filing, pre-maturely if the IPO
process is delayed. To do so could cause the company to inadvertently
become subject to the public company reporting requirements of the
federal securities laws.

SEC Review
The SECs purpose in reviewing registration statements is to ensure
adequate disclosure, not to determine the merits of the offering. In other
words, the SECs comments and the companys responses to them will
focus on whether investors are being provided with sufficient disclosure
to make an informed investment decision, not whether investing in the
company at the proposed offering price is a good or bad idea.
Once the companys registration statement is filed with the SEC, it
will be assigned to the division within the Division of Corporation
Finance that has experience with the companys industry. This assignment is based on the companys SIC code, so care should be given to
stating it correctly on the cover page of the registration statement. An SEC
staff attorney or analyst, referred to as the examiner, will be assigned to
review all aspects of the registration statement other than the accounting
aspects, and a staff accountant will be assigned to review the financial
statements and accounting-related issues. The examiner and the staff
accountant review their respective portions of the registration statement
separately, although they coordinate to discuss areas of concern and
prepare comments. The examiner will deliver to the company, typically
within 30 days of the initial filing, a letter containing the SEC staffs comments on the registration statement.
When the comment letter is received, it should promptly be circulated
to the working group. A conference call or meeting should be scheduled
for the working group to discuss the comments, the proposed responses
and the timing of the response letter. The working group then will prepare
an amendment to the registration statement and a response letter to the
SEC. The response letter will address each comment made by the SEC,

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noting where the company revised the registration statement in response

to the comment or the companys reasons for not revising the registration
statement in response to the comment. The comment letter may ask that
the company supplementally provide information to the SEC staff. The
companys response letter will contain such supplemental information or
an explanation of why the information is not available or should not be
required. Depending on the extent of the revisions to be made in response
to the SECs comments, the working group may or may not convene at the
financial printers for a drafting session prior to filing the amendment.
Once the amendment to the registration statement and the letter in
response to SEC comments are filed with the SEC, the examiner and staff
accountant will review them and provide another comment letter to the
company. This process may go through several cycles until the SEC staff
is satisfied with the disclosure in the registration statement. The SEC will
not declare a registration statement effective until all outstanding comments have been resolved to the satisfaction of the SEC.
For disclosure issues that are particularly complex or sensitive, it may
be helpful for company counsel to call the examiner to discuss the matter
and the proposed response. The companys auditors may become
involved in discussions with the SEC staff if the issues are accountingrelated. If the company reaches an impasse with an examiner or staff
accountant on an important issue, the company may request to have the
examiners or accountants supervisors within the division get involved.
Most issues can be resolved by telephone, and it is often helpful to put the
companys thoughts on the matter into a short letter that can be faxed to
the SEC staff in advance of the call. Going over the examiners head is not
something to be done lightly or in an adversarial manner, as the company
must continue to work with the examiner through the remainder of the
transaction. Politely requesting the examiners assistance in involving
more senior members of the SEC staff is generally the best strategy. Protocol generally requires the company to obtain working group consensus
before escalating an issue to higher levels within the SEC.
One ancillary challenge of navigating the SEC comment process is
that much of the information in the companys response letters (including
any confidential information contained in any supplemental materials)
will be available to the public if so requested under the Freedom of Infor-

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mation Act (FOIA) unless the proper procedures are followed. In recent
years, the number of FOIA requests for this information has increased
substantially.
If the company is concerned about any information provided electronically it must seek confidential treatment of such information when it
files its response letter with the SEC. A common mistake to avoid is to
simply state in the response letter that the company requests confidential
treatment of the contents of the letter under the FOIA. The SEC will not
accept this kind of blanket response. Rather, the company will be required
to redact each specific occurrence of confidential information from the
electronic filing and then deliver a paper copy of the full response letter
that includes the unredacted information accompanied by a separate,
formal letter requesting confidential treatment containing an analysis of
the justification for such treatment. Reaching a resolution with the SEC in
this regard will require time, which can slow the offering process.
If the company submits supplemental information, the company generally may submit the information in paper so long as it requests that the
information be returned following the SECs review at the time of the submission. However, if the company submits supplemental information in
paper and does not request its return (and request confidential treatment),
the information must then be filed with the SEC electronically in full.
The SEC review process will span many weeks. Before going effective, the working group should consider whether the registration
statement must be amended to reflect changes that have occurred in the
companys business between the initial filing of the registration statement
and the desired date of effectiveness. This step should be taken even if
SEC comments do not specifically call for it.

Exchange Listing or Nasdaq Quotation (or Both)

Early in the offering process, the company should consider where it
would like its stock to be listed. Listing the companys securities on
Nasdaq or a securities exchange, such as the NYSE, is the primary method
for achieving stockholder liquidity and generally will be required by the
underwriters.

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In January 2004, Nasdaq announced its new dual-listing initiative

with the NYSE. Initially, six companies that had previously been listed
only on the NYSE began to be listed on both the NYSE and Nasdaq. Companies desiring to be dual listed must meet the listing requirements of
both the NYSE and Nasdaq.
Company counsel will assist the company in preparing its listing
application and reserving the companys proposed trading symbol.
The company should review the requirements of the desired securities
market with its counsel and determine the likelihood of its application
being approved. Although the specific requirements differ, each
market requires that companies meet certain quantitative and corporate governance standards, certain of which are discussed in Chapter 1
and Chapter 3. In special cases, a company may petition a securities
market for an exemption from certain listing requirements that the
company falls short of satisfying.
Appendix A of this guidebook sets forth the listing requirements for
the NYSE and the Nasdaq National Market.

The NYSE vs. NASDAQ:

The Big Board or the Electronic Market
During the height of the Internet boom market (1999-2000),
Nasdaq was the clear IPO leader by capturing 85% of the number of
IPOs. The following year, Nasdaqs market share fell to 54% and in
2002, the NYSE nearly tied with Nasdaq by listing 42 new issuers
compared to Nasdaqs 43. In 2003, Nasdaq gained back some of the
market share it lost and closed out the year with 58% of the newly
listed companies. Typically, however, the NYSE captures the larger
IPOs in terms of deal size, and the NYSE controls nearly 80% of the
U.S. market in listed stocks.

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The NYSE vs. NASDAQ:

The Big Board or the Electronic Market (continued)
NYSE
The New York Stock Exchange, also known as the Big Board,
the largest and oldest stock exchange in the U.S., traces its origins
back to 1792, when a group of brokers met under a tree at the tip of
Manhattan and signed an agreement to trade securities. Unlike
some of the newer exchanges, the NYSE still uses a large trading
floor to conduct its transactions. However, the NYSE is considering
ways to increasingly use an electronic system to trade. For example,
the NYSE has proposed a series of reforms that would update the
structure of the exchange for the first time in nearly three decades by
combining traditional human-based trading floors with automatictrading facilities to create a hybrid automated and live-auction
trading market.
Nasdaq
Unlike the NYSE, the Nasdaq (once an acronym for the
National Association of Securities Dealers Automated Quotation
system) does not have a physical trading floor that brings together
buyers and sellers. Instead, all trading on the Nasdaq is done over a
network of computers and telephones. The Nasdaq began when
brokers started informally trading via telephone; the network was
later formalized and linked by computer in the early 1970s. In the
subsequent decades it has become a serious rival to the NYSE. For
example, certain prominent companies, such as, Cisco and Microsoft
have opted to list on Nasdaq instead of the Big Board. In addition,
certain other prominent companies, such as Cadence Design Systems, Charles Schwab and Hewlett-Packard Co., have decided to
dual list their stock on Nasdaq as well as the NYSE.

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Going Effective
At least two full trading days before the company and the underwriters intend to price and begin selling the stock, the company and the
managing underwriters should submit letters to the SEC requesting that
the SEC accelerate the effective date of the registration statement to a specified date and time. The registration statement then will be calendared for
review by the Assistant Director of the division reviewing the registration
statement. The company also should request that its Exchange Act registration statement on Form 8-A be declared effective simultaneously.
Before the SEC will declare the companys registration statement effective,
the NASD must notify the SEC that it has no objections to the underwriting
arrangements (this process is described in more detail in Chapter 9). The
company also should notify Nasdaq or the exchange where its stock will
be listed of the anticipated date and time that trading will commence.

Post-Effective Matters and the Closing

Final prospectus
The SEC will declare a registration statement effective even though
certain information that cannot be determined until immediately prior to
the offering is omitted. Specifically, the SEC will not require the version of
the registration statement that is declared effective to contain certain
information about the offering price, the identity of the participants in the
underwriting syndicate or the amount of underwriting discounts and
commissions. However, no later than two business days after the earlier
of the pricing or initial sale of the shares, the company must file with the
SEC a final prospectus, also known as the 424(b) prospectus, filling in
the missing information. This final prospectus is then professionally
printed and distributed to purchasers of the companys shares.
The closing
The closing is the settlement of the sale of the IPO shares. At its most
basic level, the closing is an exchange of the IPO shares for cash. The
company authorizes the delivery (typically electronic) of the stock in the
names and denominations specified by the underwriters. The underwriters, in turn, deliver a check or wire transfer for the proceeds, net of
underwriting discounts and commissions, to the company and selling
stockholders.
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Various documents are exchanged as called for by the underwriting

agreement, including cross receipts, management certificates, legal opinions and an auditors comfort letter. The closing is largely an
administrative task. While representatives of the company and the underwriters may be present, the companys and underwriters respective
counsel essentially run the closing.
The federal securities laws require that the closing occur no later than
the third business day following the pricing of the deal, unless the pricing
occurs after the close of the market, in which case the closing may occur as
late as the fourth business day following the pricing.

Practical Tip: Dont Disappear until after the Closing

IPO closings are usually anti-climactic events. Some executives
choose to attend them and turn them into a small celebration. Other
executives skip them altogether (especially on the West Coast,
where closings are typically held early in the morning). Often at the
end of the demanding IPO process, the CEO and CFO are anxious to
go on vacations and get reacquainted with their families. Before disappearing, these management team members should check in with
company counsel and make sure that all closing documents requiring their signatures are in order. Because so many of the closing
documents require original signatures, it is preferable for the CEO
and CFO to stay in town until the closing has been completed, just
in case there are any last-minute changes in the closing documents
that would necessitate additional original signatures.

The underwriters over-allotment option

The underwriters of a public offering typically receive an option to
purchase up to an additional 15% of the number of shares being sold to
cover over-allotments, if any. These over-allotment shares are purchased
on the same terms and conditions as the other IPO shares. In the process
of marketing the IPO shares during the road show, the managing underwriters will build a list of prospective investors and allocations of IPO
shares at given prices. At the closing, market and other factors may lead
to excess demand for the IPO shares and the underwriters may elect to

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exercise all or part of the over-allotment option to satisfy some of this

demand. The underwriters generally have up to 30 days following the
effective date to exercise the over-allotment option. If this option is exercised at the effective date or shortly thereafter, the closing for the overallotment shares can be combined with the closing of the initial IPO
shares. If not, a second closing must be scheduled to settle the sale of the
over-allotment shares.

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Underwriting Arrangements
and Marketing
Most IPOs are made by means of a firm commitment underwriting,
meaning that the underwriters are obligated to purchase all of the registered shares from the company at the offering price, less underwriting
discounts and commissions. The underwriters then re-sell the shares to
the public at the offering price stated on the cover of the prospectus. As a
practical matter, the underwriters reduce their risk by entering into the
underwriting agreement only after the road show has been completed, the
SEC has declared the registration statement effective, the underwriters
have solicited indications of interest from potential investors in the offering and the shares are ready to be traded. The underwriters further reduce
their risk by syndicating the deal among a number of investment banking
firms, sometimes as many as 20 or 30 or more.

The Underwriting Fee

In a firm commitment underwriting, the underwriters charge a fee,
known as the underwriting discount, as compensation for marketing and
selling the deal. This fee is calculated as a percentage of the gross proceeds
of the offering. For most IPOs , the fee is 7%. There are, however, some
exceptions. For example, in Seagate Technologys IPO, which priced in
December 2002, the underwriting discount was 4.25%. The underwriting
fee is divided among the managing underwriters and the members of the
underwriting syndicate and the selling group, with the managing underwriters getting a larger share of the fee for managing the offering.

NASD Review of Underwriting Arrangements

The SEC will not declare a registration statement effective until the
NASD has approved the underwriting arrangements. The NASD is a private, self-regulatory organization of the securities industry and operates
subject to SEC oversight. Virtually every underwriter and broker/dealer
in the United States that sells securities to the public is a member of the
NASD. SEC rules relating to the acceleration of effectiveness of the registration statement require that the issuer company inform the SEC whether

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the NASD has reviewed the underwriting arrangements, and whether the
NASD has determined that it has no objections to the arrangements.
NASD rules provide that an offering will not commence until the NASD
has reviewed the terms of the transaction and has no objections to the proposed underwriting and other terms and arrangements. The required
standard is set forth in the NASD Corporate Financing Rule.
To facilitate the NASDs review, the NASD requires that copies of the
following documents relating to the offering be provided to the NASD for
review:
the registration statement;
the preliminary and final prospectus;
the underwriting agreement;
the agreement among underwriters;
the selected dealers agreement;
any other document which describes the underwriting or other
arrangements in connection with or related to the distribution,
and the terms and conditions relating thereto; and
any other information or documents which may be material to or
part of such arrangements, terms and conditions and which may
have a bearing on the NASDs review.
As these documents are revised or amended, updated drafts must
also be provided to the NASD (including a marked copy showing the
changes). Documents that are filed with the SEC on its EDGAR electronic
filing systems are deemed to be filed with the NASD.
The NASD also requires that certain information regarding the basic
underwriting arrangements and any relationships between the company,
officers, directors and stockholders, on the one hand, and NASD members,
including the underwriters, on the other hand, be disclosed to the NASD.
The proper application of several provisions of the NASD rules requires
an understanding of the nature of these relationships. Specifically, the
NASD requires information regarding the following:
an estimate of the maximum public offering price;
an estimate of the maximum underwriting discount or commission to be paid to the underwriters;

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an estimate of the maximum reimbursement of underwriters

expenses, and underwriters counsels fees (except for reimbursement of blue sky fees);
an estimate of the maximum financial consulting and/or advisory
fees to the underwriter and related persons;
a statement of any other type and amount of compensation which
may accrue to the underwriter and related persons;
a statement of the association or affiliation with any NASD member of any officer, director or security holder of the issuer;
a description of factors to be considered in determining whether
items of value received by underwriters prior to the offering were
in connection with or related to the offering; and
a description of any agreement entered into with any underwriter
within 12 months preceding the filing of the offering that provides
for an underwriter or any of its related persons to receive items of
value, warrants, options or other securities of the issuer.
The NASD will accept disclosure of these matters based on the members or its counsels reasonable inquiry into the background of the
stockholders of the issuer and any transactions between the issuer and the
underwriters and related persons, but will not accept disclosure that is
merely based on the knowledge of the issuer. As a result, the underwriters
and their counsel must make a reasonable inquiry sufficient to provide
statements that the NASD can rely on when reviewing the offering. The
procedure typically employed involves circulation of a detailed questionnaire to the companys securityholders, officers and directors. Company
counsel and underwriters counsel should coordinate to ensure that
appropriate questionnaires are circulated to these parties to obtain the
required information. Underwriters counsel is responsible for providing
the required information to the NASD and responding to any questions
that the NASD examiner may have. Underwriters counsel should keep
company counsel informed of the progress of the NASD review so that the
entire working group is aware of any timing issues that the NASD review
process may create.

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Practical Tip: Send Out NASD Questionnaires Early

Work early in the process with underwriters counsel to prepare
and distribute questionnaires to the companys directors, officers
and stockholders soliciting information required for the NASDs
review. It is sometimes a time-consuming process to collect the
information, so getting started early will ensure that the NASD
review process does not slow the offering. Also, there are additional
documents that will be sent to stockholders, and sending the paperwork in a single package can streamline the process and increase
chances of getting people to respond in a timely manner.
In reviewing the underwriting arrangements, the NASD considers
whether the fees being charged by the underwriters are reasonable. NASD
rules provide that no member or person associated with a member may
receive an amount of underwriting compensation in connection with a
public offering which is unfair or unreasonable and no member or person
associated with a member shall underwrite or participate in a public offering of securities if the underwriting compensation in connection with the
public offering is unfair or unreasonable. The NASD does not publish
what it considers reasonable, as this will vary according to the circumstances of the transaction and general trends in the market (though the
rules indicate that the amount of compensation that is reasonable,
expressed as a percentage of the proceeds of the offering, will be higher if
more risk is borne by the underwriters, and will be lower if the size of the
offering is larger).
In determining the amount of underwriting compensation, the NASD
not only looks at the underwriting discount and commission charged in
connection with the IPO, but also looks at all items of value received or to
be received by the underwriters and related persons which are deemed to
be in connection with or related to the offering. Other items of value might
include warrants or other compensation that the underwriters may have
received in earlier transactions with the company. These other items of
value may be aggregated with the IPO underwriting discounts and commissions for the purpose of determining whether the total underwriters
compensation is reasonable. In making the reasonableness determination,
the NASD will review all items of value received by the underwriters and

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related persons during the 12-month period preceding the filing of the
registration statement. Items received prior to such 12-month period are
presumed not to be underwriting compensation. Items received during
the 6-month period preceding the filing of the registration statement will
be presumed to be underwriting compensation received in connection
with the offering, unless the underwriters can demonstrate to the NASD
that these other items of value were received in connection with a bona
fide investment or for bona fide services unconnected to the IPO. The
NASD rules provide a number of factors that are considered in determining whether items of value are received connection with or related to an
underwriting.
If the company has had prior transactions with members of the selling
group, such as an investment from a venture capital fund affiliated with
one of the underwriters, it will be important for underwriters counsel to
begin correspondence with the NASD on these issues early in order to
determine whether there will be any difficulty in obtaining NASD clearance of the underwriting arrangements.
The NASD also reviews the underwriting arrangements for other
terms that may be unreasonable, including unreasonable provisions relating to reimbursement of expenses and rights of first refusal to underwrite
future offerings. The standard forms of underwriting agreements used by
most major investment banks do not contain provisions that would be
deemed unreasonable under the NASDs rules.
The NASD also reviews the underwriting arrangements for conflicts
of interest. Where the lead underwriter has a large investment stake in the
company or certain other conflicts of interest exist, NASD rules may
require that a qualified independent underwriter set the offering price.
As a practical matter, this means that one of the co-managers that has participated in the due diligence process will price the deal.

The Underwriting Agreement

The underwriting agreement is the principal written document outlining the rights and obligations of the company, the underwriters and
any selling stockholders. Each investment banking firm has its own form
of underwriting agreement, and the form of the lead manager is the form
that will be used for a given offering. Underwriters counsel should obtain
these forms from the lead manager as soon as the IPO process begins, and

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is responsible for tailoring this form for the particular offering and negotiating it with the companys counsel. The ability to deviate from the form
will vary from underwriter to underwriter. Some underwriters are very
protective of their form and want their in-house counsel to review any
changes to the form for a particular deal. Others are more accommodating
to changes from the form in this regard. In negotiating the terms of the
underwriting agreement, the lead manager will typically be very conscious of the fact that changes may be used against it as precedent when
negotiating an underwriting agreement in future offerings.
Obligation to sell and buy the IPO shares
The underwriting agreement is, in its essence, a stock purchase agreement. The primary purpose of the underwriting agreement is to establish
the obligations of the underwriters to buy, and the company and any
selling stockholders to sell, the IPO shares at a fixed price (stated in the
underwriting agreement as the price per share to the company and any
selling stockholders net of the underwriting discount). The underwriting
agreement also typically includes provisions relating to an over-allotment
option allowing the underwriters to purchase up to an additional 15% of
the underwritten shares from the company or selling stockholders for a
period of up to 30 days following the date of the offering in order to cover
over-allotments of the stock.
Representations and warranties
The underwriting agreement contains numerous representations and
warranties made by the company to the underwriters as to the accuracy
and completeness of the registration statement, and that the registration
statement complies with applicable securities laws, and as to certain other
aspects of the companys business. If stockholders of the company are
selling shares in the IPO, then the underwriters will require the selling
stockholders to make certain representations and warranties relating to
their ownership and ability to transfer title to their shares, among others.
Underwriters will occasionally request that a selling stockholder make
representations and warranties similar to those made by the company as
to the accuracy and completeness of the prospectus and as to other aspects
of the companys business, or confirm that to the selling stockholders
knowledge the companys representations are true. The outcome of this
request typically will depend on whether the stockholder is in a position

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to evaluate the accuracy of the prospectus and whether the stockholder

has an economic incentive to bear the risk of making such representations
and warranties.
Indemnification
This part of the underwriting agreement provides the manner in
which risk will be allocated among distribution participants (the company, the underwriters and selling stockholders) in the event that the
registration statement or prospectus contains or is alleged to contain a
material mistatement or omission. The company will agree to indemnify
the underwriters from liability arrising from mistatements and omissions
in the registration statement and prospectus, except to the extent that the
liability arises from information provided by the underwriters specifically
for inclusion in the offering documents. The underwriters will agree to
indemnify the company from liability arising from misstatements or
omissions, but only to the extent that the liability arises from information
provided by the underwriters for inclusion in the offering documents.
This information provided by the underwriters is typically very limited.
The negotiation of this section is closely related to the representations
and warranties and involves many of the same considerations. Common
points of negotiation include, among others:
whether the company and the selling stockholders are jointly
and severally liable for each others representations and warranties, or only for their own;
whether indemnification obligations are of the company, the
selling stockholders or the underwriters capped at the amount
of proceeds (or, in the case of underwriters, discounts) received;
and
whether the company will be liable for misstatements or commissions in a preliminary prospectus that have been corrected
in a final prospectus when the final prospectus is not delivered
as required.

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Covenants
The underwriting agreement will have a section containing agreements by the company relating to the offering, which agreements are to be
performed following the offering. The covenants vary from deal to deal,
and from underwriter to underwriter, but there are some common covenants that are typically required. Typical covenants include that the
company agrees to inform the underwriters of proposed amendments or
supplements to the registration statement and prospectus, to inform the
underwriters of the companys communications with the SEC and to
promptly make all required amendments or supplements to the prospectus. Additionally, the company will be required to agree to provide copies
of the final prospectus, comply with SEC reporting requirements, cause
the IPO shares to be listed on the applicable exchange or market, and pay
certain costs and expenses in connection with the IPO.
One covenant that is typically negotiated is the agreement by the
company to refrain from issuing securities for a period of time following
the effectiveness of the registration statement (typically 180 days). Often
there are exceptions to this restriction (for example, issuances upon exercise of outstanding options and warrants, and issuance under the
companys equity compensation plans). The exceptions are typically one
of the more heavily negotiated provisions in the underwriting agreement.
The negotiation usually centers around issuances that the company contemplates making or reasonably expects it may need to make during the
180-day period following the IPO, and that may not be ordinary course
transactions such as issuances in connection with acquisitions and commercial transactions. Sometimes underwriters will allow an exception for
certain acquisitions and other strategic transactions.
Closing conditions
The underwriting agreement will list certain requirements that must
be satisfied as conditions to the closing of the purchase and sale of the IPO
shares and the closing of the sale of any over-allotment shares that the
underwriters elect to purchase. These conditions typically include
requirements that the representations and warranties of the company and
selling stockholders are true and correct, that the company has performed
its covenants that are to be performed prior to closing, that no material

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adverse event has occurred which impacts the company or the offering,
that the opinions of counsel have been delivered, and that an auditors
comfort letter has been delivered.
Provisions allowing termination of the offering by the underwriters
The underwriting agreement will also set forth certain situations in
which the underwriters may abort the offering after the underwriting
agreement has been signed, but prior to closing. These provisions typically include matters such as:
the suspension of trading generally on national securities
exchanges;
the suspension of trading in the companys securities;
the disruption of the securities trading settlement process;
the declaration of a moratorium on banking activities, and
the outbreak or escalation of hostilities or the occurrence of other
conditions or events which make it in the underwriters discretion
impractical or inadvisable to proceed with the offering.
While these seem like remote scenarios, they do in fact become relevant at times. These provisions take on enormous importance to the
company because there is potentially a large price to pay if they are
invoked. In addition to the loss of the benefits of the offering, companies
that have filed registration statements and fail to complete the offering
(especially under unusual circumstances) will have the burden of explaining why the failed offering is not a negative commentary on the company.
However, underwriters regularly refuse to negotiate any provision of this
section.
Provisions regarding a default by one or more of the underwriters
In the event that an underwriter defaults in its obligation to purchase
shares, the agreement contains provisions that outline how the offering
will proceed, if at all. The underwriting agreement will provide that if the
defaulting underwriter is responsible for a relatively small portion of the
offering, the other underwriters will be obligated to take responsibility for
the defaulting underwriters share. If the default is for more than the threshhold amount, there is a period of time during which the underwriters and

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the company can make arrangements for the purchase of the defaulting
underwriters allocation of the offering shares, which arrangements are
mutually satisfactory to the underwriters and the company. If such
arrangements cannot be made in that period of time, the underwriting
agreement will terminate. The stated period of time is typically 36 hours.

Practical Tip: Conditions to Closing Involving Third Parties

The underwriters obligation to purchase the IPO stock is conditioned upon a number of documents being delivered at the
closing. Many of these documents must be delivered by third parties. Examples include the comfort letter to be delivered by the
companys auditors, legal opinions to be delivered by the companys counsel, legal opinions to be delivered by foreign counsel
addressing matters related to the companys foreign subsidiaries,
legal opinions to be delivered by counsel to the selling stockholders
and legal opinions to be delivered by patent, regulatory or other
expert counsel. To avoid last minute surprises and failures to satisfy
closing conditions, particularly with respect to opinions of foreign
counsel where time zone and language issues may present delays,
these third parties should be included in the negotiation of the portions of the underwriting agreement describing the documents they
are expected to deliver at the closing.

The Comfort Letter

The comfort letter (also known as a cold comfort letter) is a critical
part of the underwriters due diligence process, and it is one of the key
closing items for an IPO. The comfort letter is a letter from the companys
accountants addressed to the underwriters (and often the companys
board of directors, who also have a due diligence defense, as discussed in
Chapter 7) that describes the accountants review of the financial information contained in the prospectus, and the results of that review. It helps to
demonstrate that the underwriters have made a reasonable investigation
of the financial information included in the prospectus. A comfort letter is
typically issued as of the date of pricing of the offering, and an update of
the letter (the bring down comfort letter) is issued as of the closing of
the IPO.

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The form and content of comfort letters is governed by accounting

professional standards as set forth in the Statement on Auditing Standards No. 72 Letters for Underwriters Underwriters and Certain Other
Requesting Parties, as amended by Statement on Auditing Standards
No. 76 and Statement on Auditing Standards No. 86, which are published
by the American Institute of Certified Public Accountants. The two
primary principles that establish the scope of a comfort letter are:
Independent accountants may properly comment in their professional capacity only on matters to which their professional expertise
is substantially relevant. This effectively limits the accountants
assurances in the comfort letter to information included in the
prospectus that is derived from the accounting records of the company and that is subject to the internal control policies and procedures of the companys accounting system. Examples of matters
on which accountants cannot provide comfort include square
footage of facilities, number of employees, beneficial ownership of
securities and (subject to limited exceptions) backlog.
The limited procedures that precede the issuance of a comfort letter (much more limited than an audit) provide only the basis for
negative assurance with respect to the items reviewed. Negative
assurance refers to a statement that nothing has, as a result of the
procedures, come to the attention of the accountant that causes the
accountant to believe that the reviewed items do not meet a specified standard.
The comfort letter process should include the following:
Early in the process, the underwriters counsel should discuss
with the accountant expectations regarding the procedures to be
conducted by the accountants in connection with the comfort letter;
The accountants should, soon thereafter, prepare a draft of the
comfort letter, so that the underwriters and the auditors can agree
upon basic form;
As soon as the prospectus develops to a point where it is substantially complete, the underwriters counsel should provide to the
accountants a copy in which the numbers for which comfort is
sought are circled; and

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The accountants should review the preliminary comfort letter

markup, and discuss with underwriters counsel any requested
comfort that the accountants find problematic.
The comfort letter will typically cover the following matters:
A list of the financial statements included in the prospectus that
the accountant has audited;
A statement regarding the independence of the accountants;
A statement that the audited financial statements included in the
registration statement comply as to form with the accounting
requirements of the Securities Act and related rules;
A statement of the procedures carried out by the accountants with
respect to unaudited financial statements for interim periods,
when such financial statements are included in the prospectus, or
condensed financial information from such financial statements is
included in the prospectus;
A statement that the unaudited interim financial statements comply as to form in all material respects with accounting requirements of the Securities Act and related rules;
A negative assurances statement regarding the interim financial
statements;
A negative assurances statement regarding the absence of adverse
changes in certain financial data (for example, capital stock, longterm debt, stockholders equity, net sales and net loss) between the
date of the latest balance sheet included in the prospectus and the
date of the comfort letter;
A list of procedures used to provide comfort with respect to specific financial data set forth in the prospectus which vary in the
degree of comfort they provide; and
A statement that the accountants offer no assurances that the comfort letter procedures will be sufficient to satisfy the purposes for
which the accountants requested the comfort letter.

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Practical Tip: Start Comfort Letter Process

as Early as Possible; Establish Expectations
The comfort letter is an easy matter to defer, particularly given
the other priorities of an IPO process. However, the comfort letter
negotiation can take a significant amount of time. This is exacerbated by the need for multiple levels of review within the
accounting firm, particularly for difficult issues. If the resolution of
comfort letter issues causes a delay in the IPO process, the company
and the underwriters will typically become frustrated with the companys auditors and underwriters counsel. In order to reduce the
risk of delay, working group members should work together as
follows:
Craft prospectus disclosure with a view toward comfort.
Many times, disclosure of a particular financial datum can
be made in a variety of ways. If one method of disclosure
(for example, expressing the datum as of a recent balance
sheet date instead of as of the date of the prospectus) lends
itself to an easier degree of comfort without negatively
affecting the quality of the disclosure, the working group
should consider that method of disclosure. Experienced
counsel will guide disclosure in this regard during the drafting process.
Discuss important financial disclosure items with the companys auditors early in the process. If the disclosure is
important, but the accountants cannot address it in the comfort letter, the underwriters and their counsel will be
required to perform due diligence on the disclosure in
another manner, which can result in delays.
Request a draft of the comfort letter from the companys
auditors early in the process and ensure that the auditors
review the preliminary comfort letter markup as early in the
process as possible, to identify any unexpected issues.

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Other Underwriting Documents

The Agreement among Underwriters and the Selected Dealers Agreement are the principal written documents that govern the relationships
among the underwriters and between the managing underwriters and the
dealers included in the selling group. Each major investment bank has its
own forms of these agreements. Investment banks typically sign on to
each others forms as master documents which apply to all future deals in
which the banks participate. The primary purpose of the agreements is to
grant the managing underwriter the authority to act on behalf of, and as
the agent for, each of the other underwriters and dealers. The company is
not a party to either of these agreements and, absent unusual circumstances, it is not necessary for the company or the companys counsel to
review these documents.

Selling Stockholder Documents

If selling stockholders are participating in the offering, a number of
additional documents will be required. The purpose of these documents
is to give the underwriters and the company comfort (prior to the time
that they begin the road show) that the selling stockholders will actually
participate in the IPO. Because neither the underwriters nor the company
are contractually bound to participate in the IPO until the underwriting
agreement is signed at the time of pricing, the underwriters and the
company work on the basis of trust for the several months of the IPO
process prior to pricing. When several selling stockholders are participating in the offering, that level of trust does not develop. Accordingly, the
underwriters and the company must have some contractual assurances
that, if the company includes the selling stockholders in the prospectus
and the company and the underwriters market an IPO of a certain size
assuming selling stockholder participation, no selling stockholder will
change its mind and decide not to participate.
The documents required of the selling stockholders include a Power
of Attorney, which appoints two or three individuals (often the companys CEO, CFO and general counsel) as attorneys-in-fact with the
power to negotiate and sign the Underwriting Agreement on behalf of the
selling stockholders, and a Custody Agreement placing the selling stockholders shares with a custodian to hold until the consummation or
termination of the offering. These documents are often subject to some
negotiation. For example, some selling stockholders may refuse to grant a

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Power of Attorney that enables shares to be sold at any price, and may
request a floor price below which the attorneys-in-fact cannot sell the
shares. It is important that these issues be resolved well in advance of the
commencement of the road show.
In many cases, the companys counsel will also act as counsel for the
selling stockholders. In other cases, particularly where a selling stockholder is a large institution, a selling stockholder may choose to retain its
own separate counsel to negotiate the selling stockholder documents and
underwriting agreement on its behalf.

Recent Reforms to IPO Allocation and Distributions Process

As a result of perceived excesses during the late 1990s, securities regulators have closely examined the IPO share distribution and allocation
process, and either have adopted or are in the process of examining a
series of new regulations to curb the perceived abuses.
In August 2002, the Chairman of the SEC requested that the NYSE
and Nasdaq convene a committee to review the allocation process of IPOs.
In response, the NYSE and the NASD formed the NYSE/NASD IPO Advisory Committee, composed of a committee of corporate, financial and
academic leaders. The Advisory Committee issued its final report with
20 recommendations for self-regulatory organizations (such as the NYSE
and Nasdaq) and the SEC to enhance public confidence in the integrity of
the IPO process, which reflect the following themes:
promoting transparency in pricing and avoiding aftermarket
distortions;
eliminating abusive allocation practices; and
improving the flow of, and access to, information regarding IPOs.
In September 2003, the NASD submitted to the SEC proposed new
Rule 2712 to expressly prohibit certain practices in the allocation and distribution of IPO securities. This proposal incorporated certain suggestions
made by the IPO Advisory Committee. The proposed rule provides the
following:
Quid Pro Quo Agreements. The rules would prohibit the allocation
of IPO shares in exchange for excessive compensation relative to
the service provided by the underwriter. This provision would

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expressly prohibit not only IPO allocations in return for inflated

commissions, but also an allocation in return compensation for
any service offered by the investment bank. The rule also prohibits
threatening to withhold allocations of IPO shares if this compensation is not paid.
Spinning. The rules would prohibit an NASD member from allocating IPO shares to an executive officer or director of a company
(or member of the officer or directors immediate family) (1) if the
member has received compensation from the company for investment banking services to the company in the last 12 months or
expects to receive or intends to receive from the company compensation for investment banking services in the next 3 months or
(2) on the condition that the officer or director send the companys
investment banking business to the NASD member.
Inequitable Penalty Bids. The rules would prohibit NASD members
from penalizing other NASD members whose retail customers
have flipped IPO shares when similar penalties have not been
imposed by the managing underwriter with respect to distribution participants. The NASD is concerned that these inequitable
penalty bids may result in undue pressure being placed on retail
investors to hold their investments longer than they actually want
to while such pressure is not placed on institutional investors.
In November 2003, the NASD proposed for comment to its members
a second set of rules relating to the IPO allocation process. These new proposed rules include the following:
Disclosure of indications of interest. This provision would require the
lead underwriter to disclose to the issuer indications of interest
prior to pricing the deal, and to disclose the final allocations after
pricing. The idea is that greater participation by issuers in pricing
and allocation decisions will allow for more informed pricing
decisions by issuers and will provide management with more
information to evaluate an underwriters performance.
Delay in market orders. Prohibit NASD members from accepting a
market order to purchase IPO shares for one trading day after an
IPO. This provision addresses the concern that investors placing
market orders on the first day of trading may inadvertently purchase shares at prices that do not reflect their investment intent as

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a result of the volatility and lack of information on that first day.

By preventing market orders for the first trading day following an
IPO, the the market will have time to develop trading information, making uncapped orders less risky.
Restrict allocation of uncompleted allocations. This provision would
impose procedures to ensure that reneged allocations are not used
to benefit favored clients of the underwriter. Without this new
rule, in a situation where the IPO shares are trading at an immediate aftermarket premium, shares that are allocated but not purchased could be allocated to favored customers with a built-in
immediate gain. The rules requires that these shares are allocate
first to the existing syndicate short position (the allocations made
by the underwriters in excess of the primary offering amount),
and any remaining returned shares must be sold on the open market with the profit returned to the issuer.
Apply lock-ups agreements to directed shares. This provision would
require that any lock-up that applies to shares owned by the
issuers officers and directors will also apply to shares they
receive in directed shares programs.
Impose new notification requirements when underwriters waive lockups. This rule would require underwriters to notify an issuer prior
to allowing a waiver of the restrictions of a lock-up agreement and
would require the underwriter to publicly announce the waiver
though a nationwide news service.
The NASD noted that its proposed rules regulating the IPO process
were mainly focused on the allocation of IPO equity securities. The NASD
also noted that many IPOs in the 1990s experienced a sharp run-up in
price shortly after the offering, and then suffered a precipitous decline
thereafter. The NASD suggested this might indicate the need for regulation of the pricing process, and it requested comments on various
additional regulatory steps that might be taken to promote transparency
in IPO pricing. These possible approaches include requiring underwriters
to:
Retain an independent broker/dealer to opine that the initial IPO
price range at which the offering is marketed and final offering
price are reasonable and to require that the opinion be disclosed in
the prospectus; or

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Use an auction system, such as a Dutch auction system (described

elsewhere in this book) or similar system to collect indications of
interest to help establish the final IPO price; or
Include a valuation disclosure section in the prospectus, including information about how the managing underwriter and issuer
arrived at the initial price range and final IPO price (for example,
the issuers one-year projected earnings or P/E ratios and share
price information of comparable companies).
As of the date of this edition of the guidebook, the NASD had not adopted
any of these approaches.

The Changed Role of Research Analysts in the IPO

Process Analyst Conflicts
One of the important roles that financial institutions play in the IPO
process involves research coverage of a companys stock. In order for the
stock to have a healthy, liquid trading market, it is important that
respected research analysts track the companys industry and the companys performance and make recommendations to the investing public
regarding whether they should buy the stock, sell the stock or hold it in
their portfolios. The same institutions that provide investment banking
services to the company also have a research group that provides research
coverage.
The conflict problem
The role of research analysts in the capital markets and the investment banking industry has received a great deal of media and regulatory
attention in recent years, particularly in the aftermath of the severe
declines in the public equity markets following the late 1990s. Historically,
analysts played a somewhat low-profile role in the industry. However, in
the late 1990s, some analysts were gaining notoriety for their following
among institutional and retail investors and the recommendations they
were making, and were receiving substantial, well-publicized compensation packages. At the same time that a relatively small number of analysts
was raising the profile of the industry, the role of the analyst in the securities industry was changing, and was resulting in potential conflicts of
interest that eventually undermined investor confidence in the capital
markets.

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The SEC began investigating the role of Wall Street analysts in the
securities industry in 1999 as it became apparent that the analysts were
playing an increasingly prominent and pivotal role in the industry, and in
the capital raising process in particular. The SEC reviewed industry practices and conducted examinations of the largest full service investment
banking firms on Wall Street. The results of the SEC investigation outlined
a number of conflicting pressures to which analysts had become exposed,
including the following:
Analysts were involved in the investment banking groups activities.
Analysts routinely participated in pitches for prospective banking
engagements, participated in road shows, initiated analyst coverage on prospective banking clients, developed relationships with
prospective banking clients and provided informal consulting to
privately held companies.
Analyst compensation was tied to the investment banking groups. Many
firms paid their analysts based on the operating performance of
the investment banking group. Some firms investment banking
groups were involved in the performance reviews of analysts and
in determining analyst compensation. Favorable research reports
could result in increased trading (and, hence, increased brokerage
commissions) and in future investment banking engagements
(and, hence, increased banking fees), which would boost the operating performance of the company, and also the compensation of
the analysts. Some firms also directly linked bonus compensation
to analysts assisting in generating new banking business.
Investment banks and analysts often held equity positions in the companies they covered. It was not uncommon for investment banks, and
even their analysts, to hold stock in the companies for which the
investment bank and the analyst provided research coverage. In
some cases analysts had purchased shares of private companies in
advance of the analysts firm managing the companys IPO.
Inadequate disclosure of conflicts. The disclosure of stock ownership
conflicts was inconsistent across firms. The disclosure of investment banking relationships between covered companies and the
analysts firm was deemed inadequate.
Suspicious timing of favorable ratings relative to lock-up release. There
were numerous examples of analysts issuing favorable reports on

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companies coincident in time with the release of the post-IPO

lock-up. These so-called booster shot reports had the effect of
boosting the stock price at precisely the time that the company
management and others subject to lock-up agreements were first
able to sell their shares.
The SEC was so concerned about these issues that, in June 2001, it
issued a lengthy investor alert urging investors to be suspicious of securities analyst reports. In addition, SEC, the NASD, the NYSE and certain
state regulators brought actions against leading investment banks. The
allegations made in these actions (which were settled with neither admission nor denial of the charges by the accused) included: issuing fraudulent
research reports; issuing research reports that were not based on principles of fair dealing and good faith and did not provide a sound basis for
evaluating facts, contained exaggerated or unwarranted claims about the
covered companies, or contained opinions for which there were no reasonable bases; receiving payments for research without disclosing such
payments; and failing to maintain appropriate supervision over their
research and investment banking operations in violation of NASD and
NYSE rules.
The regulatory response
A number of regulatory actions have been taken to correct these perceived structural problems with the investment banking and research
coverage businesses, and to instill confidence and trust in the public
capital-raising process.
Global Analyst Research Settlements. Several large investment banks,
and certain of their analysts, were subject to actions by attorneys general
and state securities regulators for their practices involving research analysts. These actions were settled in April 2003. The settlement resulted in
a number of major investment banking firms being enjoined from future
violations of the rules they were accused of violating. These firms also
agreed to make payments totaling $1.4 billion, including $875 million in
penalties. The firms that were party to the settlement (which do not
include all investment banks with research departments) also agreed to
implement the various structural changes to their research organizations.
New NYSE and Nasdaq Analyst Rules. In May 2002 and July 2003, the
SEC approved new rules for Nasdaq and the NYSE relating to analyst conflicts of interest which are specifically designed to ameliorate the risk of
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analyst conflicts that undermine the public confidence in analyst recommendations. The rules cover some of the same basic topics that the Global
Research Analyst Settlement covered, but also go further. The new rules
apply to all investment banking firms (whether or not such firms were
parties to the global settlement) and cover the following areas:
De-coupling the research and investment banking ends of the business.
The rules prohibit analysts from being under the supervision or
control of the investment banking group, and require legal and
compliance groups to act as intermediaries with respect to communications between research and banking groups regarding the
contents of research reports. The rules also prohibit securities
firms from directly or indirectly retaliating or punishing an analyst who issues an unfavorable research report or comments unfavorably in a public appearance.
Limitations on company review of reports. The rules limit the extent to
which analysts can have subject companies review their reports
prior to issuance, and require legal and compliance groups to be
copied on portions of reports submitted to subject companies for
review.
Disclosure of investment banking compensation from companies covered
by the banks research. The rules require disclosure in research
reports if the analysts investment bank managed or co-managed
a public offering of securities of the subject company in the past
12 months, received investment banking compensation from the
subject company during the past 12 months. Disclosure is also
required for non-investment banking compensation received by
affiliates of such banks, subject to certain exceptions.
Breaking links between analyst compensation and the investment banking business. Securities firms are prohibited from paying any compensation to securities analysts that is based upon investment
banking transactions, and analysts are required to disclose if their
compensation is based in any part upon the operating results of
the investment banking group. Analyst compensation must be
reviewed and approved by a compensation committee that has no
participation from the investment banking group. The committee
must base its review in part upon the analysts report performance

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and may not consider the analysts contributions to the investment banking business of the firm.
Prominence of disclosures. The disclosures regarding analyst conflicts must either be set forth on the cover of the research report, or
the cover page must include an explicit cross reference to the
pages in the report where the disclosure may be found.
Prohibition on research report issuance shortly following an IPO. The
rules prohibit securities firms from publishing research reports on,
or making public appearances regarding, a company for which
the firm acted as a managing underwriter in an IPO for a period of
40 calendar days following the IPO. The blackout period is 25 calendar days for securities firms that participated in the offering as
an underwriter or dealer but not as a managing underwriter.
Prohibition on research report issuance near time of lock-up expiration.
Analysts are prohibited from publishing research reports or making public appearances for a period of 15 calendar days prior to or
after the expiration, waiver or termination of a lock-up agreement
restricting the sale of shares following a public offering.
Disclosure of stock ownership by an analysts firm. An analyst must
disclose in a research report or public appearance if the analysts
firm has an ownership position of 1% or more of a company that is
a subject of the research report or the public appearance.
Limitations on trading by analysts in securities they cover. Research
analysts and members of their households are prohibited from (1)
obtaining pre-IPO shares in companies that they cover, (2) trading
in the securities of companies they cover for a period beginning
30 days prior to, and ending 5 days following, the issuance of a
research report or a modification in the rating or price target for
the company and (3) trading contrary to the analysts recommendation with respect to a security. Legal or compliance personnel
are required to approve securities transactions by supervisors of
research analysts.
Regulation AC (Analyst Certification). In April 2003, the SEC adopted
Regulation AC, which requires that underwriters that publish, circulate or
provide research reports must clearly and prominently include in the
reports:

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A statement by the analyst that the views expressed in the report

accurately reflect the analysts personal views about the companies and securities discussed in the report; and
A statement as to whether any part of the analysts compensation
was, is or will be directly or indirectly related to the recommendations or reviews contained in the report. If the answer is yes, the
report must also disclose detail regarding the source, amount and
purpose of that compensation, and an explicit statement that the
compensation may influence the recommendations in the report.
The rule also requires investment banking firms to keep records of
public appearances by their research analysts. Within 30 days of the end
of any calendar quarter in which an investment banks research analyst
makes a public appearance, the investment bank must create a record that
includes statements by the research analyst substantially similar to the
statements required in research reports.

Online Offerings
It has become quite common for a companys public offering to
include an online, retail component. Internet-focused underwriters, however, typically play a limited role in the overall deal, with a major portion
of the offering still being sold in a traditional institutional manner. The
SEC has issued only limited guidance in this area, but a number of practices, supported by various levels of SEC guidance, have surfaced.
E-brokers use differing methods for conducting the online portion of their
offerings. Accordingly, the company should decide whether to include an
online component to its offering early in the IPO process, fully understand
the underwriters procedures and ensure that such procedures have
received SEC approval.

Dutch Auction Offerings

Some underwriters utilize a method of distribution in IPOs that
differs somewhat from the method traditionally employed in firm commitment underwritten offerings the Dutch action. In a Dutch auction
offering, the public offering price and allocation of shares are determined
following an auction process conducted by the underwriters and other
securities dealers participating in the offering. All investors, both individuals and institutions alike, have priority to buy shares based on the
number that they indicate they are willing to pay (that is, the higher bids
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mined based on the clearing price, which is the highest price at which
all shares in the offering can be sold. Accordingly, investors whose bids
are accepted will pay the price that is either the same or lower than their
bidding price.

True Story:
WRHambrechts OpenIPO wins bid in Overstock.com IPO
In 2002, Overstock.com, Inc. (Nasdaq: OSTK), an online closeout retailer that offers discount, brand-name merchandise for sale
over the Internet, completed its IPO using the OpenIPO auction
process created by William Hambrecht, Chairman and CEO of WR
Hambrecht + Co. Hambrechts auction process, a system designed
by Nobel Prize-winning economist William Vickrey, uses a mathematical model to treat all qualifying bids in an even-handed and
impartial way (similar to the model used to auction U.S. Treasury
bills, notes and bonds).
In an OpenIPO auction, the entire process is private and the
highest bidders win. Winning bidders all pay the same price per
share the public offering price. The auction is typically open for
bids for 3-5 weeks prior to the effective date of the offering. Once the
bidding concludes, all bids are assembled and, working from
highest to lowest, the first bid price that will sell all the offerings
shares is determined. This bid sets the clearing price or the
maximum price at which all of the shares the company seeks to offer
will be fully subscribed.
The company may choose to sell shares at the clearing price, or
it may offer the shares at a lower offering price, taking a number of
economic and business factors into account.

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True Story:
WRHambrechts OpenIPO wins bid in Overstock.com IPO
(continued)
If the number of shares bid above the clearing price exceeds the
number of shares in the offering, WR Hambrecht + Co. allocates the
shares among the bidders on a pro-rata basis, with allocations
rounded to multiples of 100 or 1,000 shares, depending on the size
of the bid.
In its IPO, Overstock.com sold 3,101,000 shares of its common
stock at a price of $13.00 per share.

The Road Show

Logistics
Once the preliminary prospectus has been printed and distributed,
the management team and managing underwriters conduct the road
show. Introduced in the 1970s, road shows today play an integral part of
the IPO process. The primary purpose of the road show is to sell the offering shares to institutional investors.
A typical road show will last two to three weeks and will visit 10 or
more cities in the United States. If the company and managing underwriters have decided to include an international tranche or allocation in the
offering, the road show will include presentations outside the United
States as well, usually in Europe.
The CEO and CFO should expect to make one or two large group presentations in each city, as well as several one-on-one presentations each
day. Occasionally, the managing underwriters will have a second road
show team with other members of the companys management, doubling
the number of possible one-on-one presentations. It is not uncommon for
the management team to meet as many as 200 potential investors over the
course of a single road show.
The biggest logistical challenge is generally determining the schedule
for the road show. As a practical matter, the road show is scheduled only
after the company and the underwriters are satisfied that the company has
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responded sufficiently to the SECs comments such that no SEC comments

that would require a material revision to the registration statement are
outstanding. Depending on the subject matter of the SEC comments, this
may require one or two rounds of comments and responses before the
company and the underwriters are comfortable scheduling the road
show. For example, an unresolved comment relating to revenue recognition may warrant delaying scheduling the road show. The risk of
beginning the road show before all material SEC comments are resolved
is that if new material information is added to the registration statement
after the preliminary prospectus is printed for use in the road show, the
SEC could require the company to recirculate the prospectus, which is
expensive and could delay the pricing of the offering.
Preparation
Preparation for the road show generally begins after the initial filing
of the registration statement and during the period of time that the
company is waiting for SEC comments.

Practical Tip: Listen to the Underwriters

Once the companys road show begins, there will be almost no
time to make adjustments to the road show presentation. The underwriters have every incentive to ensure a successful road show, and
therefore company management should follow the practical suggestions of the underwriters when it comes to preparing for this event.
Underwriters often suggest the company retain a professional coach
to help management improve its road show presentation skills.
Underwriters may also recommend that the company engage a
design firm to help create the visual portion of the presentation
In the days prior to the road show, presentations will be made to the
managing underwriters sales forces. In addition to being an excellent
opportunity for the management team members to refine their presentations, these sessions also serve the purpose of educating the sales forces
about the company to enable them to call on their retail accounts to solicit
interest in the offering.

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Presentations
Road show presentations are designed to provide large amounts of
high-level information in a very short period of time. As a general rule, the
entire presentation should take 30 to 45 minutes and is often shorter.
Group presentations are virtually the same format and length as one-onone presentations, although one-on-ones are generally more conducive to
detailed Q&A. As a practical matter, the company should recognize that
not all attendees will have studied the prospectus prior to hearing the
companys presentation, and should prepare the presentation accordingly.
A representative of the lead underwriter typically introduces the
management team and makes a few comments regarding the company
and the industry.
The CEO then speaks. Investors do not expect more than an overview
of the company, given that they can review the detailed financial and business information contained in the prospectus to the extent that they are
interested. The CEOs presentation should describe the companys history, business, products and services, sales and marketing, customers,
competitive situation and other pertinent information about the company.
The CFO typically follows the CEOs presentation with a review of
financial and accounting matters. This involves a review of the companys
financial statements and general financial status.
The companys road show presentation should not disclose information about the company that is not contained in the prospectus.
Discussions of projections or other forward-looking information can be
particularly dangerous because such discussions cannot be protected by
the safe harbor described in Chapter 10. Moreover, information presented
in a road show discussion can serve as the basis for a claim under the antifraud provisions of the federal securities laws, and, if material, may raise
questions about the adequacy of a prospectus that omits the information.
Although the federal securities laws allow oral and audio/visual
communications such as the road show presentation during the pre-effective period, no written materials may be handed out to investors, analysts
or other spectators except for the preliminary prospectus. Copies of the
slide show presentations and other written or recorded materials used in
the road show presentations may not be distributed.

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Electronic Road Shows

A number of commentators have argued that companies and their
underwriters should be permitted to leverage technology to improve the
road show process by broadening investor access and reducing the time
and money spent to attend in-person meetings. For example, by utilizing
the Internet, a company may be able to make its road show available to a
much larger audience of investors. Investors who either live in cities that
are not visited in-person by the road show team or cannot attend inperson meetings due to scheduling conflicts can attend the online road
show at their convenience.
The SEC has provided some limited guidance regarding electronic
road shows. The SEC permits issuers to utilize video or electronic road
shows in connection with their offerings so long as they follow certain
procedures to ensure that the electronic road show is, for all practical purposes, the same as the live, in-person meetings. For example, the
transmission must be made available only to viewers who are of a type
customarily invited to road show presentations and viewers must receive
or have access to the prospectus before the transmission can be viewed.
Also, information disclosed during the electronic road show presentation
must be consistent with the disclosure in the prospectus and viewers must
not be permitted to copy, download, or distribute any road show material.
As discussed earlier with respect to online offerings, the company should
decide early in the IPO process as to whether an electronic road show
component will benefit its offering, fully understand the underwriters
procedures and confirm with the underwriters that such procedures have
received SEC approval.

Pricing the IPO

Incentives
The incentives of the company and the managing underwriters are
mostly, but not entirely, aligned when it comes to pricing the IPO. A
higher price raises more money for the company with less dilution and
also generates higher fees for the underwriters. An unsustainably high
price, however, can harm the company and the underwriters. Disappointing aftermarket performance may cause investors and analysts to lose
interest, make a follow-on offering more difficult, and even expose the
company to securities litigation. Similarly, poor aftermarket performance
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can expose the underwriters to potential liability and tarnish the underwriters credibility with their institutional accounts. The company and
managing underwriters therefore have an incentive to establish as high a
price as possible while still ensuring some after-market demand that will
support the trading price in the days following the IPO. However, the
company and the managing underwriters do not always see eye-to-eye on
the exact valuation that will accomplish these dual objectives, especially
since the underwriters face conflicting pressures to place stock with
favored brokerage customers at a favorable price.
Valuation analysis
The underwriters use a number of different financial models to determine company valuations. By the time the deal is priced, the company will
be familiar with the valation approach used by the managing underwriter,
which will have presented its approach to the company first during the
underwriter selection process and then again prior to recommending a
price range to include in the preliminary prospectus for marketing the
offering during the road show. If there are comparable companies in the
same industry which are already publicly traded, the underwriters generally will use a similar multiple of earnings, revenue or cash flow in
valuing the company. Another method of valuation, which is particularly
useful in valuing companies with no publicly traded counterparts, is a
discounted cash flow, or net present value, method whereby projected
cash flow or earnings for some future period are discounted to a current
valuation.
Companies should expect some discount to be taken after a valuation
of the company is determined. First, this discount reflects the desire to
ensure after-market demand as discussed above. Second, it also reflects
the relatively higher risk of investing in a young, unproven company compared with more established companies with more resources in the same
industry segment.
Finally, the managing underwriters will have a good feel for the
demand for the companys stock as they near the end of the road show
and see the levels of potential orders. During the road show, the underwriters will be tabulating the indications of interest as they come in and
should be able to provide the company with visibility as the book is
built as the road show progresses. In fact, as discussed in greater detail
earlier in this chapter and Chapter 2, certain rules proposed by the NASD

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mandates greater transparency into the IPO pricing process. A particularly strong or weak demand for the companys stock will influence the
final valuation, regardless of the preliminary results of the various calculations described above. This bears out in particular because many
institutional investors have analysts that develop their own valuation
models which may be different, positively or negatively, than the underwriters model.
Final pricing negotiation
The final pricing negotiation between the company and the underwriters will occur as the registration statement is ready to be declared
effective and the underwriters are ready to sign the underwriting agreement and commence sales of the stock. Because events at this stage move
rapidly, it usually is not practical for the companys entire board of directors to convene for the purpose of considering and approving the final
price. Therefore, boards of directors typically delegate this authority to a
pricing committee consisting of two or three members, usually including the CEO and one or more outside directors. As discussed earlier in this
chapter, the company and the underwriters typically require all selling
stockholders to name an attorney-in-fact with the power to negotiate and
determine the price on behalf of the selling stockholders.
During the pricing call with the companys pricing committee, the
underwriters will present data to support their pricing recommendation.
This data may include performance of the equity markets in general, the
performance of comparable companies in recent weeks and the corresponding valuation multiples, the book of institutional investor demand
and the extent to which the offering is oversubscribed, expected aftermarket interest in the companys stock, price information and aftermarket
performance of other recent IPO companies. Based on the data, the underwriters will make a recommendation that will form the basis either of an
agreement, further negotiation or a decision to postpone (or cancel) the
offering.

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Chapter 10
Now that Youre Public...
Once a company is public, life is noticeably different. Some of the
most significant areas of change are discussed below.

Managing Relations with Wall Street

One of the things that management of a new public company finds
most stressful, and for which it often feels inadequately prepared, is
dealing with Wall Street research analysts and disclosure issues in general. Managing analyst contacts has been characterized as fencing on a
tightrope. On the one hand, having well-respected analysts publishing
reports regarding the company raises the companys visibility with investors and contributes to liquidity in the stock. On the other hand, if
managed poorly, contacts with analysts may lead to lawsuits or SEC
enforcement actions based on claims of selective disclosure of material,
nonpublic information or insider trading.
Public companies use analyst conference calls (or webcasts on the
Internet, or both), in conjunction with press releases issued prior to such
calls, as one method of providing new or updated information to the
market. Most of these conference calls are held following the end of the
companys fiscal quarter to discuss financial results. These calls are preceded by an earnings press release, which is also furnished on Form 8-K
with the SEC prior to the call. Companies also use these calls (or webcasts)
to discuss unexpected material or irregular news (for example, corporate
reorganizations or acquisitions, including mergers, or other significant
developments). Research analysts attend these calls to evaluate the information disclosed by the company and then publish reports to inform
investors of their analysis. Each research analyst hopes to build an accurate model of the company's future performance.

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General Disclosure Obligations

General rule
The securities laws have historically given companies latitude to
determine when and how they communicate material information to the
public. The courts and the SEC have stated as a general rule that, in the
absence of insider trading or previous inaccurate disclosures, a company
has no affirmative duty to disclose material information, apart from an
obligation to make required disclosures in their periodic and current
reports filed pursuant to the Exchange Act (for example, Form 10-K, Form
10-Q, Form 8-K), as well as annual reports and proxy statements.
However, such a general rule has little practical value in light of the
day-to-day circumstances that are widely acknowledged to impose an
affirmative obligation of disclosure on a public company. In fact, a more
open communications policy is encouraged by constant inquiries from the
investment community for current information, internal pressures from
employee stockholders and insiders with respect to purchases and sales of
the companys stock, as well as the companys motivations in apprising
the investment community of current developments. In addition, as discussed in greater detail below, the NYSE and Nasdaq require listed
companies to promptly disclose material information. As a result, most
public companies adopt affirmative policies to disclose material information, subject to certain exceptions (for example, when it is necessary to
keep the information confidential or when the Company has a legitimate
business reason for not disclosing it). As discussed in greater detail below,
Regulation FD prohibits public companies from selectively disclosing
material information to certain persons, such as securities analysts and
stockholders, prior to public disclosure of the information.
Timing issues
Once a company concludes that certain information is material, the
company must then determine when such information must be disclosed
to the public. Materiality determinations are often difficult, and companies should consider various timing issues and concerns, such as whether
the company is in a position to adequately and accurately disclose the
information. Disclosure is appropriate only when the information to be
released by the company is accurate, clear and specific. For example,
information that is released prematurely may be susceptible to misinterpretation. As a general matter, the courts concede that the timing of
disclosure of material information, outside a companys periodic and
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current reporting obligations, is a matter of the companys business judgment. However, most companies as a matter of practice follow the rule,
that unless there is a legitimate business reason for delaying disclosure, a
company should promptly disclose material information. Generally, a
company has a legitimate business reason for nondisclosure when to disclose information would likely adversely impact the ability to reach
agreement on a pending transaction (for example, a merger or product
partnership). However, when price, terms and structure have been agreed
upon, courts have ruled the information generally becomes material.
Exceptions requiring disclosure
Notwithstanding the general rule discussed above, there are certain
specific circumstances in which a public company will have an affirmative
disclosure obligation. A company has an immediate duty of disclosure if
insiders possessing material, nonpublic information are trading in the
companys stock (except for trading pursuant to Rule 10b5-1 plans discussed later in this chapter), or if the company itself is involved in such
trading. In some circumstances, a company will have a duty to correct
existing information in the marketplace that is inaccurate when published. Such a duty may well arise where such previously existing
information was published by the Company, is attributable to the
Company through express or tacit endorsement in one form or another, or
where such information was generated by a person or institution with
whom the Company has a special relationship. However, a company generally does not have an obligation to rectify or correct rumors in the
marketplace that are not attributable, directly or indirectly, to the company. A company may also have a duty to update existing information
that it put in the marketplace that is still material information but subsequently becomes incorrect due to later facts.
Additionally, even if a company is not required to disclose material
information under the federal securities laws, the company is subject to
the Nasdaq rules or applicable exchange rules. Nasdaq requires listed
companies to promptly disclose to the public material corporate information and that such information be provided to the Nasdaq MarketWatch
Department by telephone and facsimile at least 10 minutes prior to public
announcement. Also, the NYSE requires listed companies to promptly
disclose to the public material corporate information via press release. (In
fact, the NYSE has stated that it continues to believe that a press release

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constitutes the single best way to ensure that new material information
released during the trading day becomes available to all traders and the
investing public as promptly as possible.)
Disclosures of forward-looking information using the safe harbor
Historically, a large portion of securities fraud suits were based on
projections and other forward-looking statements that companies failed
to meet. In 1995, as part of its attempt to reduce the incident of abusive
securities litigation, Congress passed the Federal Private Securities Litigation Reform Act, which, under some limited circumstances, provides for
a safe harbor for certain forward-looking statements. However, this safe
harbor can provide immunity for forward-looking statements only if it is
used properly.
The safe harbor works differently depending on whether the communication is written or oral. For written statements, such as in press releases
and SEC filings, the safe harbor applies where the forward-looking statement is identified as such and is accompanied by meaningful cautionary
statements identifying important factors that could cause actual results to
differ materially from those projected in the forward-looking statement.
To invoke the safe harbor for oral communications, such as conference
calls, the company simply needs to announce at the beginning of the call
that it may give forward-looking information (and, ideally, identify the
nature of such information), that actual results could differ materially and
that the factors that may cause the difference are explained in the Risk
Factors section of the Companys SEC filings, identifying the filings (for
example, our Form 10-K for the fiscal year ended December 31, 2003,
filed with the SEC on March 15, 2004). If the referenced document contains a meaningful description of the risks facing the company, the oral
forward-looking statements cannot be the basis of a private securities suit,
even if they turn out to be off the mark.
In addition to properly invoking the safe harbor, it is important to
understand that the statement must be truly forward-looking (that is,
truly a projection of the future) to be protected by the safe harbor. For
example, if a company knows present or historical facts that belie the projection, the statement would not qualify as forward-looking and would
not be protected by the safe harbor.

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A new public company should ensure that all analyst calls, press
releases and any other public statements include the disclosure necessary
for the company to invoke the protections of the safe harbor. (However,
note that the safe harbor does not apply to IPOs and a few other transactions and does not protect a company in an enforcement action brought by
the SEC.)
Regulation FD (Fair Disclosure)
Background
Effective October 23, 2000, the SEC adopted Regulation FD (Fair Disclosure), which introduced new rules intended to improve the
transparency and fairness of the dissemination of information and
address the SECs growing concerns regarding the selective disclosure of
material information by companies to securities analysts and selected
institutional investors. Regulation FD prohibits selective disclosure of
material information.
As reflected in well-publicized reports, many companies had been
selectively disclosing important nonpublic information, such as advance
warnings of earnings results, to securities analysts or selected institutional
investors or both, before making full disclosure of the same information to
the general public. These disclosures took the form of limited-access
analyst conference calls or one-on-one conversations, during which material information regarding corporate earnings and other key financial and
operating metrics were disclosed, directly or indirectly, by giving qualitative feedback on analysts assumptions and financial models. As a result,
those who had the information before public announcement were in a
position to make a profit or avoid a loss at the expense of those investors
who were kept in the dark. The SEC believed that the practice of selective
disclosure was leading to a loss of investor confidence in the integrity of
the capital markets. The SEC stated that selective disclosure bore a close
resemblance in this regard to tipping and insider trading, which are topics
discussed in greater detail later in this chapter. Moreover, many commentators believed that these inefficiencies in the public dissemination of
information had contributed to the speculative euphoria that characterized the late 1990s.

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Regulation FD was also designed to address another important

concern of the SEC the potential for corporate management to treat material information as a commodity to be used to gain or maintain favor with
particular analysts or investors. The SEC believed that in the absence of a
prohibition of selective disclosure, analysts may feel pressured to report
favorably about a company or otherwise slant their analysis to have continued access to selectively disclosed information. The SEC expressed
concern with reports that analysts who published negative views of a
company were sometimes excluded by that company from calls and meetings to which other analysts were invited.
Finally, the SEC acknowledged that recent technological developments had made it much easier for companies to disseminate information
broadly. Historically, companies may have had to rely on analysts to serve
as information intermediaries. In addition to press releases, companies
now can use a variety of methods and mediums to communicate directly
with the market.
Regulation FD in a nutshell
Regulation FD requires that, whenever a public company intends to
disclose material information to securities market professionals and stockholders that are likely to use the information in buying and selling
securities, it must do so through a public disclosure. In addition, if the
company discovers that it has mistakenly made a material selective disclosure to any such person, it must make prompt public disclosure of the
information (within 24 hours of learning of such disclosure).
Some of the key elements of Regulation FD are as follows:
Material information. The regulation does not define what is material or nonpublic information. Instead, it relies on the definitions
from case law which hold that information is material if there is a
substantial likelihood that a reasonable investor would consider it
important in making an investment decision, or the information
would be viewed as having significantly altered the total mix of
information available in the market.
However, the SEC has provided a non-exclusive list of certain
types of information that is likely to be material:
earnings data, either historical or projected;
acquisitions, joint ventures and dispositions of assets;

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new products or discoveries or developments regarding key

customers or suppliers;
changes in control or management;
changes in auditors or auditor notification that a company
may not rely on an audit report;
events regarding the issuers securities (defaults, redemptions, repurchase plans, splits, changes in dividends,
changes in rights, and public and private sales of additional
securities); and
bankruptcy-type events.
The SEC has made it clear, however, that by providing such a list it
did not mean to imply that each of these items is per se material
the information and events on the list still require analysis and
judgment.
The SEC Staff Accounting Bulletin No. 99, which addresses financial statement materiality looking at quantitative and qualitative
factors, can be useful in making materiality determinations as well.
However, the company cannot assume that items are immaterial
simply because they fall below a certain percentage threshold.
Finally, Nasdaqs definition of material news may also be helpful in making materiality determinations. Nasdaq defines material news as information that would reasonably be expected to
affect the value of the companys securities or influence investors
decisions. Nasdaqs list of events that triggers its advance notice
requirement is similar to the SECs list discussed above.
Non-public information. Information is nonpublic if it has not been
disseminated in a manner making it available to investors generally.
Required public disclosure. Regulation FD requires that whenever an
issuer discloses material informationit shall make public disclosure of that information. A variety of methods can satisfy this
requirement. These include making a public filing with the SEC
on Form 8-K, the issuance of a press release on a wire or news service and holding press conferences or conference calls at which
members of the public may either attend or listen via telephone or

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the Internet, so long as the company discloses that it intends to

have such a conference call.
Disclosures to members of the financial community. Although Regulation FD is very broad at first glance, it does not apply to all of a
companys communications with the outside world. The regulation applies only to communications with market professionals
and security holders under circumstances in which it is reasonably foreseeable that someone will trade on the basis of the information. Regulation FD does not apply to communications with
advisors who owe a duty of trust or confidence to the company
(for example, lawyers, accountants, investment bankers) or to
communications with the press, rating agencies, and business
communications with customers. In addition, the SEC carved out
communications made to persons who expressly agrees to maintain the disclosed information in confidence (for example, pursuant
to a non-disclosure agreement entered into prior to the disclosure
that prohibits trading on the information).
Disclosures by persons acting on behalf of the public company. Regulation FD does not govern the conduct of all employees. Rather, it
applies only to communications made by senior management,
investor relations professionals, and others who regularly communicate with the market and investors. Statements made in connection with most registered securities offerings will be exempt
from Regulation FD.
Timing of disclosure. Intentional disclosures covered by the regulation (which includes disclosure with respect to which the issuer is
reckless) must be made public simultaneously with the covered
disclosure to a member of the financial community. If an issuer
discovers that it has mistakenly made a material selective disclosure to a covered person, it must make a prompt public disclosure,
within 24 hours, of the covered disclosure.

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Regulation FD does not create a private right of action for violations.

Thus, a stockholder cannot file a suit for a company's violation of Regulation FD. However, the SEC may bring an enforcement action against the
company and the individual who made a disclosure where a violation
was intentional or reckless.

Practical Tips: Managing Contacts with Analysts

and Investors
Prior to the effective date of its IPO, a company should work
together with its counsel to adopt an analyst policy and an investor
relations policy. Managing relations with analysts and investors is
not always intuitive, and guidance from someone who regularly
defends companies in stockholder lawsuits can be invaluable.
Among other things, the company should heed the following:
Make sure that the policies are realistic. Having a policy that
is not practical, and therefore not followed, may put the
company at a disadvantage in defending a stockholder lawsuit.
Designate company spokespersons who are authorized to
talk to the financial community. Require employees to refer
all analyst, investor and financial press inquiries to one of
the designated spokespersons. Get a tutorial from the companys counsel and make sure that each of the companys
designated spokespersons attends.
Prepare scripts and anticipate Q&As for analyst calls; preclear scripts and material press releases with counsel, and
ensure that the appropriate safe harbor language is included
in every communication.
Do not distribute analysts reports or otherwise endorse
them.

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Practical Tips: Managing Contacts with Analysts

and Investors (continued)
Do not be pressured into disclosing information; it is often
appropriate to say, We are not commenting on that. Consider imposing an analyst blackout period during which no
calls from analysts will be accepted (for example, during the
last two weeks of each quarter), to avoid inadvertent violations of Regulation FD.
Review analyst and investor relations policies periodically
as the companys situation changes.

True Story: The Schering-Plough Enforcement Action

and Settlement
In September 2003, the SEC announced its first settlement of a
Regulation FD enforcement case. The settlement with ScheringPlough Corporation and its former Chairman and CEO illustrates
the SECs views on enforcement of Regulation FD and highlights the
important of strict adherence to the rules.
The SECs complaint against Schering-Plough alleged that the
companys Chairman and CEO and its Senior Vice President of
Investor Relations met privately with analysts and portfolio managers. During these meetings, the company allegedly disclosed,
through a combination of spoken language, tone, emphasis and
demeanor, material and adverse nonpublic information regarding
the companys earnings prospects, including the fact that analysts
estimates for third quarter 2002 earnings were too high and that
earnings would significantly decline in 2003.

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True Story: The Schering-Plough Enforcement Action

and Settlement (continued)
Immediately after the meetings, analysts at two of these firms
downgraded their ratings on the company, and portfolio managers
at three of the firms heavily sold the companys stock. The price of
the companys stock declined over the next several days by more
than 17% on approximately four times normal volume.
The SEC charged the company with violations of Section 13(a)
of the Exchange Act and Regulation FD. Schering-Plough paid a
$1 million fine, and the Chairman and CEO paid a $50,000 fine.

Periodic Reporting and the Disclosure Obligations of

a Public Company and its Stockholders
Quarterly reports on Form 10-Q and annual reports on Form 10-K
The IPO registration statement is only the first SEC disclosure filing
that a public company will make. Companies must file quarterly reports
on Form 10-Q within 45 days of the end of each of the first three quarters
of their fiscal years and annual reports on Form 10-K within 90 days of the
end of the last quarter of their fiscal years. The SEC recently amended its
rules and forms to accelerate the filing of Forms 10-Q and 10-K for accelerated filers, and these changes will be phased in through 2005. (For more
information on these new rules please refer to Appendix E.) Failure to make
timely filings may result in the companys ineligibility to use Registration
Statement on Form S-3 for follow-on public offerings and Rule 144 being
unavailable for certain resales of restricted shares of the companys stock.
As a general matter, public companies simply do not miss filing deadlines,
and any delinquency in a required filing can be interpreted by analysts
and investors as a sign that the company does not have its house in order.

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Proxy solicitation materials and annual reports

Once the company has registered its securities under the Exchange
Act, it will be required to comply with the SEC proxy rules. The company
will be required to file with the SEC proxy statements that comply with
Schedule 14A relating to annual and special meetings of stockholders.
Definitive proxy solicitation materials relating to an annual meeting at
which the only agenda items are the election of directors, amendments to
stock plans, certain stockholder-sponsored proposals, and ratification of
the independent auditors selected by the Audit Committee of the Board of
Directors are required to be filed with the SEC concurrent with mailing to
stockholders.
However, proxy solicitation materials containing agenda items other
than these items may not be distributed to stockholders until the materials
have first been filed with the SEC for its review. Such preliminary proxy
solicitation materials must be submitted to the SEC at least 10 days prior
to the date definitive copies are first sent to stockholders. Because the SEC
may review these preliminary proxy materials in detail, it is often advisable to submit the preliminary materials earlier than 10 days before the
scheduled mailing date, so that any changes requested by the SEC can be
accommodated without disrupting the mailing schedule.
Most public companies solicit proxies for their stockholder meetings.
If the company elects not to solicit proxies from stockholders, the stockholders must nevertheless be furnished with an information statement
containing information substantially equivalent to that required in a
proxy statement.
In addition, the SEC proxy rules require that, where the solicitation is
made on behalf of management of the company and relates to an annual
meeting of stockholders at which directors are to be elected, the proxy
statement must be accompanied or preceded by an annual report to stockholders. This annual report must contain, among other things, audited
financial statements, MD&A, a brief description of the business done
during the most recent fiscal year, and information regarding each of the
companys directors and executive officers. The annual report gives the
company a chance to tell its story not only to its stockholders but also to
the financial community and investing public at large. As a result, the
annual report is often a lengthy document prepared with great concern for
literary content and visual form. If this will be the companys practice, it

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should recognize that the preparation of the report will involve a great
deal of lead time, especially with respect to graphics and color printing,
and the company should therefore begin early enough so that it will be
completed in time for mailing not later than the date the notice of annual
meeting and proxy statement are mailed to stockholders. The annual
report and proxy materials, as is the case with all public disclosures by the
company, should be carefully prepared, as they could give rise to liability
for material misstatements or omissions.
Current reports on Form 8-K
Certain significant events that occur between periodic filings, such as
certain changes of control, material acquisitions or dispositions, bankruptcies, changes in accountants, and resignations of directors must be
reported on Form 8-K. A public company may also use Form 8-K to report
on other events which are not specifically required to be disclosed, but
which the company wishes to include promptly in its formal SEC disclosure documents.
The SEC has adopted amendments to Form 8-K, effective August 23,
2004. The amendments add 10 disclosure items to Form 8-K, including
transferring 2 items to the current report from the periodic reports. The
amendments will also provide investors with more timely disclosure of
material information by replacing the current 5 business and 15 calendar
day Form 8-K deadlines with a new 4 business day deadline.
These amendments are responsive to the current disclosure goals of
Section 409 of the Sarbanes-Oxley Act by requiring public companies to
disclose, on a rapid and current basis, material information regarding
changes in a companys financial condition or operations as the SEC, by
rule, determines to be necessary or useful for the protection of investors
and in the public interest.
The eight new disclosure items include:
entry into a material agreement outside of the ordinary
course of business;
termination of a material agreement outside of the ordinary
course of business;
creation of a material direct financial obligation or a material
obligation under an off-balance sheet arrangement;

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triggering events that accelerate or increase a material direct

financial obligation or a material obligation under an off-balance sheet arrangement;
material costs associated with exit or disposal activities;
material impairments;
notice of delisting or failure to satisfy a continued listing rule
or standard; transfer of listing; and
non-reliance on previously issued financial statements or a
related audit report or completed interim review (restatements).
The two disclosure items transferred, in part, from the periodic
reports are:
unregistered sales of equity securities; and
material modifications to rights of security holders.
Expanded disclosure items include:
departure of directors or principal officers, election of directors,
or appointment of principal officers; and
amendments to charter or bylaws and change in fiscal year.
The disclosure documents referred to above are not simply forms to
be filled in. They are substantive disclosure documents which are relied
upon by analysts and investors, and which, if carefully prepared, may
protect the company from liability. For these reasons, they should not be
left until the last minute or delegated to administrative personnel. Rather,
they should be prepared by, or under the close supervision of, the CFO or
other senior personnel who have perspective on the companys business,
results of operations, risks and prospects. Like the companys IPO prospectus, Forms 10-Q, 10-K and 8-K, and Schedule 14A are based on
Regulation S-K. A well-drafted IPO prospectus will serve as a good starting point for a public companys first periodic reports.

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Practical Tip: Make a 12-Month Compliance Calendar

Shortly after the effective date of a companys IPO, the CFO and
the companys counsel should create a list of SEC reporting deadlines, annual meeting events and similar compliance items covering
a full annual cycle. Toward the end of the year covered by the calendar, a new calendar for the following year can be created, and so on.
Appendix D contains a sample compliance calendar.

Resales of Restricted Stock

Overview
Just because a company has gone public does not mean that all of its
shares, however or whenever acquired, may be publicly traded. The companys registration statement on Form S-1 registers only those shares to be
offered and sold to the public in the IPO. Similarly, the companys registration statement on Form S-8 applies only to those employee benefit plan
shares specifically registered. Shares that were acquired while the
company was private remain unregistered and may be publicly resold
only if they are included in an effective registration statement or if an
exemption from registration is available. These unregistered shares are
referred to as restricted stock.
One of the goals of an IPO is to provide liquidity for the companys
employees and private investors. Newly public companies are often surprised by the level of activity that this new liquidity generates, especially
when the lock-up period expires. In order to adequately respond to
inquiries of employees and investors, the company should have some
familiarity with the basic rules governing resales of restricted stock as it
embarks on the new path of being a publicly traded company.
Stockholders of the company who propose to sell restricted stock into
the public market following the IPO must comply with the applicable provisions of Rule 144 or Rule 701 under the Securities Act. These rules apply
to both restricted securities and control securities. Control securities are
any securities held by an affiliate of the company. An executive officer,

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director, or large stockholder, who, directly or indirectly, controls the

management or policies of the company is deemed an affiliate for purposes of the rule.
Rule 144
Briefly, under Rule 144 of the Securities Act, unregistered stock may
be publicly resold if:
the shares have been beneficially held for at least one year;
the company has been subject to the reporting requirements of the
Exchange Act for at least 90 days and has filed all required
reports;
the amount of stock sold by the seller, together with certain sales
made by the seller within the preceding three months, does not
exceed the greater of one percent of the outstanding shares of the
company or the average weekly reported volume of trading in the
companys stock during the preceding four calendar weeks;
the shares are sold in a brokers transaction or directly with a market maker; and
a notice on Form 144 is filed with the SEC and the principal
exchange on which the companys shares are traded.
However, pursuant to Rule 144(k), sales of unregistered securities by
a non-affiliate of the company who has held the shares for at least two
years may be made without compliance with the public information
requirement, the volume limitation, the manner of sale requirement or the
Form 144 filing requirement noted above.
Rule 701
Rule 701 provides even more relief for employees, consultants, directors and certain others who hold unregistered shares of a companys stock
that they obtained pursuant to a written compensatory benefit plan (such
as a stock option plan) or a written contract relating to compensation (such
as an employment agreement) prior to the IPO. This stock will be considered 701 stock so long as the company complied with the limitations on
offers and sales under Rule 701. Ninety days after a company becomes
subject to the reporting requirements of the Exchange Act (that is 90 days

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following the effective date of the companys IPO), non-affiliates may sell
701 stock without compliance with the current public information,
holding period, volume limitation or Form 144 filing requirements of
Rule 144, and affiliates may sell 701 stock without compliance with the
holding period requirement of Rule 144.
Application of Rule 144 and Rule 701
The application of Rule 144 and Rule 701 to particular fact patterns
can be complex. Issues often arise regarding the determination of affiliate
status, the permissibility of tacking the holding period of one holder to
that of a subsequent holder, and the aggregation of sales of related or affiliated parties for purposes of computing compliance with volume
limitations. The company need not attempt to master these rules in this
level of detail, as the companys counsel generally will provide advice
regarding these issues.
Stock certificates issued prior to the IPO generally bear a restrictive
legend referring to the Securities Act, indicating that the shares represented by the certificate are unregistered and may not be transferred
unless subsequently registered or unless an exemption from registration
is available. The companys transfer agent will not transfer a stock certificate bearing a restrictive legend unless the transfer agent receives
instructions from the company or its counsel that the legend may be
removed and the shares may be transferred in compliance with the provisions of the Securities Act. For this reason, when a broker receives
legended stock that a holder wishes to sell, the broker typically will
send a legend removal request directly to the companys counsel. Much of
the analysis necessary for determining the Rule 144 or Rule 701 status of
unregistered securities will have already been conducted in preparation
of the overhang analysis included in the IPO prospectus. However,
company counsel may require additional detail from the company when
preparing a legend removal instruction letter. Sellers usually are impatient to have their trades cleared, and the company can facilitate the
delivery of the legend removal instruction letter by promptly responding
to its counsels requests for information.

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Section 16 and Insider Trading

Section 16 reporting and short-swing liability
Each of the directors, officers and beneficial owners of more than 10%
of any class of the companys equity securities registered under Section 12
of the Exchange Act are subject to Section 16 of the Exchange Act. The
three sections of Section 16 that concern Section 16 insiders are: Section
16(a) requiring disclosure and reporting; Section 16(b) imposing liability
for short swing trading; and Section 16(c) prohibiting short sales.
Determining Beneficial Ownership under Section 16
The issue of beneficial ownership arises in two contexts under
Section 16: (1) determining who is a 10% stockholder; and (2) determining
beneficial ownership for purposes of reporting and short-swing profit.
Beneficial ownership in the first context (that is, 10% stockholder determinations) is determined by reference to Rule 13d-3. Rule 13d-3 provides
that a person is the beneficial owner of a security if the person has or
shares the power to vote, or direct the voting of, or the power to dispose,
or direct the disposition of, that security. In addition, a person is the beneficial owner of securities where such power can be obtained within
60 days through the exercise or conversion of derivative securities.
For all Section 16 purposes other than determining who is a 10%
stockholder, beneficial ownership means a direct or indirect pecuniary
interest in the subject securities through any contract, arrangement,
understanding, relationship or otherwise. Pecuniary interest means the
opportunity, directly or indirectly, to profit or share in any profit derived
from a transaction in the subject securities.
Section 16(a) Reporting Obligations
Section 16(a) imposes the reporting obligations on Section 16 insiders.
It provides that Section 16 insiders (1) must file an initial report on Form
3 with the SEC of their beneficial ownership of equity securities of the
company (including derivative securities, such as options, warrants and
stock appreciation rights) and (2) must report subsequent changes in their
beneficial ownership of those securities on Forms 4 and 5.
In 2002, the SEC implemented new and amended rules that require
most changes in beneficial ownership to be reported by Section 16 insiders
to the SEC within two business days after the change occurs. Examples of

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the many transactions by a Section 16 insider involving the companys

securities that will require filing within two business days include: stock
and option grants, regrants, repricings and cancellations, stock option
exercises, open market purchases, discretionary transfers to or from a
company stock fund in a 401 (K) plan, and transactions under non-qualified deferred compensation plans. Certain other transactions may be filed
on Form 5 within 45 days after the end of the companys fiscal year.
In the event that a Section 16 insider fails to timely file any required
report under Section 16(a), the company must report such failure in its
subsequent proxy statement, information statements and annual Report
on Form 10-K under a section entitled Section 16(a) Beneficial Ownership
Reporting Compliance. The company must identify by name its
Section 16 insiders who, during the prior fiscal year, reported transactions
late or failed to file required reports, and must disclose the number of
delinquent filings and the number of transaction that were reported late
for each such insider.
Although the company is not obligated to prepare or file reports
under Section 16(a) for its Section 16 insiders, many companies assist their
reporting persons or submit reports on their behalf to facilitate accurate
and timely filing. The two-business day filing requirement will most
likely present an administrative challenge to the newly public company
and advance planning will be necessary to ensure compliance. In addition, Section 16(a) requires public companies to post Section 16 reports
filed by its Section 16 insiders on its public web site by the end of the business day after the filing.
Section 16(b) Short-Swing Liability
Section 16(b) is a liability provision, and it provides that Section 16
insiders are liable to the company for any profits made purchases of the
companys stock within six months of a sale of the companys stock. To
violate Section 16(b), there must be a purchase and sale (or a sale and
purchase) within a period of less than six months. The prohibition on
short-swing trades applies regardless of whether the purchase or the sale
occurs first. The purpose of Section 16(b) is to prevent the unfair use of
information about the company that may have been obtained by Section
16 insiders by virtue of their position.

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Section 16(b) is applied strictly, and liability is not dependent on a

proven or actual use of the material, non-public information and may be
imposed regardless of good faith. In other words, the Section 16 insiders
actual intentions and actual awareness or possession of inside information
at the time of the trade are irrelevant. If a Section 16 insider makes a shortswing trade, he or she is required to disgorge the profits from the trade to
the company. If the company fails to bring a suit against the Section 16
insider for recovery of the profits within 60 days after demand by a stockholder to do so (or fails to prosecute the suit diligently), a suit may be
brought on behalf of the company by the stockholder. Certain attorneys
specialize in discovering short-swing trading violations, and the company
can expect to receive letters from such attorneys from time to time seeking
information regarding Section 16 insiders trading activities. These attorneys actively review computerized databases of all Forms 3, 4 and 5 filed
by Section 16 Insiders in the hope of matching transactions that will result
in Section 16(b) liability.
Section 16(c) Prohibition of Short Sales
Section 16(c) prohibits Section 16 insiders from engaging in both traditional short sales of the companys securities and certain other
transactions that are economically or functionally equivalent to a short
sale.

Practical Tips: Ensuring Section 16 Compliance

Given the administrative demands of the Section 16 filing
requirements, companies should consider the implementing the following procedures to help ensure compliance:
annually review the status of the companys Section 16
insiders and determine whether the designations are still
appropriate;
require all Section 16 insiders to pre-clear all transactions in
the companys securities and all Rule 10b5-1 trading plans with
an internal compliance officer (for example, the CFO or general
counsel);

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Practical Tips: Ensuring Section 16 Compliance

(continued)
consider requiring each Section 16 insiders brokers to (1)
confirm with the Company all proposed trades (other than
trades made pursuant to a pre-cleared and compliant Rule
10b5-1 plan) and Rule 10b5-1 plans have been pre-cleared by
the compliance officer and (2) promptly report the details of
all trades (including trades made pursuant to Rule 10b5-1
plans);
establish a specific e-mail address for Section 16 notification
purposes so that if the compliance person is on vacation or
unavailable, someone can still easily check for broker notifications;
circulate proposed option grant lists to the compliance
officer before the board meeting at which approval for such
grants is being sought;
meet in person with each Section 16 insider to explain the
rules and procedures, including pre-clearance procedures;
confirm that the company has a power of attorney from each
Section 16 insider that authorizes specified members of the
companys management team to sign and file Section 16
reports on behalf of the Section 16 insiders;
ensure that the companys insider trading policy includes
the mandatory pre-clearance and notification procedures;
send periodic reminders to Section 16 insiders of reporting
requirements and deadlines; and
obtain EDGAR filing codes for each Section 16 insider.

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Insider trading; insider trading compliance programs; pension fund

blackouts
Insider Trading
The securities laws broadly prohibit fraudulent activities of any kind
in connection with the offer, purchase or sale of securities. A person may
be subject to criminal and civil fines and penalties, as well as imprisonment, for engaging in transactions in the companys securities at a time
when such person was aware of material, non-public information about
the security or the company as well as for disclosing the information
(tipping) to others who then trade on such information. This is known
as insider trading. The person who is aware of material, non-public
information about the company or its securities is often referred to as an
insider, even though the person may not be an executive officer or director of the company.
Insider Trading Compliance Program
There may often be occasions when material, non-public information
regarding a public company should not, for legitimate business reasons,
be publicly disclosed at a particular time (for example, prior to the
announcement of the execution of a merger or acquisition agreement). The
implementation of an insider trading compliance program is important to
protect the company and its insiders from liability under Rule 10b-5 and
the other insider trading laws.
A good insider trading compliance program will include a strong, but
thoughtful, policy regarding the unauthorized disclosure of non-public
information acquired in the workplace in general and the misuse of material, non-public information in securities trading.
The policy should also establish a windows of time during which
certain insiders cannot engage in transactions in the companys securities.
For example, many public companies have trading windows that open
one or two trading days after an earnings release and close three or four
weeks prior to the end of their fiscal quarters. While the length of time of
the closure varies from company to company in light of its revenue and
earnings cycles and other factors, the trading window can prevent insiders from trading for periods ranging from 10 days to 6 weeks. Regardless,
the policy always prohibits a person who is aware of material, non-public
information from trading. As an added measure of precaution, many
companies have mandatory pre-clearance procedures for their insiders,
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executive officers and directors, which apply even during open trading
windows, and designate one or more corporate officers as compliances
officers to oversee such procedures. The good compliance program
should also include a training component, which begins with new hires
and involves regular periodic training for directors, officers and other
employees.
Prohibition against Trading during Pension Fund Blackout Periods
The Sarbanes-Oxley Act of 2002 contains a prohibition against trading
by directors and executive officers of a company during a pension fund
blackout period. The SEC has also adopted a new regulation Regulation
Blackout Trading Restriction, or BTR to clarify the scope and operation
of that provision of the Sarbanes-Oxley Act. The purpose of these new
rules is to equalize the treatment of corporate executives and rank-and-file
employees with respect to their ability to trade in company stock during
pension fund blackout periods.
Regulation BTR provides that during a pension fund blackout period,
directors and executive officers of a public company are prohibited from
purchasing, selling or otherwise acquiring or transferring a security
acquired in connection with service as a director or officer. For purposes
of these rules, a blackout period means any period of more than three
consecutive business days during which pension plan participants (or
beneficiaries) are temporarily suspended from trading in company securities held in their individual accounts but only if the suspension applies
to at least 50% of the pension plan participants. The penalty for violations
is disgorgement of any profits. There are a number of transactions that are
exempt from these rules. For example, purchases and sales made under a
Rule 10b5-1 trading plan are exempt. The rules also require the company
to provide advance notice of a pension fund blackout period to directors
and executive officers and to file such notice on Form 8-K.
Rule 10b5-1 trading plans
Legal and company policy constraints (for example, SEC insider
trading rules, company-imposed trading windows and other black-out
periods), frequently prevent executive officers and directors from selling
company stock. Individually, and in combination, these constraints and
other factors can effectively prevent insiders from selling stock for
extended periods of time. Even when trading windows are open and

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other constraints lifted, insiders who decide to engage in market transactions risk being second-guessed by regulators, prosecutors and private
securities class action plaintiffs.
In October 2000, the SEC adopted Rule 10b5-1 to provide a safe harbor
for certain trading arrangements that are designed to cover situations in
which a person can demonstrate that the material, non-public information
was not a factor in the trading decision. However, a trading plan only
merits the protection of the safe harbor if it is in writing, was adopted in
good faith by the person before he or she became aware of any material,
nonpublic information and the plan:
specified the amount of, the price at, and the date of the purchases
or sales;
included a formula or algorithm, or computer program, for determining the amount of, the price at, and the date of the purchases
or sales to be made; or
did not permit the person to exercise any subsequent influence
over how, when, or whether to effect purchases or sales (so long as
the actual person who did exercise such influence (for example,
the broker, was not aware of the material, non-public information.
Any person can adopt a trading plan, including the company or a
stockholder otherwise unaffiliated with the company. In fact, a Rule
10b5-1 trading plan can be used by an entity (for example, a stockholder
of the company that is a venture capital firm) as an affirmative defense to
insider trading if it can demonstrate (1) that the individual making the
investment decision on behalf of the entity was not aware of any material,
non-public information and (2) the entity had implemented reasonable
policies and procedures to ensure that individuals making investment
decisions on its behalf would not violate insider trading laws.
Trading plans, if properly constructed, may provide insiders with
liquidity and diversification opportunities, while reducing the risk of
insider trading allegations by serving as an affirmative defense. Even if
the insider is aware of material, nonpublic information at the time of a
trade, he will not be liable for insider trading if he can demonstrate that
plan complied with Rule 10b5-1.

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While Rule 10b5-1 trading plans can provide several potential benefits, they do present a few risks. For example, these plans have not yet
been tested in any regulatory or court action. Also, implementing a
trading plan requires the insider to plan future trades in advance, resulting in reduced flexibility. The insider essentially relinquishes the ability to
easily modify those future trades, even if his financial situation or the
value of the stock changes significantly. And while trading plans can be
modified, and terminated, there are risks to entering a plan and then deviating from it. Accordingly, insiders should consider adopting a trading
plan only if they intend to follow it to the letter and should assume that
they will not sell any additional shares outside of the plan.
Persons subject to Section 16 who adopt trading plans must still file
Forms 4 and avoid short-swing trading, and Rule 144 still applies to sales
made pursuant to trading plans by affiliates. However, the SEC has clarified that an insider may modify the Form 144 to state that the
representation regarding the sellers lack of knowledge of material information is made as of the date the plan was adopted, rather than the date
the person signs the Form.
A company should consider various issues regarding trading plans as
well. The company must ensure that its insider trading policy permits
trades made pursuant to compliant plans. The company must also determine to what extent it desires to retain authority to approve an insiders
proposed trading plan before allowing the insider to benefit from an
exemption from the insider trading policy. The company and insiders
must also decide how much information they are going to publicly disclose regarding the adoption of trading plans. Disclosing that insiders
trades are being made pursuant to pre-established Rule 10b5-1 plans may
help avoid unintended signaling effects that the market may infer from
such sales, and may deter some potential plaintiffs from filing securities
lawsuits based in part on insiders trades.

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Additional Reporting Requirements for

Certain Stockholders
Section 13 of the Exchange Act; Schedules 13D-G
Sections 13(d) and 13(g) of the Exchange Act, and the related SEC regulations, require any person who acquires beneficial ownership of more
than 5% of the outstanding shares of any class of the companys securities
that is registered under Section 12 of the Exchange Act (a 5% Stockholder) to report such ownership to the SEC by filing a Schedule 13D or
Schedule 13G with the SEC via its EDGAR system. A 5% stockholder must
also provide a copy of the filing to the company and the national securities
exchange on which the companys securities are traded.
Determining beneficial ownership for purposes of Sections 13(d) and (g)
Rule 13d-3 provides that a person is the beneficial owner of a security
if the person has or shares the power to vote, or direct the voting of, or the
power to dispose, or direct the disposition of, that security. In addition,
such person is the beneficial owner of securities where such power can be
obtained within 60 days through (1) the exercise of any option, warrant or
right, (2) the conversion of a security, (3) the revocation of a trust, discretionary account or similar arrangement, or (4) the automatic termination
of a trust, discretionary account or similar arrangement. Finally, a person
is the beneficial owner of securities if the rights described in (1), (2) or (3)
above are acquired for the purpose of changing the control of the company, irrespective of whether that right can be exercised within 60 days.
Beneficial ownership may be acquired either individually or as a
group. If two or more persons agree to act together in acquiring or voting
securities, a group is considered to have acquired the securities of each
member thereof as of the date of that agreement.
Initial reporting on Schedule 13G
Within 45 days following the calendar year in which the company
completes its IPO, each 5% Stockholder who became a 5% Stockholder
before consummation of the companys IPO must report such ownership
to the SEC on a Schedule 13G. These pre-offering stockholders are identified as exempt stockholders because their shares were acquired before
the companys public offering was consummated.

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Continuing reporting following the IPO

As soon as the company becomes a public company, any exempt
stockholders who acquire more than 2% of the companys stock within
any 12-month period, or any other person who becomes a 5% Stockholder,
may be required to file a Schedule 13D, which is a significantly more
extensive form than the Schedule 13G. However, the Schedule 13D filing
need not be made if the 5% Stockholder is a passive investor, meaning
such 5% Stockholder beneficially owns less than 20% of the companys
common stock and did not acquire the companys securities for the purpose, or with the effect, of influencing or changing control of the company.
A 5% Stockholder who qualifies as a passive investor may continue filing
reports on Schedule 13G in lieu of the more burdensome report on Schedule 13D. Directors and officers, because of their positions of influence in
relation to the company, have been deemed by the SEC staff not to qualify
as passive investors under any circumstance and are required to file
reports on Schedule 13D, as applicable.
Generally, reports on Schedule 13G must be amended annually to
indicate any change in beneficial ownership. In addition, whenever a
passive investor who was filing reports on Schedule 13G acquires more
than 10% of the companys securities, the investor is required to file an
amendment to its report on Schedule 13G promptly after the date of the
additional acquisition of the companys securities. From that time on, such
investor must file an amendment to its report on Schedule 13G promptly
anytime after its beneficial ownership in the companys outstanding securities changes (whether by increase or decrease in holdings) by more than
5%. A non-passive investor must amend its report on Schedule 13D
promptly to indicate any material changes to the information on such
schedule and must also promptly amend its report to indicate any change
of 1% or more in such investors beneficial ownership in the companys
outstanding securities.

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216

Chapter 11
Special Considerations for Non-U.S. Companies
Over the last 10 years, the number of foreign companies accessing the
U.S. public markets has increased significantly. Since 1997, over 600
foreign companies have registered securities with the SEC for the first
time. A public offering in the United States can provide a non-U.S.
company with access to the worlds largest capital markets at favorable
valuations. It can also subject the company to numerous expenses, regulatory compliance burdens and liability. This chapter highlights issues of
special concern to non-U.S. companies contemplating a public offering in
the United States and points out certain areas where non-U.S. issuers are
treated differently from U.S. issuers. Except as noted below, most of the
issues identified in the preceding chapters of this book also apply to
non-U.S. issuers.

Foreign Private Issuers

Under the U.S. securities laws, a foreign private issuer is subject to
somewhat narrower disclosure obligations than U.S. issuers and is
exempt from the application of certain U.S. securities regulations. The U.S.
securities laws define a foreign private issuer as a corporation or other
organization (other than a foreign government) that is incorporated or
organized under the laws of any foreign country unless:
more than 50% of the outstanding voting securities of the issuer
are directly or indirectly held of record by residents of the United
States; and
any of the following:
the majority of the executive officers or directors are United
States citizens or residents;
more than 50% of the assets of the issuer are located in the
United States; or
the business of the issuer is administered principally in the
United States.

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In determining the percentage of outstanding voting securities held

by U.S. residents, the inquiry may be limited to accounts held by brokers,
dealers, banks and other nominees located in the United States, the
issuers jurisdiction of incorporation, and the jurisdiction that is the
primary trading market for the issuers voting securities, if different than
the jurisdiction of incorporation.

Mechanics of the Public Offering

Type of security to be offered
A non-U.S. issuer may offer its shares directly to United States investors or instead may make its public offering in the United States through
the use of American Depositary Receipts (ADRs).
An ADR is a negotiable instrument issued by a third-party financial
institution, referred to as a Depositary, and evidences ownership of a
certain number of underlying shares of the non-U.S. issuer, which underlying shares are held by the Depositarys correspondent bank, referred to
as a Custodian Bank, located in the home country of the non-U.S. issuer.
Investors trade in the ADRs and not the underlying security. ADRs add
complexity and additional documentation to the IPO process, but can be
useful in circumventing difficult and expensive transfer procedures,
certain voting restrictions, and tax and foreign exchange control problems
in the issuers home jurisdiction.
There are specific advantages in using ADRs as opposed to making a
direct offer of shares of a non-U.S. issuer in the United States. Laws in
certain foreign jurisdictions prohibit or limit direct foreign ownership or
impose a transfer or stamp tax for transfers of shares. Use of ADRs avoids
the concerns associated with direct foreign ownership or transfer taxes, as
the shares underlying the ADRs are held by the Custodian Bank located
in the issuers home country, and when ADRs are transferred, the underlying shares held by the Custodian Bank are not transferred.
Advantages may also accrue to U.S. investors as a result of holding
ADRs as opposed to directly holding shares of a non-U.S. issuer. ADRs
can be transferred and exchanged by presentment to the Depositary rather
than having to deal with a transfer agent located outside the
United States. Further, dividends can be paid to U.S. investors in U.S.

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dollars. The Depositary takes on the responsibility of handling currency

conversions and facilitating stockholder communications and voting
rights in exchange for fees, which are paid by the ADR holders.
The question of whether shares of a non-U.S. issuer should be offered
directly or through ADRs should be discussed with counsel at the beginning of the offering process.
Form of registration statement to be used
Foreign private issuers are eligible to register shares in connection
with an initial public offering on a registration statement on Form F-1,
which is similar in many respects to a registration statement on Form S-1.
However, the Form F-1 registration statement must contain additional
disclosure relating to the following:
the nature and extent of the principal non-U.S. trading market for
the companys securities;
limitations on the rights of investors outside of the home jurisdiction to hold and vote the stock;
governmental restrictions applicable to the export or import of
capital, and the payment of dividends and interest to investors
outside of the home jurisdiction, as well as procedures for nonresident holders to claim dividends;
taxes to which United States investors may be subject under the
laws of the home jurisdiction or treaties between the home jurisdiction and the United States;
historical exchange rates between U.S. dollars and the home country currency;
the ability of United States stockholders and the SEC to make
claims under U.S. securities laws against the company and its
officers and directors located outside of the United States; and
laws or regulations of the home jurisdiction applicable to rights of
stockholders, stockholder meetings, restrictions on changes of
control, and other material rights, where such laws or regulations
are significantly different from those in the United States.

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The Form F-1 registration statement may omit some of the more
detailed executive compensation and stock ownership information
required in a Form S-1 registration statement. However, in order to
appear less foreign to U.S. investors, many foreign issuers elect to
include some amount of the information that they may otherwise omit
under the SEC rules.
A non-U.S. company wishing to make a public offering in the United
States using ADRs, in which it intends to raise capital, is required to work
with a Depositary to register the ADRs on a registration statement on
Form F-6, and to register the underlying shares on a Form F-1 registration
statement. Different variations of ADR programs exist. A non-U.S.
company wishing to use the ADR program should consult its U.S. counsel
for information on the procedures and implications of doing so.
Review process
One important difference between registration on a Form F-1 registration statement by a foreign private issuer and registration on a Form S-1
registration statement by a United States issuer is the review process.
While the Form S-1 review process does not commence until the Form S-1
registration statement is publicly filed with the SEC via EDGAR, the initial
submission of a Form F-1 registration statement to the SEC can be done on
a confidential, paper basis. This allows the foreign issuer to receive the
first round of SEC comments before making any public disclosure of its
offering plans. As a result, if the SEC comments reveal any show stoppers, the company may simply terminate the offering process without
having exposed any sensitive business or financial information, or even
the fact that it was contemplating a public offering.
Translation of certain documents into English
Documents required to be filed as exhibits to the registration statement, such as charter documents and material contracts, must be filed in
English, or a summary of such documents in English must be filed. Translation may require a significant amount of lead time. Therefore, it is
important to identify the documents that will need to be filed and begin
translation early in the registration process.

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Financial Disclosure Requirements

A foreign private issuer must include in its registration statement on
Form F-1 financial statements and selected financial data covering the
same periods as would be required of a U.S. issuer filing a registration
statement on Form S-1. The companys financial statements may be prepared either in accordance with U.S. generally accepted accounting
principles (U.S. GAAP) or another comprehensive body of generally
accepted accounting principles. If the financial statements are not prepared in accordance with U.S. GAAP, the registration statement must
disclose the basis of preparation, discuss the material differences in
accounting principles between U.S. GAAP and the principles used, and
provide a table which reconciles the primary financial statements to U.S.
GAAP by quantifying material variances applicable to the income statement and balance sheet.
A foreign issuer is not required to select the U.S. dollar as its reporting
currency. If the reporting currency is not the U.S. dollar, the issuer may
include a translation for the most recent fiscal year and any subsequent
interim period presented using the exchange rate as of the most recent
balance sheet included in the filing. If materially different, the exchange
rate as of the latest practicable date should be used.
Financial reporting under one set of accounting standards and in one
currency is difficult enough. Reporting under two sets of accounting standards and providing a translation into a second currency can be
overwhelming. Underwriters often recommend that a company report in
U.S. dollars and U.S. GAAP, if at all possible, to allow for easier comparison of the companys performance with that of U.S. issuers. A foreign
issuer planning a public offering in the United States should consult with
its counsel in its home jurisdiction and explore whether financial statements prepared in accordance with U.S. GAAP and reported in U.S.
dollars can be used to satisfy local reporting requirements.

Ongoing Reporting Requirements

Foreign private issuers are not required to file annual reports on
Form 10-K, quarterly reports on Form 10-Q or current reports on Form 8K. Rather, foreign private issuers with securities registered under the
Exchange Act must file an annual report on Form 20-F with the SEC
within 6 months after the end of each fiscal year. Quarterly reports are not

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legally required, although the companys underwriters may insist that the
company file quarterly reports on Form 6-K to provide investors with the
same level of information as would be provided by a U.S. issuer. A foreign
private issuer generally must file a report on Form 6-K whenever the
company gives public information under the laws of its home jurisdiction.
In addition, Form 6-K requires that a foreign private issuer must promptly
provide to the SEC any information that is filed with any foreign stock
exchange on which its securities are listed and made public by such
exchange or information that is distributed to its securityholders. While a
foreign private issuer is not specifically required by SEC regulations to file
a current report on Form 8-K to report acquisitions, dispositions or other
material events, companies listed on the Nasdaq National Market must
disclose to the United States public any material information that would
reasonably be expected to affect the value of its securities or influence
investors decisions. In addition, a company with shares listed on the
Nasdaq National Market must provide a formal annual report to its
stockholders.

Corporate Governance
Certain corporate governance requirements are imposed by U.S.
securities laws, the rules and regulations of Nasdaq and other U.S. stock
exchanges, and the expectations of U.S. investors. Many of these requirements may seem strange to a non-U.S. issuer, but compliance with them
may be essential to a successful offering in the United States. For example,
U.S. investors expect a companys management team to operate under the
ultimate authority of the companys board of directors, which should
exercise independent judgment on important matters. U.S. stockholders
expect the board of directors to have the authority to issue additional
shares of the companys authorized stock in connection with financings,
certain acquisitions or other events without stockholder approval or compliance with stockholder preemptive rights. In addition, the NYSE and
Nasdaq have published a number of proposals relating to director independence, including various proposals requiring independent directors,
and independence requirements related to auditing, nominating and compensation functions of the board of directors, many of which are discussed in
earlier chapters of this guidebook.

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The Sarbanes-Oxley Act of 2002 introduced sweeping reform covering corporate governance of and disclosures by reporting issuers in the
United States. Although there are some differences between the treatment
of U.S. issuers and non-U.S. issuers under the Sarbanes-Oxley Act and the
SEC rules adopted under that Act, which changes are largely with respect
to the frequency of providing the required disclosure, the reforms generally apply equally to both. A summary of selected SEC rules adopted
under the Act is provided in Appendix E. In preparing for an IPO in the
United States, a foreign issuer should consult with its U.S. counsel regarding the application and impact of the Act and any corporate governance
restructuring or housekeeping that may be necessary or advisable.

Exemptions from Certain Provisions of the Exchange Act

Foreign private issuers are exempt from the proxy solicitation
requirements of Section 14 of the Exchange Act and the short-swing
trading prohibition and reporting requirements of Section 16 of the
Exchange Act.
While a company may qualify as a foreign private issuer at the time
of its IPO, it may later cease to qualify as a foreign private issuer due to
changes in the composition of its stockholder base, management team,
board of directors or in the nature of its operations. Therefore, it is important for management to keep a close eye on the foreign private issuer tests
in order to determine if the company will no longer be eligible to operate
under the more lenient rules applicable to foreign private issuers.

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224

Appendix A
NYSE Minimum Numerical Standards for Domestic Companies
(as of May 31, 2004)

Size / Volume Criteria (a company must meet one of the following size/volume criteria):
1.
2.
3.

Round-lot Holders1
OR:
Total Shareholders1
together with average monthly trading volume for the most recent 6 months (in shares)
OR:
Total Shareholders1
together with average monthly trading volume for the most recent 6 months
(in shares); and
number of publicly held share outstanding2

2,000
2,200
100,000
500
1,000,000
1,100,000

Market Value of Public Shares (a company must have an aggregate market value of):
1.
2.

IPOs Spin-offs, Carve-outs and Affiliated Companies3

OR:
Public Companies4

$60,000,000
$100,000,000

Financial Criteria (a company must meet one of the following financial standards):
1.

2.

3.

Earnings Test
Aggregate pretax earnings:5
(a) Over the last 3 years (must be positive amounts in all 3 years); and
(b) Each of the 2 preceding years
OR:
Valuation/Revenue Test (a company must meet either of the following requirements):
Valuation / Revenue with Cash Flow Test:
(a) Global market capitalization;
(b) Revenues during the most recent 12-month period; and
(c) Aggregate cash flows for the last 3 fiscal years (must be positive amounts
in all 3 years)6 or:
Pure Valuation / Revenue Test:
(a) Global market capitalization;7 and
(b) Revenues during the most recent fiscal year
OR:
Affiliated Company Test
(a) Global market capitalization;
(b) At least 12 months of operating history (although it is not required
to have been a separate entity);
(c) Parent or affiliated company is a listed company in good standing; and
(d) Parent or affiliated company retains control of the entity or is under common
control with the entity.

$10,000,000
$2,000,000

$500,000,000
$100,000,000
$25,000,000
$750,000,000
$75,000,000
$500,000,000

Notes:
1. The number of beneficial holders of stock held in street name will be considered in addition to the holders of
record. The NYSE will check such holdings that are in the name of NYSE-member organizations.
2. If the unit of trading is less than 100 shares, the requirement relating to the number of publicly held shares will be
reduced proportionately. Shares held by directors, officers, or their immediate families and other concentrated holdings of 10 percent or more are excluded in calculating the number of publicly held shares.
3. In connection with IPOs and carve-outs, the NYSE will accept an undertaking from the companys underwriter to
ensure that the offering will meet or exceed the NYSEs standards. Similarly, for spin-offs, the NYSE will rely on a
representation from the parent companys financial advisor in order to estimate the market value based on the asdisclosed distribution ratio.
4. If a company either has a significant concentration of stock or changing market forces have adversely impacted the public
market value of a company that otherwise would qualify for an NYSE listing, such that its public market value is no more
than 10% below the minimum, the NYSE will consider stockholders equity of $60 million or $100 million, as applicable, as
an alternate measure of size.
5. Pre-tax income is adjusted for various items as defined in Section 102.01C of the NYSE Listed Company Manual.
6. Represents net cash provided by operating activities excluding the changes in working capital or in operating assets
and liabilities, as adjusted for various items as defined in Section 102.01C of the NYSE Listed Company Manual.
7. Average global market capitalization for already existing public companies is represented by the most recent six
months of trading history. For IPOs, the company's underwriter or, in the case of spin-offs and carve-outs, the parent company's financial advisor, must provide a written representation that demonstrates the company's ability to
meet the global market capitalization requirement based upon the completion of the offering.
Additional Considerations:
In addition to meeting the NYSE's minimum numerical standards listed above, there are other factors that the NYSE
will consider, and the NYSE has broad discretion regarding the listing of a company. Thus, the NYSE may deny listing
or apply additional or more stringent criteria based on any event, condition, or circumstance that makes the listing of
the company inadvisable or unwarranted in the opinion of the NYSE. Also note that the NYSE can make such a determination even if the company meets the standards set forth above.

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Nasdaq National Market

Listing Requirements
(as of May 31, 2004)

A company must meet all of the requirements under at least one of the
three listing standards for initial listing on The Nasdaq National Market.
Requirements

Standard 1

Standard 2

$15 million

$30 million

N/A

N/A

N/A

$75 million1,2
or
$75 million
and
$75 million

Income from continuing operations

before income taxes (in latest fiscal
year or 2 of last 3 fiscal years)

$1 million

N/A

N/A

Publicly held shares3

1.1 million

1.1 million

1.1 million

Market Value of Public Float

$8 million

$18 million

$20 million

$5

$5

$52

Shareholders equity
Market value of listed securities1
or
Total assets
and
Total revenue

Minimum Bid Price

Market

Makers5

Shareholders (round lot holders)

Operating History
Corporate Governance
Requirements6,7,8

Standard 3

400

400

400

N/A

2 years

N/A

Distribution of Annual and Interim Reports

Independent directors
Audit Committees
Shareholders Meetings
Quorum
Solicitation of Proxies
Shareholder Approval
Stockholder Voting Rights
Auditor Peer Review
Notification of Material Noncompliance

1. Listed securities are securities listed on NASDAQ or listed on a national securities exchange.
2. Companies already listed or quoted on another marketplace qualifying only under this requirement of Standard 3 must meet the market value of listed securities and the bid price requirements for 90 consecutive
trading days prior to applying for listing.
3. Publicly held shares is defined as total shares outstanding less any shares held by officers, directors, or beneficial owners of more than 10% or more.
4. Round lot holders are shareholders of 100 shares or more.
5. An Electronic Communications Network (ECN) is not a market maker under these rules.
6. These requirements are set forth in NASD Marketplace Rules 4350 and 4351.
7. Nasdaq has the ability to provide exemptions from corporate governance requirements for foreign issuers
when provisions of the rules are contrary to law, rule or regulation of any public authority exercising jurisdiction over such issuer or contrary to generally accepted business practices in the issuers country of
domicile, except to the extent any such exemptions would be contrary to the federal securities laws; however,
a foreign issuer that receives an exemption must specifically disclose it in the issuers IPO registration statement and annual reports following its IPO.
8. Foreign Issuers and IPO issuers have been afforded a transition period as to certain of the new rules.

A-2

Appendix B
Sample Due Diligence Checklist
Please provide copies of the indicated documents or the information
requested and indicate items that the Company considers inapplicable. In
each instance, requests for documents or information regarding the
Company extend to similar documents and information regarding subsidiaries of the Company, if any.
1.

Basic Corporate Records

a. Articles/Certificate of Incorporation, including amendments
since inception.
b. Bylaws, including amendments since inception.
c. Minutes or other records of all meetings or actions of the board of
directors, any committees thereof, and of stockholders, including
written notices (if given) or waivers thereof since inception.
d. Communications with stockholders since inception, including
annual reports, proxy statements and correspondence.
e. Press releases since inception.
f. Summary of the corporate history of the Company and any predecessors, including any mergers, acquisitions, changes in control
and divestitures.
g. List of countries and U.S. states where the Company is qualified to
do business.
h. List of cities and countries where the Company operates its business or maintains inventory, owns or leases property or has
employees, agents or independent contractors, with approximate
size and number of employees and a description of operations or
services performed at each location.
i. List of cities and countries in which the Company currently contemplates undertaking business operations, either directly or
through other parties.
j. List of any subsidiaries, including the address of each such subsidiarys headquarters.

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2.

Stockholder Information
a. List of names, addresses and holdings of current record and beneficial owners of Company stock, indicating the dates such stock
was issued and fully paid for.
b. List of names, addresses and holdings of current record and beneficial owners of Company options and warrants, including date of
grant, exercise price, number of shares subject to the option or
warrant and vesting terms.
c. List of any oral or written promises to receive stock, options, warrants or any other form of interest in the Company.
d. Share, option or warrant books, ledgers and other records of share,
option or warrant issuances of the Company since inception.

3.

Securities Issuances
a. Documents generated in connection with equity financings of the
Company, including stock purchase agreements and related
documentation, such as offering circulars, private placement
memoranda and prospectuses relating to the offer or sale of equity
securities.
b. Documents generated in connection with any convertible debt
financings of the Company.
c. Samples of common stock certificates, warrants, options, debentures and any other outstanding securities.
d. Stock option and purchase plans and equity incentive plans of any
sort, including forms of option and purchase agreements which
have been or may be used thereunder, and any options or warrants not under an equity plan.
e. Agreements and other documentation (including related permits)
relating to repurchases, redemptions, exchanges, conversions or
similar transactions involving the Companys securities and
schedule of any dividends paid or declared since inception.
f. Voting trust, stockholder, or other similar agreements covering
any of the Companys securities.
g. Agreements relating to registration rights.

B-2

Appendix B - Sample Due Diligence Checklist

h. Agreements relating to preemptive rights or co-sale rights.

i. Agreements or other documents setting forth any arrangement
with or pertaining to the Company to which directors, officers or
owners of more than 5% of the voting securities of the Company
have been a party since inception including indemnification
agreements or agreements relating to the voting or transfer of
securities.
j. Forms D or any other forms filed to qualify for an exemption
under the Securities Act of 1933.
k. Governmental permits, notices of exemption and consents for
issuance or transfer of the Companys securities and evidence of
qualification or exemption under applicable blue sky laws.
4.

Corporate Finance
a. List of banks or other lenders with which the Company has a
financial relationship and brief description of nature of relationship, e.g., lines of credit, etc.
b. Summary of short-term debt, long-term debt, intercompany debt
and capital lease obligations of the Company.
c. Summary of currently outstanding interest rate or foreign currency swaps, caps, options, forwards or other derivative
instruments or arrangements to which the Company is a party.
d. Agreements evidencing borrowings by the Company, whether
secured or unsecured, documented or undocumented, including
loan and credit agreements, mortgages, deeds of trust, letters of
credit, indentures, promissory notes and other evidences of
indebtedness, and any amendments, renewals, notices, or
waivers.
e. Documents and agreements evidencing other material financing
arrangements, including capital leases, synthetic leases, sale and
leaseback arrangements, installment purchases, or similar
agreement.
f. Documents and agreements relating to any guarantees by the
Company or releases of guarantees.
g. Bank letters or agreements confirming lines of credit, including
any amendments, renewal letters, notices, waivers, etc.
B-3

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

5.

Financial Information
a. Contact information for outside parties responsible for providing
the Company with accounting or tax advice.
b. Written investment policies of the Company.
c. Financial statements of the Company since inception.
d. Current internal financial projections, forecasts, budgets and cash
flow anlyses of the Company.
e. Management letters or special reports by auditors and any
responses thereto.
f. Description of and reasons for any change in accounting methods
or principles.
g. Detailed aging schedule for accounts receivable and accounts
payable at end of each fiscal quarter of last five years.
h. Detailed description of critical accounting policies, and explanation of revenue and cost recognition methods.
i. Information on planned acquisitions and dispositions.
j. Information on bad debt reserves and unusual charges to operations for the past three fiscal years.
k. Detailed description of any off-balance sheet arrangements, liabilities or obligations of any nature (i.e., fixed or contingent, matured
or unmatured) that are not shown or otherwise provided for in the
Companys current financial statements. Please include: the
nature and purpose of any such off-balance sheet arrangements;
the importance to the Company of such arrangements; the
amounts of revenue, expenses and cash flows arising from such
arrangements; and any known event, demand, commitment,
trend or uncertainty that is reasonably likely to result in the termination (or reduction in availability to the Company) if any such
arrangement and the course of action the Company has taken or
proposes to take in response to such circumstances.
l. Description of any non-GAAP financial measures, accompanied
by the most directly comparable GAAP financial measure and a
reconciliation to GAAP, along with the reasons for use of nonGAAP measures.

B-4

Appendix B - Sample Due Diligence Checklist

m. Any reports on internal controls.

n. Proposed disclosure controls and procedures and list of persons
serving (or proposed to serve) on the Disclosure Committee, along
with a copy of the committee charter.
o. Detailed explanation of any change in or disagreement with auditors on accounting and financial matters in the last five fiscal
years.
6.

Taxes
a. Federal, state, local and foreign tax returns since inception, including sales tax returns and consolidated returns of the Company.
b. Information with respect to any foreign, Internal Revenue Service
or state audit of the Companys or any of its subsidiaries or their
respective predecessors returns and the results of each audit.
c. Description of any undertakings given by the Company to tax
authorities or any special tax rulings or agreements arranged with
tax authorities.
d. Description of any preferred tax status or tax benefit which may be
adversely affected by the proposed initial public offering and any
related transactions.
e. Information to analyze tax positions taken in connection with
acquisitions, dispositions, restructurings, reorganizations, or the
like since inception and any tax strategies in connection with any
transactions currently proposed including any ongoing tax
indemnities.
f. Any notices, elections, or other correspondence with foreign, federal, state and local tax authorities regarding the reorganization of
the Company and its predecessors to the extent material.

B-5

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

7.

Intellectual Property
a. List of U.S. and other country patents and patent applications held
by the Company.
b. List of U.S. and other country trademarks, trade names, service
marks or registered copyrights, including applications for each of
the foregoing filed by the Company, indicating in each case the
date of expiration of the rights and material coverage.
c. List of proprietary processes controlled by the Company and other
trade secrets.
d. List and copies of material license agreements.
e. Lists of proprietary third party tools, code protocols and other
third party intellectual property employed in the Companys
products and services.
f. Name of law firm(s) handling patent, trademark, copyright or
other proprietary rights matters for the Company including
contact person and telephone number.
g. Any correspondence from third parties regarding potential
infringement of intellectual property rights of others.
h. List of any claims by third parties with respect to the intellectual
property rights of the Company.
i. Material research and development agreements relating to
product research, development and testing to which the Company
is a party.

8.

Operations
a. Business plans.
b. List of third party developers showing total and type of project for
each developer during the last and current fiscal years, with
contact names and phone numbers, and forms of agreements
entered into with third party developers.

B-6

Appendix B - Sample Due Diligence Checklist

c. List of major licensees indicating which product is subject to the

license and showing royalty obligations, advance payment on royalty, credits of any royalties against advance payment and
frequency of accounting obligation for each licensee during the
most recent fiscal year, with contact names and phone numbers.
d. List of top ten accounts payable with contact names and phone
numbers.
e. List of top ten accounts receivable with contact names and phone
numbers.
f. Backlog at end of most recent fiscal year and most recent fiscal
quarter.
g. Form of agreements relating to the sale or lease of the Companys
equipment.
h. Service contracts without royalty agreements.
i. List of service price changes over past five years.
j. Backlog of orders to customers at end of three most recent fiscal
years and four most recent fiscal quarters.
k. Any agreements containing non-competition obligations or exclusivity provisions.
l. Any intercompany agreements between the Company and its
subsidiaries.
m. Description of any toxic chemicals used in production and manner
of storage and disposition. Description of any EPA, Toxic Substances Control Act or other investigation or claim.
n. Any other material agreements or drafts of proposed material
agreements of the Company.
9.

Sales and Marketing

a. List of the Companys products and services.
b. List of the Companys ten largest customers or groups for the last
three years, indicating amounts and nature of services provided
and providing contact names and phone numbers for each
customer.

B-7

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

c. List of the Companys suppliers (other than suppliers of goods

and services generally required by all businesses, e.g., office supplies, utilities, etc., unless in excess of $50,000 from an individual
supplier during any 12 month period) including for each supplier,
(i) total and type of purchases by the Company from that supplier
during current and prior fiscal years and (ii) details of products
and services purchased from such supplier that are available only
from that supplier or which are potentially difficult to obtain in
sufficient quantities or in a timely manner from other suppliers.
d. List of the Companys competitors.
e. Pertinent market research or marketing studies (including any
studies or reports relied on or commissioned or prepared by the
Company).
f. Any recent analyses of the Company prepared by investment
bankers, engineers, management consultants, auditors or others.
g. Recent presentations to industry, trade or investment groups.
h. Marketing and sales literature and forms, including price lists, catalogs, purchase orders, technical manuals, user manuals, etc.
i. Service and support contracts, marketing agreements and material agency and advertising contracts, if any.
j. Distribution agreements, if any.
k. Forms of warranties and guarantees provided to customers.
10. Employees
a. Organizational charts by department and by legal entity.
b. Number of employees by department and by functional area.
c. Forms of employment agreements, if any, including independent
contractor service agreements.
d. Employee Confidentiality and Invention Assignment Agreements
and any consultant or contractor agreements.
e. Employment agreements or non-competition agreements or
invention assignment agreements of officers and other key
employees with former employers.

B-8

Appendix B - Sample Due Diligence Checklist

f. Employee benefit, pension, profit sharing, compensation and

other plans.
g. Description of commissions paid to managers, agents or other
employees since inception of the Company.
h. Any collective bargaining agreements or other material labor
contracts.
i. Description of any significant labor problems or union activities
the Company has experienced.
j. Copies of any NLRB or U.S. Department of Labor filings.
11. Officers and Directors; Corporate Governance
a. Completed Officers and Directors Questionnaires (including the
NASD Questionnaire).
b. Resume for each officer and director/director nominee.
c. Employment, change of control agreements, and severance
agreements with any key employee or member of management,
indemnification agreements and golden parachute agreements,
if any.
d. Schedule of compensation paid during the last five fiscal years to
officers, directors and key employees showing separately salary,
bonuses and non-cash compensation (e.g., use of cars, property,
etc.).
e. Bonus plans, retirement plans, pension plans, deferred compensation plans, profit sharing and management incentive agreements.
f. Agreements for loans to officers or directors (including relocation
loans) and any other agreements (including consulting and
employment contracts) with officers or directors, whether or not
now outstanding, including (i) loans to purchase stock and
(ii) consulting contracts.
g. Description of any transactions between the Company and any
officer, director, or owner of 5% or more of any class of the Companys securities or any associate of any such person or entity or
between or involving any two or more of such persons or entities.

B-9

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

h. List of directors who have been determined by the board of directors to be independent under applicable SEC and NYSE/
Nasdaq rules.
i. List of directors who serve on the Audit Committee and name of
the director who is the financial expert on the Audit Committee,
along with a copy of the committee charter.
j. Audit Committee pre-approval procedures for audit and nonaudit serves and regarding auditor fees.
k. Corporate policies relating to the engagement of the Companys
auditors, including policies relating to the scope of services to be
performed by the Companys auditors.
l. List of directors who serve on Compensation Committee, along
with a copy of the committee charter.
m. List of directors who serve on Nominating and Governance Committee, along with a copy of the committee charter.
n. Lists of directors who serve on any other committees of the board
of directors, along with a copy of the charters from such
committees.
o. Corporate codes of ethics, corporate governance guidelines or
other codes of conduct of the Company, including whistleblower policies and procedures.
p. Insider trading compliance program and policies.
q. Description
provisions.

of

any

defensive

measures

or

anti-takeover

12. Tangible Property

a. List of real and material personal property owned by the
Company.
b. Documents of title, mortgages, deeds of trust, leases and security
agreements pertaining to the properties listed in 12(a) above.
c. Outstanding leases for real and personal property to which the
Company is either a lessor or lessee, including ground leases and
subleases, estoppel certificates and related subordination or nondisturbance agreements.

B-10

Appendix B - Sample Due Diligence Checklist

d. List of any security interests in personal property, including any

UCC filings.
e. Description of any toxic chemicals used in production and manner
of storage and disposition. Description of any EPA or other investigation or claim.
f. Environmental Site Assessments or reports concerning any real
property owned or leased by the Company.
g. Environmental, Health and Safety compliance verification reports
(e.g., compliance audits) and quality assurance documents.
h. Correspondence, memoranda, notes or notices of violation from
foreign, federal, state or local Environmental, Health and Safety
authorities.
13. Litigation and Audits
a. Letters from counsel sent to auditors for year-end and current
interim audits.
b. Complaints, orders or other significant documents in pending or
threatened matters involving claims of $25,000 or more or seeking
injunctive or other equitable relief.
c. Active litigation files, including letters asserting claims, complaints, answers, etc. (non-privileged material only).
d. Any litigation settlement documents.
e. Any decrees, orders or judgments of courts or governmental
agencies.
f. Correspondence, memoranda or notes concerning inquiries from
governmental (i) tax authorities, (ii) occupational safety, health
and hazard officials, (iii) environmental officials, or (iv) authorities regarding equal opportunities violations, antitrust violations,
or violations of any other law, rule or regulation.
g. Description of any warranty claims that have been made against
the Company, any subsidiary, or any partnership or joint venture
and the resolution of such claim.
h. Information regarding any material litigation to which the
Company is a party or in which it may become involved.

B-11

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

14. Insurance
a. List and copies of material insurance policies of the Company covering property, liabilities and operations and any significant
claims currently pending thereunder.
b. List of any other insurance policies in force, such as key person
policies, director indemnification policies or product liability
policies.
15. Partnership, Joint Venture Agreements and Other Corporate Transactions
a. List of partnership or joint venture agreements, if any.
b. Partnership roll-up documents, if any.
c. Any material purchase agreements and other significant documents relating to any acquisitions or dispositions by the Company
since inception or currently proposed.
d. Any material purchase agreements and other significant documents relating to any reorganization and any going private
transactions, mergers, consolidations, spin-offs or reincorporation
since inception or currently proposed.
e. List of special purpose entities in which the Company, any of its
current or former executive officers or directors have a significant
interest (on an individual or an aggregate basis) or that have purchased assets or assumed liabilities from the Company or that
have significant obligations to the Company (each a SPE).
Include a brief description of each SPEs primary purpose or activities. Any agreements or documents setting forth any
arrangements (or if not memorialized, a description of any such
arrangement) between or among the Company and any SPE.
16. Governmental Regulations and Filings
a. Summary of material inquiries by a governmental agency, if any.
b. Status of foreign and domestic government contracts subject to
renegotiation, if any.
c. Material foreign and domestic governmental permits, licenses,
certificates, etc. which the Company has obtained or had revoked.

B-12

Appendix B - Sample Due Diligence Checklist

d. Material filings made and significant correspondence by the

Company with any state, federal or foreign governmental or regulatory agencies since the Companys inception.
17. Miscellaneous
a. Materials that support statements to be made in the prospectus,
including any documents to be cited, summarized or quoted in the
prospectus.
b. Any other materials or documents that are significant or should be
reviewed and considered regarding the Company, its business
and financial condition, or any subsidiary.

B-13

Waiting Period

Pre-Filing Period

Post-Effective Period

File amendments to
Registration Statement
and respond to additional
rounds of SEC comments

Drafting Sessions
30 days

4-6 weeks

Organizational Meeting /
Management Due
Diligence Presentations

Initial filing of
Registration Statement
with SEC

2-4 weeks

Receive SEC
comments

3-5 days

Effective Date

Closing

Appendix C

Corporate
Housekeeping and
IPO preparations

Sample IPO Timeline

Print "Red Herring"

and commence road show
(after receiving initial
SEC comments)

C-1

Appendix D
Sample Compliance Calendar
The sample compliance calendar on the following pages is designed
for a newly public companys first full cycle of SEC reporting and its first
annual meeting of stockholders following the IPO. For convenience, the
schedule assumes that the company is a Delaware corporation with a
fiscal year that ends on December 31, and that the SEC declared its registration statement effective on June 15, 2004.
The calendar is structured for the newly public company and not an
accelerated filer. (Please note that the newly public company is not an
accelerated filer primarily because it will not have been subject to the
reporting requirements of the Exchange Act for at least 12 months.)
The calendar is not comprehensive, rather it is designed to provide
the newly public company with a snapshot of its reporting obligations
during the first full cycle as a public company. The company should work
together with its counsel and auditors to develop a schedule that is personalized for the company and its specific needs and tailored to ensure
compliance with its charter documents, applicable corporate law, applicable SEC rules and regulations, as well as the rules and regulations of the
exchange on which the companys shares are listed.

D-1

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Sample Compliance Calender

Schedule of Actions for 2004-05
Annual Meeting of Stockholders and SEC Filings
June 2004
M T W T F S S M
1 2 3 4 5
6 7 8 9 10 11 12 4 5
13 14 15 16 17 18 19 11 12
20 21 22 23 24 25 26 18 19
27 28 29 30
25 26
S

July 2004
T W T
1
6 7 8
13 14 15
20 21 22
27 28 29

F
2
9
16
23
30

August 2004
September 2004
S S M T W T F S S M T W T F S
3 1 2 3 4 5 6 7
1 2 3 4
10 8 9 10 11 12 13 14 5 6 7 8 9 10 11
17 15 16 17 18 19 20 21 12 13 14 15 16 17 18
24 22 23 24 25 26 27 28 19 20 21 22 23 24 25
31 29 30 31
26 27 28 29 30

October 2004
November 2004
December 2004
M T W T F S S M T W T F S S M T W T F S
1 2
1 2 3 4 5 6
1 2 3 4
3 4 5 6 7 8 9 7 8 9 10 11 12 13 5 6 7 8 9 10 11
10 11 12 13 14 15 16 14 15 16 17 18 19 20 12 13 14 15 16 17 18
17 18 19 20 21 22 23 21 22 23 24 25 26 27 19 20 21 22 23 24 25
24 25 26 27 28 29 30 28 29 30
26 27 28 29 30 31
31
S

February 2005
March 2005
S S M T W T F S S M T W T F
1
1 2 3 4 5
1 2 3 4
2 3 4 5 6 7 8 6 7 8 9 10 11 12 6 7 8 9 10 11
9 10 11 12 13 14 15 13 14 15 16 17 18 19 13 14 15 16 17 18
16 17 18 19 20 21 22 20 21 22 23 24 25 26 20 21 22 23 24 25
23 24 25 26 27 28 29 27 28
27 28 29 30 31
30 31
May 2005
June 2005
July 2005
S M T W T F S S M T W T F S S M T W T F
1 2 3 4 5 6 7
1 2 3 4
1
8 9 10 11 12 13 14 5 6 7 8 9 10 11 3 4 5 6 7 8
15 16 17 18 19 20 21 12 13 14 15 16 17 18 10 11 12 13 14 15
22 23 24 25 26 27 28 19 20 21 22 23 24 25 17 18 19 20 21 22
29 30 31
26 27 28 29 30
24 25 26 27 28 29
31
September 2005
October 2005
November 2005
S M T W T F S S M T W T F S S M T W T F
1 2 3
1
1 2 3 4
4 5 6 7 8 9 10 2 3 4 5 6 7 8 6 7 8 9 10 11
11 12 13 14 15 16 17 9 10 11 12 13 14 15 13 14 15 16 17 18
18 19 20 21 22 23 24 16 17 18 19 20 21 22 20 21 22 23 24 25
25 26 27 28 29 30
23 24 25 26 27 28 29 27 28 29 30
30 31
S

January 2005
M T W T F

D-2

S S M
5
12 3 4
19 10 11
26 17 18
24 25

April 2005
T W T F S
1 2
5 6 7 8 9
12 13 14 15 16
19 20 21 22 23
26 27 28 29 30

August 2005
S S M T W T F S
2
1 2 3 4 5 6
9 7 8 9 10 11 12 13
16 14 15 16 17 18 19 20
23 21 22 23 24 25 26 27
30 28 29 30 31
December 2005
S S M T W T F
5
1 2
12 4 5 6 7 8 9
19 11 12 13 14 15 16
26 18 19 20 21 22 23
25 26 27 28 29 30

S
3
10
17
24
31

Appendix D - Schedule of Actions for 2004-05

DATE
June 15, 2004

June 15, 2004

June 30, 2004
August 16, 2004
September 30, 2004
November 15, 2004
December 31, 2004
February 14, 2005
February 28, 2005

March 4, 2005
March 31, 2005
March 31, 2005
March 31, 2005
April 1, 2005
April 1, 2005

May 3, 2005
May 16, 2005
June 30, 2005
August 15, 2005
September 30, 2005
November 14, 2005
December 31, 2005

ITEM
Effective date of the companys registration statement
the company becomes subject to the reporting requirements of the Exchange Act
Form 3s due for all Section 16 Insiders (executive officers,
directors, and 10% stockholders)1
Fiscal year 2004 second quarter end
Deadline for filing Form 10-Q for fiscal year 2004 second
quarter
Fiscal year 2004 third quarter end
Deadline for filing Form 10-Q for fiscal year 2004 third
quarter
Fiscal year 2004 year end
Deadline for filing Form 5s2 and Schedule 13Gs3
Mail broker solicitations to brokers and central depository systems requesting information as to number of
beneficial owners requiring annual reports and definitive
proxy materials4
File preliminary proxy materials, if necessary5
Deadline for filing Form 10-K for 2004 fiscal year6
Record date for 2005 Annual Meeting of Stockholders7
Fiscal year 2005 first quarter end
File definitive proxy materials and annual report8
Mail definitive proxy materials and annual report to
stockholders of record and to brokers requesting copies
for beneficial owners; file with SEC, on same day, definitive proxy materials and annual report9
Hold 2005 Annual Meeting of Stockholders
Deadline for filing Form 10-Q for fiscal year 2005 first
quarter10
Fiscal year 2005 second quarter end
Deadline for filing Form 10-Q for fiscal year 2005 second
quarter10
Fiscal year 2005 third quarter end
Deadline for filing Form 10-Q for fiscal year 2005 third
quarter10
Fiscal year 2005 year end

D-3

The Initial Public Offering

A Guidebook for Executives and Boards of Directors
1. In general, the Form 3 must be filed within 10 days after the event by which the person becomes a reporting person (i.e., executive officer, director, 10% holder or other person).
(See paragraph 2(a) of the General Instructions to Form 3.) However, a reporting person of
an issuer that is registering securities for the first time under Section 12 of the Exchange Act
must file a Form 3 no later than the effective date of the registration statement. (See paragraph 2(b) of the General Instructions to Form 3.)
2. The Form 5 must be filed by each reporting person within 45 days after the companys fiscal year end. General Instructions 1(a) of Form 5. (See also Rule 16a-3(f).)
3. Each person who beneficially owns greater than 5% of the companys common
stock at the end of the calendar year, who acquired the shares prior to the companys IPO,
must report such persons ownership to the SEC on a Schedule 13G filing within 45 days
of the end of the calendar year. The 5% stockholder must also provide copies of the
Schedule 13G filing to the company and the national securities exchange on which the
companys common stock is listed. (See Rule 13d-1.)
4. Rule 14a-13 requires the company to contact brokers, dealers, voting trustees,
banks, associations or other entities that exercise fiduciary powers in nominee name or otherwise not less than 20 business days prior to the record date of the meeting to determine the
number of copies of the proxy materials that these organizations will require for distribution
to beneficial owners.
5. Rule 14a-6(a) of Regulation 14A requires the company to file preliminary proxy solicitation materials with the SEC at least 10 calendar days prior to the date on which the company first sends or gives the proxy materials to stockholders; however, a shorter period may
be authorized upon a showing of good cause. Please note that the company is not required
to file preliminary proxy materials that relate to an annual meeting of stockholders at which
only the following routine matters will be considered: (1) the election of directors; (2) the
election, approval or ratification of accountants; (3) a properly included stockholder proposal (see Rule 14a-8); and (4) the approval or ratification of an employee benefit plan (see paragraph (a)(7)(ii) of Item 402 of Regulation S-K). If the SEC elects to undertake a complete
review of the preliminary proxy materials, the review period may take up to 30 days or more.
If the company anticipates a preliminary proxy filing will be required, the timetable for holding the annual meeting should be adjusted accordingly.
6. The company must file its annual report on Form 10-K within 90 days after the end
of the fiscal year. (See paragraph (A)(1)(b) of the General Instructions to Form 10-K.)
7. All state corporate statutes allow for the use of a record date to establish the persons
eligible for notice of and voting at meeting of stockholders. State corporate law generally allows the record date to be fixed in the bylaws of the company or established by resolution of
the board of directors. The record date must generally be no more than nor fewer than a
fixed number of days before the date of the meeting. Under Delaware law, the record date
must not be more than 60 nor less than 10 days before the meeting of stockholders. (See
Section 213(a) of the Delaware General Corporation Law.)
8. Rule 14a-6(b) requires the company to file the definitive proxy solicitation materials
with the SEC no later than the date they are first sent or given to stockholders. Rule 14a-3(c)
requires the company to mail to the SEC, solely for its information, the annual report on the
date the report is first sent or given to stockholders or the date on which preliminary copies,
or definitive copies, if a preliminary filing was not required, of the proxy solicitation materials are filed with the SEC. The definitive proxy materials must be filed within 120 days after
the end of the fiscal year covered by the companys annual report on Form 10-K in order to
incorporate by reference certain information from the proxy materials into the Form 10-K.
(See paragraph G(3) of the General Instructions to Form 10-K.)
9. Section 222(b) of the Delaware General Corporation Law requires the company to
give written notice of meetings of stockholders not less than 10 days nor more than 60 days
before the date of the meeting. In addition, Rule 14a-3(b) requires that the proxy materials be
accompanied or preceded by an annual report to stockholders.
10. The company must file its quarterly reports on Form 10-Q within 45 days after the
end of each fiscal quarter. (See paragraph (A)(1)(b) of the General Instructions to Form 10-Q.)

D-4

Appendix E
Summary of Selected SEC Rules Adopted in Response to
the Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 became law. The Act
makes a number of significant changes to federal regulation of public
company corporate governance and reporting obligations. This Appendix
has been designed solely to address certain of these reforms relating to
domestic, public companies, as of the date of this publication and does not
attempt to address all related applicable laws or regulations. This section
was designed solely for overview purposes and therefore deliberately
summarizes or paraphrases the applicable statutory and regulatory provisions in order to condense the information presented. As a result, the
descriptions contained in this section are necessarily incomplete and this
section should not serve as a replacement for consultations with experienced counsel.
1. Certification of Principal Executive Officer and Principal Financial Officers. Exchange Act rules 13a-14 and 15d-14 require an issuers
principal executive officer(s) and the principal financial officer(s), or
persons performing similar functions, to certify in each annual or quarterly report (including any amendments) that:
the officer has reviewed the report;
based on the officers knowledge, the report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report;
based on the officers knowledge, the financial statements, and
other financial information included in the report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the company as of, and for, the periods presented in the report;

E-1

The Initial Public Offering

A Guidebook for Executives and Boards of Directors

the signing officers1:

are responsible for establishing and maintaining disclosure controls and internal control over financial reporting for the company;

have designed such disclosure controls to ensure that material

relating to the company and its consolidated subsidiaries is
made known to such officers, particularly during the period in
which the periodic reports are being prepared;

have evaluated the effectiveness of the companys disclosure

controls as of the end of the period covered by the report;

have designed such internal control over financial reporting, or

caused such internal control over financial reporting to be designed
under their supervision, to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;

have evaluated the effectiveness of the companys disclosure

controls and procedures presented in the report such officers
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and

have disclosed in the report any change in the companys internal control over financial reporting that occurred during the
companys most recent fiscal quarter (the companys fourth fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the companys internal control over financial reporting; and

the signing officers have disclosed to the companys auditors and

the audit committee of the board of directors (or persons fulfilling
the equivalent functions):

1. Companies may temporarily omit the italicized certifications pertaining to internal

control over financial reporting until the SEC requires companies to file their respective management's report on internal control over financial reporting. The managements report will
be required by companies that are accelerated filers for fiscal years ending on or after June
15, 2004. All other filers will be required to comply for their fiscal years ending on or after
April 15, 2005.

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

all significant deficiencies and material weaknesses in the

design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the companys
ability to record, process, summarize and report financial information; and
any fraud, whether or not material, that involves management
or other employees who have a significant role in the companys internal controls.
that the report fully complies with the requirements of Section 13(a)
or 15(d) of the Exchange Act and that information contained in
such report fairly presents, in all material respects, the financial
condition and results of operations of the company.
2. Managements Report on Internal Control and Auditor Attestation.
Exchange Act rules 13a-15 and 15d-15 require the management of a public
company to assess the companys internal control over financial reporting2 annually and include a report on its assessment in the companys
annual report. The managements report on internal control over financial
reporting will be required by companies that are accelerated filers for
fiscal years ending on or after June 15, 2004. All other filers will be
required to comply for their fiscal years ending on or after April 15, 2005.
In addition, the companys independent auditor must issue an attestation report on managements assessment and the company must include
the attestation report as part of the companys annual report. The management report must include the following elements:

2. The SEC defines internal control over financial reporting as a process designed
by, or under the supervision of, the issuers principal executive and principal financial officers,
or persons performing similar functions, and effected by the issuers board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and
principles that: (1) pertain to the maintenance of records that in reasonable detail accurately
and fairly reflect the transactions and dispositions of the assets of the issuer; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts
and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer's assets
that could have a material adverse effect on the financial statements.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Responsibility. The report must include a statement regarding

managements responsibility for establishing and maintaining the
companys internal control over financial reporting.
Framework for Evaluation. The report must include a statement
identifying the framework management used to evaluate the
effectiveness of the companys internal control over financial
reporting. The rules do not require a specific framework but rather
set forth guidelines by which a suitable framework will be judged.
Managements evaluation process, however, should be sufficient
to support managements conclusion about the effectiveness of
internal control over financial reporting. The most commonly
used internal control framework in the U.S. is that of The Committee of Sponsoring Organizations of the Treadway Commission.
Assessment of Effectiveness. The report must include managements
assessment, as of the end of the most recent fiscal year, of the effectiveness of the companys internal control over financial reporting.
Management may not rely on the companys independent auditors
to perform the required assessment, although management should
coordinate with the independent auditors in making the assessment. Managements report must also include disclosure of any
material weaknesses identified by management in such controls.3 If management has identified material weaknesses in its
internal control, it may not declare that its internal control is effective is effective. The SEC has stated that a companys independent
auditors may assist management in documenting internal control
over financial reporting without impairing its independence.
However, management: (1) must be involved throughout the process; (2) cannot delegate its responsibilities to assess its internal
control over financial reporting to the auditors; and (3) must make
all decisions. A company may not disclose that its internal controls over financial reporting are effective if it has identified one or
more material weaknesses.

3. The SEC defines material weakness as deficiencies in the design or operation of

internal control that could adversely affect a companys ability to record, process, summarize and report financial data consistent with assertions of management in the companys financial statements.

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

The SEC does not provide specific procedures for conducting managements assessment. However, the SEC does suggest that the
company (1) should document its evaluation to enable it to provide
reasonable support for its conclusions regarding the effectiveness
of the internal controls and (2) the procedures should be broad
enough to evaluate the design of the internal control over financial
reporting and to test the operating effectiveness of such controls.
(Please note that some auditing firms suggest that companies
should begin to conduct an assessment at least 90 days prior to the
fiscal year end to allow ample time for the auditor attestation
process and for corrective action, if any, to be taken).
Auditors Attestation. The management report must contain a statement that the companys independent auditors have issued an
attestation report on managements assessment of the companys
internal control over financial reporting. This attestation report
must be included in the annual report.
Although the SEC rules do not require management to conduct an
extensive quarterly evaluation of internal control over financial reporting,
if there is a change that would materially affect, or is likely to materially
affect, the companys internal control over financial reporting in any fiscal
quarter, management must evaluate the change and disclose that evaluation in the companys quarterly report.
3. Disclosure Controls and Procedures. Exchange Act rules 13a-15
and 15d-15 require public companies to establish and maintain disclosure controls and procedures designed to ensure that information
required to be disclosed in SEC reports is recorded, processed, summarized and reported, in the time periods specified by the SEC. Accordingly,
the new rules require each public company to:
design its disclosure controls and procedures;
establish and maintain disclosure controls and procedures;
evaluate the effectiveness of the disclosure controls and procedures at least every 90 days; and
report the certifying officers conclusions on the effectiveness of
the disclosure controls and procedures in each periodic report.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

The SEC has not mandated any particular procedures for conducting
the review and evaluation required in connection with the required certifications, but expects each company to develop a process that is consistent
with its business and internal management and supervisory practices.
However, the SEC recommends that companies create a disclosure
committee with responsibility for considering the materiality of information and determining disclosure obligations on a timely basis. The SEC
suggests that the committee include the principal accounting officer or
controller, the general counsel or other senior legal official with responsibility for disclosure matters, the principal risk management officer and the
chief investor relations officer. The SEC further recommends that the committee report to senior management, including the principal executive
and financial officers. Item 307 of Regulation S-K also requires a public
company to include in its annual reports on Form 10-K and Form 10-KSB,
and quarterly reports on Form 10-Q and Form 10-QSB the conclusions of
its CEO and CFO regarding the effectiveness of the companys disclosure
controls and procedures.
4. Earnings Releases must be reported on Form 8-K. Under Item 12 of
Form 8-K (Item 2.02 under the SECs amended Form 8-K, effective August
23, 2004), all public releases or announcements (including oral announcements or releases) disclosing material, non-public information regarding
results of operations or financial condition for a completed fiscal period
must be furnished with the SEC (rather than filed) on Form 8-K within
5 business days of public announcement. (Please note that effective
August 23, 2004 the 5 business day requirement will be shortened to four
business days pursuant to the SECs amended Form 8-K). The impact of
furnishing rather than filing the information is that the submission is
not subject to the liability provisions of Section 18 of the Exchange Act nor
will the furnished information be incorporated by reference into any registration statement, proxy statement or other report unless the company
specifically incorporates such information into those documents by reference. Repetition of previously disclosed information does not trigger this
Form 8-K reporting requirement. However, if a subsequent release or
announcement contains additional material, non-public information, then
the company is required to submit the new release or announcement on
Form 8-K. In addition, the SEC has provided a limited exception to the
filing obligation for material, non-public information regarding historical

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

operating results or financial condition disclosed orally, telephonically or

by webcast, broadcast or similar means within 48 hours of the initial release
that triggers the Form 8-K requirement if:
the oral information is provided as part of a presentation that is
complementary to the written information;
the related written release or announcement has been furnished to
the SEC on Form 8-K prior to the presentation;
the presentation is accessible to the public by dial-in conference
call, webcast or similar technology;
the financial and statistical information contained in the presentation is posted on the companys web site along with any information that would be required under Regulation G (the SECs
regulation concerning non-GAAP financial measures discussed
below); and
the presentation was announced by a widely disseminated press
release that included information as to how to access the presentation and information about the location of the companys web site.
5. Disclosure of Non-GAAP Financial Information. SEC Regulation G
imposes heightened disclosure requirements when a public company uses
non-GAAP financial measures4 in public announcements generally
(including oral announcements) and in SEC filings (including registration
statements on Form S-1 and SB-2 in connection with an IPO).
When a public company (or any person acting on behalf of the company) makes a public announcement or disclosure of any material
information that contains a non-GAAP financial measure, Regulation G
requires that the non-GAAP financial measure contained in such public
disclosures to be accompanied by:

4. The SEC defines a Non-GAAP Financial Measure as (subject to specified exclusions) a numerical measure of a companys historical or future financial performance, financial position or cash flows that (1) excludes amounts, or is subject to adjustments that have
the effect of excluding amounts, that are included in the most directly comparable measure
calculated and presented in accordance with GAAP in the companys statement of income,
balance sheet or statement or statement of cash flows (or equivalent statements); or (2) includes amounts, or is subject to adjustments that have the effect of including amounts, that
are excluded from the most directly comparable measure so calculated and presented in accordance with GAAP.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

the most directly comparable financial measure calculated and

presented in accordance with GAAP; and
a quantitative reconciliation (by schedule or other clearly understandable method), of the differences between the non-GAAP
financial measures presented and the most directly comparable
GAAP financial measure.
For non-GAAP financial measures disclosed orally, telephonically, in
a webcast or broadcast or by similar means, a company may satisfy the
requirement that the corresponding GAAP information and reconciliation
accompany the non-GAAP financial measures if the company posts the
accompanying information on its web site. However, the information
must be posted on the companys web site at the time that the oral nonGAAP financial measure is used and the location of the comparable
GAAP financial measure and reconciling information must be disclosed
during the presentation of the non-GAAP financial measure.
Regulation G exempts financial information presented in connection
with a proposed business combination transaction if the disclosure is contained in a communication that is subject to SECs communication rules
applicable to business combination transactions.
In addition, amendments to Item 10 of Regulation S-K and Item 10 of
Regulation S-B require companies using non-GAAP financial information
in filings with the SEC (including registration statements of Form S-1 in
connection with an IPO) to provide:
a presentation, with equal or greater prominence, of the most
directly comparable GAAP financial measure;
a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between non-GAAP financial measures with the most directly comparable GAAP financial
measures;
a statement describing the reasons why the companys management believes the non-GAAP financial information provides useful information to investors; and
a statement disclosing the additional purposes, to the extent material, if any, for which the companys management uses the nonGAAP financial measure that are not otherwise disclosed.

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

Amendments to Item 10 of Regulation S-K and Item 10 of

Regulation S-B also specifically prohibits the use of the following nonGAAP financial measures in filings made with the SEC:
Excluding charges or liabilities that required, or will require, cash
settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than EBIT and EBITDA;
Adjusting a non-GAAP performance measure to smooth or eliminate non-recurring, infrequent or unusual items, when (1) the
charge or gain is reasonably likely to recur within two years or (2)
there was a similar charge or gain within the prior two years;
Presenting non-GAAP financial measures on the face of financial
statements prepared in accordance with GAAP or the accompanying notes;
Presenting non-GAAP financial measures on the face of any pro
forma financial information required to be disclosed by Article 11
of Regulation S-X; and
Using titles or descriptions for non-GAAP financial measures that
are the same as, or confusingly similar to, titles or descriptions
used for GAAP financial measures.
6. Disclosures Regarding Audit Committee Financial Expert. The
SEC expanded Item 401 of Regulation S-K and Regulation S-B to require
public companies to disclose whether at least one member of the audit
committee of its board of directors qualifies as an audit committee financial expert (described below), as determined by the board of directors. In
addition to this disclosure, the SEC rules require that:
if the company discloses that it has at least one audit committee
financial expert, it must disclose the name of the expert and
whether that person is independent of management as that term is
defined for audit committee members under the companys relevant listing standards;
if the company discloses that it does not have at least one audit
committee financial expert, it must explain why it does not have
one; and

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if the board of directors has determined that it has more than one
audit committee financial expert serving on its audit committee
then it may, but is not required to, disclose the names of those
additional persons, but if it does disclose the names, it must indicate whether they are independent.
Revised Item 401 of Regulation S-K and S-B requires companies to
include the disclosure in their annual reports on Forms 10-K and 10-KSB.
The SEC defines audit committee financial expert as a person who has
each of the following attributes acquired through relevant experience:
an understanding of generally accepted accounting principles and
financial statements;
the ability to assess the general application of such principles in
connection with the accounting for estimates, accruals and
reserves;
experience preparing, auditing, analyzing or evaluating financial
statements that present a breadth and level of complexity of
accounting issues that are generally comparable to the breadth
and complexity of issues that can reasonably be expected to be
raised by the companys financial statements, or experience
actively supervising one or more persons engaged in such activities;
an understanding of internal controls and procedures for financial
reporting; and
an understanding of audit committee functions.
The audit committee financial expert must have acquired the abovereferenced attributes through at least one of the following ways:
Education and experience as a principal financial officer, principal
accounting officer, controller, public accountant or auditor or
experience in one or more positions that involve the performance
of similar functions;
Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or
person performing similar functions;

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

Experience overseeing or assessing the performance of companies

or public accountants with respect to the preparation, auditing or
evaluation of financial statements; or
Other relevant experience.5
7. Director Nominations. The SEC amended Item 7 of Schedule 14A
to require a company to disclose in its proxy materials, where action is to
be taken with respect to the election of directors, whether its board of
directors has a nominating committee and, if so, whether and how the
committee accepts recommendations for nominees from security holders.
The revised Item 7 also requires a description of the following:
If the company does not have a nominating committee or a committee performing similar functions, the basis for the boards view
that it is appropriate for the company not to have such a committee, as well as the names of directors who participate in the director nomination process;
Whether the nominating committee has a charter, and if so, where
a copy of the charter is available (either on the companys web site
or as an appendix to the proxy statement);
Information regarding the independence of members of the nominating committee;
Whether the nominating committee has a policy regarding the
consideration of director candidates submitted by security holders; if so, a description of the material elements of that policy; and
if not, the basis for the boards view that it is appropriate for the
company not to have such a policy;
The procedures by which security holders may, if permitted, submit names of director candidates for consideration by the nominating committee;
Information regarding specific, minimum qualifications, if any, for
nominees to the board of directors and specific qualities or skills
that the nominating committee believes are necessary for one or
more of the companys directors to possess;
5. If a person qualifies as an audit committee financial expert solely though other relevant experience, Item 401 requires that the company disclose such other relevant experience.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

The process by which the nominating committee identifies and

evaluates director candidates, including differences between candidates submitted by security holders and candidates submitted
by other means;
The category of the persons or entities who nominated each
nominee (except nominees who are executive officers or who are
standing for reelection) approved by the nominating committee
for inclusion on the companys proxy card by one or more of the
following categories: security holder, non-management director,
CEO, other executive officer, third-party search firm, or another
specified source;
The function of any paid third party who identifies or assists in
identifying or evaluating potential nominees; and
If the nominating committee does not nominate a candidate recommended by a security holder or group of security holders who
either individually or in the aggregate beneficially own greater
than five percent (5%) of the companys voting stock for at least
one year as of the date of the recommendation, certain information concerning the security holder(s) who nominated the candidate and the candidate (provided that the security holder(s) and
the candidate give consent to be named).
In addition, the SEC has amended Form 10-Q, Form 10-QSB, Form 10-K
and Form 10-KSB to require a company to disclose any material changes
to the procedures by which its security holders may recommend nominees to the board in its quarterly or annual report.
8. Disclosure Regarding Security Holder Communication with the
Board of Directors. The SEC has amended Item 7 of Schedule 14A to
require a description of the means, if any, by which security holders may
communicate with members of the board of directors. Specifically, the
new disclosure rules require a company to disclose in its proxy materials,
where action is to be taken with respect to the election of directors,
whether or not there is a process by which security holders may communicate with the board of directors and, if not, the basis for the boards view
that it is appropriate for the company not to have such a process. If such a
process exists, companies must disclose:

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

the manner in which security holders can send such communications to the board (and if applicable, to specified board members);
and
if all such communications are not sent directly to board members,
information regarding the process for determining which communications will be sent to board members.
The new rules also require disclosure of whether a company has a
policy regarding the attendance of directors at annual security holder
meetings and the number of directors who attended the prior years
annual meeting.
A company may satisfy the new disclosure requirements regarding
security holder communication with the board of directors either by
including the disclosure in its proxy statement or by indicating in its
proxy statement where such disclosure may be found on its web site.
9. Disclosure Regarding Code of Ethics. The SEC has created a new
Item 406 of Regulation S-K and Regulation S-B to require public companies to disclose:
whether the company has adopted a written code of ethics that
applies to the companys principal executive officer, principal
financial officer, principal accounting officer or controller, and persons performing similar functions; or
if the company has not adopted a code of ethics, the reasons it has
not done so.
Companies must include such disclosure in their annual reports on
Forms 10-K and 10-KSB. In addition to requiring disclosure regarding the
adoption of an ethics code, the SEC requires that companies make their
codes of ethics publicly available by one of the following three alternative
methods:
as an exhibit to their annual report;
on their web site (provided that a company choosing this option
also must disclose its web site address and intention to provide
disclosure in this manner in its annual report); or

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The Initial Public Offering

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by means of an undertaking in their annual report to provide a

copy of the code of ethics to any person without charge upon
request.
Public companies must report on Form 8-K (1) any amendment to the
companys code of ethics that applies to the specified officers; or (2) any
waiver of a provision of a code of ethics (i.e., a material departure from a
provision of the code of ethics) granted to a specified officer, including the
name of the officer to whom the waiver was granted. As an alternative to
providing the required disclosure on a Form 8-K, a company may use its
own public web site as a method for disseminating the disclosure about
amendments to, or waivers of, its code of ethics. However, a company
may take advantage of the web site option only if it had previously disclosed in its most recently filed annual report:
that it intends to disclose these events on its public web site; and
its public web site address.
If a company elects to disclose this information on its web site, it must do
so within the five business day time period that the SEC requires for
Form 8-K filings. (Note: Effective August 23, 2004, this 5 business day
requirement will be shortened to 4 business days under the SECs
amended Form 8-K). In addition, SEC rules require a company electing to
provide web site disclosure to make the disclosure available on its web
site for a period of at least 12 months after it initially posts the disclosure.
After the 12-month posting period, the company must retain this disclosure for a period of not less than five years and make it available to the
SEC upon request.
10. The Sarbanes-Oxley Act enhanced auditor independence requirements. Financial statements filed with the SEC must be certified by
independent accountants. In January 2003, the SEC approved new rules to
strengthen its existing requirements regarding auditor independence.
Accordingly, the auditing firm selected by the companys audit committee to prepare financial statements to be filed with the SEC (including
financial statements included in registration statements in connection
with an IPO) must satisfy the SECs additional independence requirements. The SECs additional rules regarding auditor independence are
summarized below:

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

Required Communication with Audit Committee. SEC rules require that

the issuers independent accountants inform the audit committee of the
following items with the SEC:
critical accounting policies and practices;
alternative accounting treatments for both specific transactions
and general accounting policies; and
other material written communications with management, including, among others:

management representation letters;

reports on observations and recommendations on internal controls;

schedules of unadjusted audit differences, and a listing of

adjustments and reclassifications not recorded, if any;

engagement letters; and

independence letters.

Prohibited Non-Audit Services. Section 2-01 of Regulation S-X lists nine

types of non-audit services that an independent auditor may not provide
to its audit clients:
bookkeeping services;
financial information system design and implementation;
appraisal or valuation services, fairness opinions, or contribution
in-kind reports;
actuarial services;
internal audit outsourcing services;
management functions or human resources;
broker/Dealer, investment adviser, or investment banking services;
legal services and expert services unrelated to the audit; and

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

any other service that the Public Accounting Oversight Board

determines by regulation to be impermissible.6
Pre-Approval of Services. Section 2-01 of Regulation S-X requires that all
audit and permissible non-audit services performed by the independent
auditor are either:
pre-approved by the audit committee; or
approved pursuant to pre-approval policies and procedures established by the companys audit committee that are detailed as to
the particular service to be rendered and do not delegate approval
authority to management.7
In addition to the pre-approval requirements described above,
Item 14 of Form 10-K and Form 10-KSB and Item 9 of Schedule 14-A
require a company to provide disclosure in its proxy statement (or Form
10-K if no proxy is filed) regarding the audit committees pre-approval of
services provided by the independent accountant, as well as the types of
services performed. If a company uses pre-approval policies and procedures, it must either describe or provide a copy of such policies and
procedures. Additionally, Item 9 of Schedule 14-A requires the company
to disclose what percentage of the total fees paid to the independent
accountants were approved pursuant to the limited de minimis exception
to the requirement for pre-approval of all audit and permissible non-audit
services. This disclosure must also include fees paid to the independent
accountant for the two most recent fiscal years in each of the following categories, as well as a description of the services rendered in the last three
categories: (1) audit fees; (2) audit-related fees; (3) tax fees; and (4) all other
fees.
Audit Partner Rotation. Under Section 2-01 of Regulation S-X, an independent public accounting firm may not provide audit services to an
issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the
audit, has performed audit services for the issuer in each of the issuers
five previous fiscal years. Section 2-01 of Regulation S-X subject these
6. An audit committee may allow an independent accountant to provide one of the first
five prohibited non-audit services listed above in very limited circumstances where it is reasonable to conclude that the results of these services will not be subject to audit procedures
during an audit of the audit client's financial statements.
7. The requirement for pre-approval of all audit and permissible non-audit services are
subject to a very limited de minimis exception.

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Appendix E - Summary of Selected SEC Rules Adopted in Response

to the Sarbanes-Oxley Act of 2002

audit partners to a five-year time-out period before they may again work
on the audit engagement. Certain other audit partners are subject to a
seven-year rotation period and a two-year time-out period.
Cooling-off period. The SEC amended Section 2-01 of Regulation S-X to
require a cooling off period of one year before members of the audit
engagement team begin employment for an audit client in the following
positions: (1) Chief Executive Officer; (2) Controller; (3) Chief Financial
Officer; (4) Chief Accounting Officer; (5) member of the board of directors;
(6) General Counsel; and (7) other financial positions with a financial
oversight role.
Compensation. Pursuant to Section 2-01 of Regulation S-X, an accountant is not independent if a partner (other than a specialty partner) earns
or receives compensation (construed broadly) at any point during the
audit and professional engagement based on the audit partner selling
engagements to the audit client with respect to services other than audit,
review and attestation services.

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E-18

Appendix F
Sample Plain English Comments from the SEC
Below is a list of sample SEC comments that were released publicly
by the SEC in its June 1999 Staff Legal Bulletin regarding Plain English disclosure (originally issued in September 1998 and updated in June 1999).
Entire prospectus. The following SEC comments were applicable to the
entire prospectus:
#1

Do not use Company to refer to your company. Instead, use

your actual company name or a shortened version of it throughout your prospectus.

#2

Throughout your prospectus, you are capitalizing terms that you

are using for their common meanings. For example, you capitalize
Common Stock, Preferred Stock, Registration Statement,
Prospectus, Merger Agreement, etc.

#3

Do not define terms in parenthetical phrases when the meanings

are clear from their context. For example, you define The X Company, Inc., as (X Company). Similarly, you define the Securities
and Exchange Commission as (SEC), the Internal Revenue
Service as (IRS), and Securities Exchange Act as (the
Exchange Act).

#4

Many of the terms you use are unique to this prospectus. Eliminate this over-reliance on defined terms. Instead, disclose
material information in a clear, concise, and understandable
manner.

#5

If you choose a shortened name or abbreviation, ensure its

meaning is clear from the context. For example, consider using
Hard Disk Drive Group as the shortened name of Hard Disk
Drive Group Company, Inc. rather than HDDG since the
meaning of this abbreviation is unclear without the benefit of a
parenthetical definition.

#6

The term such is typically legalese for this, these, or the.

Please replace this term throughout your prospectus with a concrete, everyday word that means the same thing.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

#7

Replace embedded lists of information in paragraph form with

bullet points. Also, use bullet points, regular numbers, or letters
instead of small Roman numerals in parentheses.

#8

Eliminate parenthetical phrases that disrupt the flow of information and make sentences very long. If the information in the
parenthetical phrase is part of the sentence, merely set it off by
commas. If the parenthetical phrase does not fit as part of the sentence, include it in its own sentence.

#9

Minimize the use of footnotes where possible. For example, if the

text in a footnote applies to the entire table, include the text in the
narrative discussion that precedes the table. Also, if a number of
footnotes repeat the same text, consider moving this text to the
introductory paragraph or adding a column to the table that
includes this information.

#11 Eliminate all unnecessary redundancy throughout your

prospectus.
#12 Currently, your prospectus is written from the perspective of
someone who is already quite familiar with the transaction and
the entities involved. For example, throughout your prospectus,
you make several references to certain circumstances, certain
matters, certain amendments, certain persons, and certain
extraordinary matters. Replace the term certain with a brief
description of what makes the information qualify as certain.
Cover, summary and risk factors. The following SEC comments are applicable to the forepart of the prospectus (the cover page, summary section,
and the risk factors section):
#13 The forepart of your prospectus contains a lot of jargon, technical
terms, and legalese. For example:
Jargon/technical terms proprietary drug, intravenous solutions, logistics capabilities, coordinated manufacturing and
distribution efforts, proprietary medicines, vertically integrated, cost-efficient providers, revenue synergies, lower
margin products utilization realigning sales forces, centralized management information systems, profit-enhancing synergies, global platform

F-2

Appendix F - Sample Plain English Comments from the SEC

Legalese definitive agreement, consummation, those preceded by, herein set forth, under, by such, forward-looking
statements, without limitations, cease to conduct, completion
of the combination, commencing hereinafter, so surrendered,
defeased, as amended, qualified in its entirety
Eliminate the legalese and industry jargon from the forepart of
your prospectus. Instead, explain these concepts in concrete,
everyday language. Further, place any industry terms you use in
context so those potential investors who do not work in your
industry can understand the disclosure.
#14 The forepart of your prospectus contains many defined terms.
The meanings of the terms you use in the forepart of your prospectus must be clear from the context. Accordingly, eliminate
the defined terms throughout the forepart of your prospectus
and use terms whose meanings are clear from the context
instead.
Cover page. The following SEC comments are applicable to the cover page
of the prospectus:
#15 Your cover page exceeds the one page limit imposed by securities regulations. Much of the information you include here is
very detailed and is repeated in the summary. Move the information that is not required by the securities regulations to be on the
cover page or is not key to an investment decision off the cover
page.
#16 Limit the cover page to the information that is required by the
securities regulations and other information that is key to an
investment decision.
#17 Using [all capital letters] [and] [cascading margins] impedes the
readability of the text on the cover page. Revise text written in all
capital letters and eliminate cascading margins from your cover
page.
#18 The text on your cover page is dense and the margins are quite
narrow. This is because you are including much more information than is required by securities regulations. As a result, your
cover page is not visually inviting. The layout of your cover page
must highlight the information required by the securities regulations and encourage investors to read your prospectus. Move
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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

any information that is not required or is not key to an investment decision off the cover page. Then, surround the remaining
information with ample white space and use wider left and right
hand margins.
Summary. The following SEC comments relate to the summary section in
the front part of the prospectus:
#19 The introductory paragraph to your summary states that the
summary is not complete. A summary, by its very nature, does
not and is not required to contain all of the detailed information
that is in the prospectus. However, if you have elected to include
a summary in your prospectus, it must be complete. Do you
mean to say that, because this is a summary, it may not contain
all of the information that is important to your investors? Delete
the reference to an incomplete summary from your prospectus.
#20 We note your summary contains a lengthy description of the
companys business and business strategy. Further, we note the
identical disclosure appears later in your prospectus. In the summary, you are to carefully consider and identify those aspects of
the offering that are the most significant and determine how to
best highlight those points in clear, plain language. The summary
should not include a lengthy description of the companys business and business strategy. This detailed information is better
suited for the body of the prospectus. If you want to highlight
key aspects of your business strategy, consider listing these in a
bullet-point format, with one sentence per bullet point.
Risk factors. The following SEC comments pertain to the risk factors section
of the prospectus:
#21 We note in the introductory paragraph to your risk factors
section you state that this section is not complete, that there may
be risks that you do not consider material now but may become
material, or there may be risks that you have not yet identified.
You must disclose all risks that you believe are material at this
time. Delete this language from your introductory paragraph.
#22 Currently, it appears you are including more than one risk factor
under one subheading. In order to give the proper prominence
to each risk you present, we suggest you assign each risk its own
descriptive subheading.

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Appendix F - Sample Plain English Comments from the SEC

#23 Present the risks in more concrete terms. For example, in the first
risk factor on page **, you discuss the risks due to the costs
associated with the benefit plans. So investors can better understand these risks, clearly state that the costs are not expenses of
running those plans, but rather the added compensation expense
that stems from the shares purchased or granted to employees
and executives under those plans.
#24 In each risk factor, get to the risk as quickly as possible and
provide only enough detail to place the risk in context. Where
you repeat later in the prospectus the details you currently
include in your risk factors section, eliminate the extensive detail
here. Instead, include a very brief overview to place the risk in
context and provide a specific cross reference to the more
detailed discussion elsewhere in the prospectus.
#25 Provide the information investors need to assess the magnitude
of the risk.
#26 The securities regulations state that issuers should not present
risk factors that could apply to any issuer or to any offering. If
you elect to retain these and other general risk factors in your
prospectus, you must clearly explain how they apply to your
industry, company, or offering.
#27 Revise each subheading to ensure it reflects the risk that you
discuss in the text. Many of your subheadings currently either
merely state a fact about your business or describe an event that
may occur in the future. Succinctly state in your subheadings the
risks that result from the facts or uncertainties.
#28 The subheadings in your risk factors section are too vague and
generic to adequately describe the risk that follows. Revise your
risk factor subheadings so they reflect the risk that follows. As a
general rule, your revised subheadings should work only in this
prospectus. If they are readily transferable to other companies
offering documents, they are probably too generic.
#29 To the extent possible, avoid the generic conclusion you make in
most of your risk factors that the risk discussed would have a
material adverse effect on your [operations] [financial condition]

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

[business]. Instead, replace this language with specific disclosure

of how your [operations] [financial condition] [business] would
be affected.
Body of the prospectus. The following SEC comments are applicable to body
of prospectus
#30 Avoid relying on defined terms as a primary means of explaining
information in the prospectus. We note that the body of your
prospectus contains a large number of defined terms. Most of
these are terms that you created solely for use in this prospectus.
Revise your prospectus to eliminate your over-reliance on
defined terms.
#31 If you must include technical terms in the body of your prospectus that are understood only by industry experts, you must make
every effort to concisely explain these terms where you first use
them. Where this is simply not possible, explain these terms in a
glossary. In addition, do not use technical terms or industry
jargon in your concise explanations. You should not use a glossary to define commonly understood abbreviations, like SEC, or
acronyms, like NASDAQ. Further, you should not use a glossary
to define terms that you have created solely for the purpose of
your registration statement. We urge you not to create a vocabulary that is unique to your offering.
#32 You must avoid copying complex information directly from
legal documents without any clear and concise explanation of
this information. Rewrite this disclosure so it is clear, concise,
and understandable. If you believe the language as it appears in
the underlying legal documents is indispensable to your prospectus, you must present it clearly, using bullet lists and concise
sections and paragraphs, and explain what it means to investors.

F-6

Glossary
The definitions below are intended to convey plain English explanations of
certain terms. For technically complete, legally precise definitions, experienced
counsel should be consulted.
The definitions of many of the words and phrases in this Glossary use other
defined words and phrases. Terms in a given definition that themselves (or variations thereof) appear elsewhere under their own listings are italicized.
Accelerated Filer. A public company that meets the following conditions as of the end of its fiscal year:
The companys common equity public float was $75 million or
more as of the last business day of its most recently completed second fiscal quarter;
The company has been subject to the reporting requirements of
Section 13(a) or 15(d) of the Exchange Act for a period of at least
12 calendar months;
The company has previously filed at least one annual report pursuant to Section 13(a) or 15(d) of the Exchange Act; and
The company is not eligible to use Form 10-KSB and Form 10-QSB
(i.e., it is not a small business issuer).
Acceleration Request. A written (or, in some cases, oral) request to the
SEC to declare a registration statement effective at a certain date and time.
The SEC requires that the request be delivered at least two business days
prior to the anticipated effective date.
Affiliate. A person or entity that directly or indirectly controls, is controlled by, or is under common control with, a company. Examples of
affiliates include executive officers, directors, large stockholders, subsidiaries and sister companies.
Aftermarket. Trading on stock exchanges and over-the-counter
markets in a companys stock after an initial public offering.
Aggregate Offering Price. The total offering price of an offering to the
public, which is equal to the number of offered shares multiplied by the
price per share to the public.

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A Guidebook for Executives and Boards of Directors

American Depositary Receipts (ADRs). Negotiable instruments,

created by a U.S. bank, that evidence ownership of a specified number of
shares of a foreign security held in a depositary in the issuing companys
country of domicile. The certificate, transfer, and settlement practices for
ADRs are identical to those for U.S. securities. U.S. investors often prefer
ADRs to direct purchase of foreign shares because of the ready availability
of price information, lower transaction costs, and timely dividend
distribution.
American Stock Exchange (Amex). The second-oldest U.S. stock
exchange, located on Wall Street in New York City. The Amex typically
lists small to medium cap stocks of younger or smaller companies. The
Amex is the only primary exchange that offers trading across a full range
of equities, options and exchange traded funds (ETFs). The Amex is also
one of the largest options exchanges in the U.S., trading options on broadbased and sector indexes as well as domestic and foreign stocks.
Analyst. A person with expertise in evaluating financial investments.
An analyst performs investment research and makes recommendations to
institutional and retail investors to buy, sell, or hold; most analysts specialize in a single industry or business sector.
Annual Report. A report containing financial statements and certain
other information required by SEC regulations which is distributed to
stockholders on an annual basis. One method of satisfying the annual
report requirement is to distribute a copy of the companys Form 10-K,
which is often accompanied by a letter from the CEO, and is commonly
referred to as a 10-K wrap.
Banknote Company. A public company must provide a physical certificate of ownership to holders of the company's stock who request it. A
banknote company specializes in the design and printing of stock
certificates.
Beneficial Ownership. The beneficial owner of a security includes any
person who directly or indirectly, through any contract, arrangement,
understanding, relationship or otherwise, has or shares voting or investment power with respect to such security. A person or entity may be the
beneficial owner of a security even though title may be in another name
for safety, convenience or otherwise (such as when securities beneficially
owned by an individual are held by a broker in street name). There may be
more than one beneficial owner of a single security.

G-2

Glossary

Best Efforts Offering. As opposed to a firm commitment underwriting,

refers to an offering where the underwriters do not purchase the securities
from the issuer or resell them to the public. In a best efforts offering, underwriters act only as an agent of the issuer in marketing the securities to
investors. Most best efforts offerings today are handled by investment
banks specializing in lesser known or more speculative securities.
Blue Sky Laws. State securities laws loosely analogous to the federal
securities laws. The term is said to have originated with a judge who
asserted that a particular stock offering had as much value as a patch of
blue sky.
Broker. An individual or firm that trades securities for buyers or
sellers in exchange for a commission.
Capitalization. The total amount of a companys outstanding debt
and equity securities. The term also is commonly used to refer to the
capital (debt and equity) structure of a company.
Charter Documents. A companys basic incorporation documents,
including the Articles or Certificate of Incorporation and the Bylaws.
Cheap Stock. The term used to describe securities, most commonly
stock options, granted to employees, directors, consultants or other
service providers with an exercise price below the fair value of the underlying security as of the date of grant. The SEC generally views the
difference in exercise price and fair market value (measured as of the date
of grant) as compensation and requires that the company record a corresponding compensation expense.
Closing. The closing of an offering is held on the third or fourth business day following the effective date. At the closing, the company delivers
the registered securities to the underwriters in exchange for the net offering proceeds.
Comfort Letter (or cold comfort letter). A letter written by the companys accountants and delivered to the underwriters and the companys
board of directors as part of the due diligence process. The comfort letter
gives assurance to the underwriters and the companys board of directors
that the financial information included in the registration statement corresponds to the audited and unaudited financial statements and other
financial records of the company and may also discuss the results of
certain additional agreed upon procedures.

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Confidential Treatment. The method whereby a company can request

that certain sensitive or confidential information contained in exhibits to
filings made with the SEC be redacted from the documents and not made
available to the public. Typical examples of the type of information for
which confidential treatment may be sought include financial information
(such as pricing terms, royalty rates and milestone payments) and trade
secrets (such as technical specifications).
CUSIP Number. CUSIP is an acronym for the Committee on Uniform
Security Identification Procedures. This committee was established in
1964 by the American Bankers Associations Department of Automation
to create a uniform security identification system. The CUSIP Service
Bureau, operated by Standard & Poors, administers this system assigns
unique numbers (CUSIP numbers) and standardized descriptions of securities, both of which are critically important for the accurate and efficient
clearance and settlement of securities transactions.
Dealer. Individual or entity acting as a principal in a securities
transaction.
Depository Trust Company (DTC). DTC provides a central securities
certificate depository through which brokers deliver securities by computerized bookkeeping entries, vastly reducing physical transfer of stock
certificates
Directed Shares. Refers to shares of stock sold in an initial public
offering which are directed to certain individuals by the company.
Director and Officer (D&O) Liability Insurance. A form of insurance
against liability asserted against directors and officers of a company and
incurred by such persons in those capacities or arising out of such persons
status as directors and officers of the company.
Director and Officer (D&O) Questionnaire. A questionnaire distributed by the company to its directors and officers during the early stages
of a public offering. The questionnaire solicits information regarding executive compensation, securities ownership and insider transactions. The
D&O Questionnaire aids the company in the due diligence process and
confirms data that is disclosed in the registration statement.
Division of Corporation Finance. The division of the SEC that
reviews registration statements filed pursuant to the Securities Act.

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Glossary

Due Diligence. A fact-finding process conducted by various working

group members to verify the accuracy and completeness of the registration statement.
Earnings Per Share (EPS). Net income of a company for a specified
period of time divided by the number of equity securities outstanding at
such time. Fully diluted EPS assumes the exercise or conversion of certain
warrants, options and convertible securities into common stock.
EDGAR System. The Electronic Data Gathering, Analysis, and
Retrieval system, which is an electronic system implemented by the SEC
for the receipt, acceptance, review and dissemination of documents submitted in electronic format.
EDGAR Filer Manual. The manual prepared by the SEC setting out the
technical format requirements for EDGAR filings. See also Regulation S-T.
Effective Date. The date of the SEC order declaring the registration
statement for a public offering to be effective, at which time the sale of
shares to the public can commence.
Electronic Communication Networks (ECNs). In addition to traditional market makers, the NASDAQ network also includes other brokerdealers operating as Electronic Communication Networks, or ECNs,
which provide electronic facilities for investors to trade directly with one
another without going through a market maker. ECNs operate as ordermatching and order-routing mechanisms and do not maintain inventories
of securities themselves.
Equity. Represents the ownership interest of stockholders in a
company.
Exchange Act. See Securities Exchange Act of 1934, as amended.
Final Prospectus. The offering document sent to all purchasers of the
companys stock in and immediately following a public offering. The final
prospectus is an updated version of the preliminary prospectus, contains
all final offering information (such as pricing and underwriting details)
and reflects amendments to the registration statement subsequent to the
date of the preliminary prospectus.
Financial Printer. A printer that specializes in printing financial documents, such as registration statements and other documents filed
pursuant to the Securities Act and the Exchange Act.

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The Initial Public Offering

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Firm Commitment Underwriting. As opposed to a best effort offering,

the firm commitment underwriting refers to an underwriting where the
underwriters commit to purchase shares from the company at a negotiated discount and then resell the shares to the public.
Flipping. The practice of an investor buying stock in an IPO at the
offering price and quickly selling it for a profit when it starts trading.
Though it became common during the Internet boom of the late 1990s, this
practice is generally discouraged by the company and its underwriters,
who seek investors willing to make a long-term commitment to the
company.
Foreign Private Issuer. Any foreign issuer other than a foreign government, except an issuer meeting the following conditions: (1) more than
50% of the outstanding voting securities of such issuer are owned by U.S.
residents; and (2) any of the following: (i) the majority of the executive
officers or directors are U.S. citizens or residents; (ii) more than 50% of the
assets of the issuer are located in the U.S.; or (iii) the business of the issuer
is administered principally in the U.S. Foreign private issuers are subject
to somewhat narrower disclosure obligations than U.S. issuers. See also
Form 20-F and Form F-1.
Form 3. Used to report initial beneficial ownership of securities. A
Form 3 must be filed by all Section 16 insiders within 10 days after such
person becomes a Section 16 insider, except in connection with the initial
registration of securities under the Exchange Act when the report is due on
the effective date of the registration statement. Required pursuant to
Section 16 of the Exchange Act.
Form 4. Used to report changes in beneficial ownership of securities.
Section 16 insiders must file a Form 4 by the end of the second day following the day on which a reportable change in such persons beneficial
ownership of securities occurred, except where extensions may be available in connection with a Rule 10b5-1 trading plan or for transactions
eligible for deferred reporting on Form 5. Required pursuant to Section 16
of the Exchange Act.
Form 5. Used to report beneficial ownership of securities annually.
Section 16 insiders must file a Form 5 on or before the 45th day after the
end of the reporting companys fiscal year to report certain transactions in

G-6

Glossary

such companys equity securities. However, if each of such transactions

has been reported on a previous Form 3 or Form 4, no Form 5 need be
filed. Required pursuant to Section 16 of the Exchange Act.
Form 8-A. A form of registration statement used to register securities
pursuant to the Exchange Act.
Form 8-K. The prescribed form for current reports of certain specified
events, such as a change in control, significant acquisition or disposition
of assets, bankruptcy or receivership, or a change in accountants. The
Form 8-K may also be used to voluntarily report other important events.
Form 10-K. An annual report on Form 10-K is required to be filed by
a reporting company within 90 days after the end of each fiscal year,
unless the reporting company is an accelerated filer subject to accelerated
filing deadlines as discussed in Appendix E. The Form 10-K consists of the
cover page, Part I (information relating to the companys business, property and legal proceedings), Part II (financial information), Part III
(information relating to the Companys directors, officers and principal
stockholders) and Part IV (exhibits and financial statement schedules). See
also Annual Report.
Form 10-KSB. Form 10-KSB, which has more simplified disclosure
requirements than Form 10-K, may be used by small business issuers in lieu
of the Form 10-K.
Form 10-Q. Reporting companies are required to file quarterly
reports on Form 10-Q within 45 days after the end of each of the first three
quarters of each fiscal year, unless the reporting company is an accelerated
filer subject to accelerated filing deadlines as discussed in Appendix E. The
Form 10-Q is less comprehensive than the Form 10-K.
Form 10-QSB. Form 10-QSB, which has more simplified disclosure
requirements than Form 10-Q, may be used by small business issuers in lieu
of the Form 10-Q.
Form 20-F. Form 20-F may be used by foreign private issuers both to
register securities under the Exchange Act and as an annual report which
must be filed within six months after the end of each fiscal year.
Form F-1. Form F-1 is used by foreign private issuers to register shares
pursuant to the Securities Act.

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Form S-1. The basic registration statement form used to register securities pursuant to the Securities Act when no other form is authorized or
prescribed. The Form S-1 registration statement is the form most commonly
used in connection with an IPO. The Form S-1 requires comprehensive
disclosure about the company and does not permit incorporation by reference of documents or information.
Form S-2. The Form S-2 registration statement is available for any
company that has been subject to the reporting requirements of the
Exchange Act for at least 36 months and has filed all required reports pursuant to the Exchange Act in a timely manner for at least the preceding 12
months and any portion of the month preceding filing of the registration
statement. Form S-2 allows the incorporation by reference of certain required
information from documents previously filed pursuant to the Securities
Act or the Exchange Act.
Form S-3. The Form S-3 registration statement is available for any
company that has been subject to the reporting requirements of the
Exchange Act for at least 12 months and has filed all required reports pursuant to the Exchange Act in a timely manner for at least the preceding 12
months and any portion of the month preceding filing of the registration
statement. Depending on the type of offering, there may be additional
financial thresholds and other requirements. As compared to Form S-2,
Form S-3 allows a greater level of incorporation by reference of certain
required information from documents previously filed pursuant to the
Securities Act or the Exchange Act.
Form S-4. The Form S-4 registration statement is used to register securities issued by reporting companies in connection with certain business
combinations, reclassifications, mergers, consolidations and asset transfers.
Form S-8. The Form S-8 registration statement may be used by reporting
companies to register securities to be offered pursuant to employee benefit
plans.
Form SB-1. The Form SB-1 registration statement may be used in lieu of
Form S-1 by a small business issuer to register up to $10 million in securities
if it has not registered more than $10 million in the preceding 12 months
(other than securities registered on a Form S-8), including securities in the
offering being registered.

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Glossary

Form SB-2. The Form SB-2 registration statement may be used by a

small business issuers to register securities, without the offering amount
limitations of Form SB-1.
GAAP (Generally Accepted Accounting Principles). Rules and procedures generally accepted within the accounting profession. The Financial
Accounting Standards Board (FASB) is the body primarily responsible for
developing rules governing U.S. generally accepted accounting practices.
Green Shoe. This term refers to the option typically granted to the
underwriters to cover over-allotments in the offering. This name derives
from the fact that the over-allotment option technique was first used in a
public offering of the securities of The Green Shoe Company. See Overallotment option.
Gross Proceeds. Offering proceeds before underwriting discounts and
commissions are deducted.
Hot Issues. A hot issue is an IPO that trades up in the aftermarket in
the period immediately following initial sales of the stock. Special NASD
rules apply to the distribution of hot issues.
Incorporation by Reference. Certain forms filed under the Securities
Act and Exchange Act enable the incorporation of certain required disclosure documents and information by reference to other previously filed
documents and information, thereby simplifying the registration or filing
process.
Independent Director. See the discussion of various standards for
determining director independence in Appendix E. In general, an independent director is a person other than an officer or employee of the
company or its subsidiaries or any other individual having a relationship,
which, in the opinion of the companys board of directors, would interfere
with the exercise of independent judgment in carrying out the responsibilities of director.
Initial Public Offering (IPO). The process of a company registering
shares of its capital stock with the SEC and offering the shares to the
public for the first time.

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Insider. Generally, an insider is a person with access to material information relating to a company before it is announced to the public, and
who has a duty to the issuer not to misuse such information. The term
includes, but is not necessarily limited to, directors, officers and key
employees.
Institutional Investors. Organizations whose primary purpose is to
invest their own assets or those entrusted to them by others, the most
common of which are employee pension funds, insurance companies,
mutual funds, university endowments, and banks.
IPO. See Initial Public Offering.
Lock-Up Agreement. An agreement between a company or the underwriters on the one hand, and a stockholder on the other hand, whereby the
stockholder agrees that it will refrain from reselling its shares for a specified period of time after the effective date of a registration statement. See also
Overhang Analysis.
Managements Discussion and Analysis of Financial Condition and
Results of Operations (MD&A). The section of the registration statement
discussing and analyzing the companys financial condition, changes in
financial condition and results of operations. The MD&A typically
includes period-to-period comparisons of the three most recent fiscal
years and the current fiscal year to date compared to the corresponding
prior year period.
Management Interviews. Due diligence meetings conducted by the
managing underwriters where members of the companys management
team make presentations and answer questions about the company.
Managing Underwriters. The underwriters who, singly or together
with co-managers, participate in the preparation of the registration statement, conduct portions of the due diligence and conduct the road show.
Market Capitalization. The value of a company as determined by the
market price of its issued and outstanding common stock. It is calculated
by multiplying the number of outstanding shares by the current market
price of a share.
Market Makers. The NASD member firms that use their own capital,
research, retail or systems resources to represent a stock and compete with
each other to buy and sell the stocks they represent. Market makers, also
known as dealers, provide liquidity (the ability of a security to absorb a

G-10

Glossary

large amount of buying and selling without substantial movement in

price) by standing ready to buy or sell securities at all times at publicly
quoted prices for their own account and by maintaining an inventory of
securities for their customers. There are over 500 member firms that act as
Nasdaq market makers.
MD&A. See Managements Discussion and Analysis of Financial Condition and Results of Operations.
NASD. See National Association of Securities Dealers.
NASD Questionnaire. A questionnaire distributed by underwriters
counsel to the directors, officers and security holders of a company in connection with a public offering in order to gather and confirm information
that must be provided to the NASD.
National Association of Securities Dealers (NASD). The NASD,
which operates subject to the oversight of the SEC, is the largest SRO in
the U.S. with a membership that includes nearly every broker-dealer that
engages in the securities business with the U.S. public. NASD registers
member firms, writes rules to govern their behavior, examines them for
compliance and disciplines those that fail to comply.
Nasdaq National Market. The highest tier on the NASDAQ market,
and it consists of more than 3,000 companies that have a national or international shareholder base, have applied for listing, meet stringent
financial requirements and agree to specific corporate governance standards. See also NASD, Nasdaq Stock Market, Inc. and Nasdaq SmallCap
Market. The listing requirements of The Nasdaq National Market are set
forth in Appendix A.
Nasdaq SmallCap Market. The lower tier of the NASDAQ market,
and it is comprised of more than 1,400 companies that desire the sponsorship of Market Makers, have applied for listing and meet specific and
financial requirements. See also NASD, Nasdaq Stock Market, Inc. and Nasdaq
SmallCap Market.
Nasdaq Stock Market, Inc. (NASDAQ). Operates the Nasdaq Stock
Market, one of the worlds largest electronic screen-based equity securities
markets, and the Nasdaq SmallCap Market; it also operates the Over-theCounter Bulletin Board. See also NASD, Nasdaq Stock Market, Inc. and Nasdaq
SmallCap Market.

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Net Proceeds. Gross proceeds of an offering less the underwriting discounts and commissions and offering expenses.
New York Stock Exchange (NYSE). The oldest and largest U.S. stock
exchange, located on Wall Street in New York City. Tracing its origins
back to 1792, the NYSE is one of the few remaining financial markets to
use a physical trading floor to conduct trading. Representatives of buyers
and sellers, known as specialists, meet and shout out prices in an open
outcry system. The NYSE is also known as the Big Board and the
Exchange. The listing requirements of the NYSE are set forth in
Appendix A.
No-Action Letter. See SEC No-Action Letter.
NYSE/NASD IPO Advisory Committee. The NYSE and NASD convened the IPO Advisory Committee in October 2002 at the request of the
Chairman of the SEC, to review the IPO underwriting process, particularly price setting and allocation practices, in light of recent experience,
and to recommend to the securities industry community such changes as
may be necessary to address the problems that have been observed. On
May 29, 2003, the Committee issued a report with 20 recommendations for
the SROs and the SEC.
Options. Options are securities giving the holder the right to purchase securities of the company at a certain price.
Over-the-Counter (OTC) Bulletin Board Market. An electronic
screen-based market maintained by NASDAQ for equity securities that,
among other things, are not listed on The Nasdaq Stock Market or any
primary U.S. national securities exchange. Companies do not list on the
OTC Bulletin Board; rather, NASD members may post quotes only for
companies that file periodic reports with the SEC or with a banking or
insurance regulatory authority.
Over-allotment option. The option granted in an initial public offering,
or other underwritten securities offering, by the company, selling stockholders or both to the underwriters to purchase additional shares, to cover
over-allotments identical terms to those on which the original shares were
sold to the underwriters. Also known as the Green Shoe.
Overhang Analysis. An analysis of the number of outstanding shares
of a companys stock that become freely tradeable at particular intervals
following the IPO.

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Glossary

Periodic Reporting Requirements. The ongoing requirements applicable to reporting companies to make filings pursuant the Exchange Act,
including quarterly reports on Form 10-Q and annual reports on
Form 10-K.
Plain English Disclosure. The SEC requirement for the orderly and
clear presentation of complex information contained in registration statements. The rule requires companies to write the cover page, summary and
risk factors sections of registration statements in plain English.
Poison Pill. A type of strategic defensive measure that is designed to
delay the timing and raise the cost of an unsolicited or hostile acquisition
and thereby encourage would-be suitors to negotiate with the companys
board of directors. A poison pill is typically implemented by means of a
stockholder rights plan.
Preliminary Prospectus. The offering document used by the
company and the underwriters to market a public offering. The preliminary prospectus is essentially Part I of the registration statement and may
omit certain information relating to the offering (such as the final offering
price). Also known as the Red Herring because of the red ink used on the
front page, which indicates that some information, including the price and
size of the offering, is subject to change.
Prospectus. See Final Prospectus and Preliminary Prospectus.
Proxy Statement. A document containing information prescribed by
SEC regulation that must be provided to stockholders in connection with
the solicitation of their votes.
Public Offering Price. The price at which a new issue is offered to the
public by underwriters.
Quiet Period. Extends to the 25-day period following the effective date
of a registration statement in connection with an IPO (or 90-day period if,
following the IPO, the company is not listed on a stock exchange or overthe-counter market).
Red Herring. See Preliminary Prospectus.
Registrar and Transfer Agent. An agent, usually a commercial bank,
appointed by a company to maintain records of security owners, to cancel
and issue certificates and to resolve problems arising from lost, destroyed
or stolen certificates.

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

Registration Rights. Contractual rights to participate in or require a

public offering of equity securities.
Registration Statement. The document that must be filed with the
SEC to register shares of a companys stock in connection with a public
offering. See also Form F-1, Form S-1, Form S-2, Form S-3, Form S-4, Form S-8,
Form SB-1 and Form SB-2.
Regulation AC (Analyst Certification). An SEC rule that requires that
brokers, dealers and certain persons associated with a broker or dealer
include in research reports certifications by the research analyst that the
views expressed in the report accurately reflect his or her personal views,
and disclose whether or not the analyst received compensation or other
payments in connection with his or her specific recommendations or
views.
Regulation BTR (Blackout Trading Restriction). An SEC rule that
addresses the operation of Section 306(a) of the Sarbanes-Oxley Act and its
prohibition against trading in issuer equity securities by an issuers directors and executive officers during a pension plan blackout.
Regulation FD (Fair Disclosure). An SEC rule that provides that
when an issuer, or person acting on its behalf, discloses material, nonpublic information to certain enumerated persons (in general, securities
market professionals and holders of the issuers securities who may well
trade on the basis of the information), it must make public disclosure of
that information.
Regulation G. An SEC rule that requires public companies that disclose or release non-GAAP financial measures to include, in that
disclosure or release, a presentation of the most directly comparable
GAAP financial measure and a reconciliation of the disclosed non-GAAP
financial measure to the most directly comparable GAAP financial
measure.
Regulation S-B. An SEC rule that sets forth the disclosure requirements applicable to the content of the non-financial statement portions of
registration statements and other filings under the Securities Act and the
Exchange Act made by small business issuers.

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Glossary

Regulation S-K. An SEC rule that sets forth the disclosure requirements applicable to the content of the non-financial statement portions
of registration statements and other filings under the Securities Act and the
Exchange Act.
Regulation S-T. An SEC rule that sets forth the format and other technical requirements for documents filed with the SEC in electronic, or
EDGAR, format. See also EDGAR Filer Manual.
Regulation S-X. An SEC rule that sets forth the form and content of
and requirements for financial statements included with registration statements and other filings under the Securities Act and the Exchange Act.
Reincorporation. The process of changing the jurisdiction of incorporation of a company (often to Delaware).
Reporting Company. Any business entity that (1) has filed a registration statement pursuant to the Exchange Act which has become effective, or
(2) has become required to file periodic reports pursuant to the Exchange Act
because such business entity has exceeded certain maximum thresholds
regarding the number of equity holders and amount of assets.
Restricted Securities. Securities of a company acquired directly or
indirectly from the company in a transaction or chain of transactions not
involving any public offering. Restricted securities may only be resold in
the public markets by way of a registered offering or exemption pursuant
to the Securities Act. See also Rule 144.
Risk Factors. The portion of a registration statement that sets forth the
principal risks faced by the company and other factors that make the purchase of stock in the offering speculative or high risk.
Road Show. The presentations made by the executive management of
the company, during a public offering, in one-on-one or group presentations, to prospective purchasers of securities in the public offering,
typically institutional investors. The road show for an IPO typically lasts
from one to three weeks.
Rule 144. An SEC rule that provides a safe harbor that sets forth the
conditions whereby a holder of unregistered securities may make a sale in
the aftermarket without registration under the Securities Act. Rule 144
requires that no security purchased through a private placement may be
sold for at least one year after the date of purchase. Thereafter, securities

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The Initial Public Offering

A Guidebook for Executives and Boards of Directors

may be sold in brokers transactions subject to certain volume limitations

and other requirements. The restrictions of Rule 144 for non-affiliates of the
company lapse after the securities have been held for two years after the
date of purchase. Stockholders making resales of unregistered securities
without complying with the Rule 144 requirements bear a high burden of
proof in establishing compliance with the federal securities laws.
Rule 701. Rule 701 under the Securities Act sets forth the conditions
whereby a holder of unregistered securities received pursuant to a written
compensatory benefit plans may resell such securities in the public
markets without registration under the Securities Act. In some cases,
Rule 701 may allow resale prior to the date that would otherwise be
allowed under Rule 144.
Sarbanes-Oxley Act of 2002. An Act that made a number of significant changes to federal regulation of public company corporate
governance and reporting obligations.
Schedule 13D. See Section 13.
Schedule 13G. See Section 13.
SEC. See Securities and Exchange Commission.
SEC No-action Letter. A letter that is issued by the SEC stipulating
that it does not object to a course of action proposed by a registrant. If the
staff of the SEC issues such a letter, it generally confirms in the letter that
it will not recommend that the SEC take enforcement action relating to the
proposed action. Also, the SEC generally states specifically that the positions discussed in the letter are based on the specific facts and
circumstances set forth in the request from the registrant, and that any different facts or circumstances may require a different conclusion.
Secondary Offering. The portion of a registered offering being offered
and sold by selling stockholders.
Section 13. Section 13 of the Exchange Act, which requires that any
holder of more than 5% of any class of registered equity securities report
such ownership on a Schedule 13D or Schedule 13G.
Section 16. Section 16 of the Exchange Act, which requires the periodic
disclosure of equity ownership (and changes in ownership) of Section 16
insiders. Section 16 also requires the disgorgement of any profits (shortswing profits) realized by Section 16 insiders from the purchase and sale,

G-16

Glossary

or sale and purchase, of equity securities of the company in any 6-month

period. See also Form 3, Form 4, Form 5, Section 16 Insider and Short Swing
Profits.
Section 16 Insider. Any executive officer, director or beneficial owner of
greater than 10% of a class of registered equity securities. See also Form 3,
Form 4, Form 5, Section 16 and Short Swing Profits.
Securities Act. The Securities Act of 1933, as amended, which is the
federal statute prohibiting the offer or sale of a security (except certain
exempt securities or in certain exempt transactions) unless the security
has been registered with the SEC, and imposing prospectus delivery
requirements. The Securities Act also contains antifraud provisions prohibiting false representations and disclosures. Enforcement responsibilities
were assigned to the Securities and Exchange Commission by the Exchange Act.
Securities and Exchange Commission (SEC). The federal agency
created by the Exchange Act to administer the Exchange Act and the Securities Act. The statutes administered by the SEC are designed to promote full
public disclosure and protect the investing public against fraudulent and
manipulative practices in the securities markets
Securities Exchange Act. The Securities Exchange Act of 1934, as
amended, which is the federal statute regulating reporting obligations of
reporting companies, tender offers, certain trading practices and insider
trading. It created the Securities and Exchange Commission to enforce both
the Securities Act and the Exchange Act and requires that public companies
enter its continuous disclosure system and file annual and quarterly
reports and proxy statements with the SEC. The Exchange Act also establishes a self-regulatory system for the supervision of the trading markets
and gives the SEC oversight jurisdiction over stock exchanges and the
NASD.
Self-Regulatory Organization (SRO). A non-government organization that has statutory responsibility to regulate its own members through
the adoption and enforcement of rules of conduct for fair, ethical and efficient practices. Examples include the NASD and the national securities
and commodities exchanges (for example, the NYSE).
Selling Group. A group of dealers and underwriters selected by the
managing underwriters, as the agent for the other underwriters, to market
shares in a public offering.

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A Guidebook for Executives and Boards of Directors

Selling Stockholder. A stockholder of a company that is selling shares

in a registered public offering. See also Secondary Offering.
Short-Swing Profits. Profits realized from the purchase and sale, or
sale and purchase, of an equity security of a reporting company by a
Section 16 insider in any 6-month period. Section 16 of the Exchange Act
requires the disgorgement of short-swing profits realized by such
persons.
Small Business Issuer. A U.S. or Canadian issuer having annual revenues and a public float of less than $25 million. Small business issuers
qualify for simplified disclosure requirements under certain circumstances. See also Regulation S-B, Form SB-1 and Form SB-2.
Standard Industrial Classification (SIC). Code used to classify entities by the type of economic activities in which they are engaged.
Stock Split. An increase or decrease in the total number of outstanding shares of capital stock. An increase in the total number of outstanding
shares is called a forward split, and a decrease is called a reverse split.
For example, a 2-for-1 stock split would double the total number of outstanding shares of capital stock of a company; each stockholder would be
entitled to two shares for each one share he or she owns. A 1-for-3 reverse
stock split would reduce the total number of outstanding shares of
capital stock of a company to one-third of that total number; every three
shares of stock held by a stockholder would become one share after the
reverse split. Stock splits are effected in two ways: (1) as a stock dividend
or (2) as a stock split whereby the certificate of incorporation is amended.
A stock dividend is the payment of additional shares to existing holders
and can only be used to effect a forward split. A stock dividend can often
be effected by resolution of the board of directors, and without the need
for stockholder approval. A stock split is the division or combination of
existing shares into new shares and requires both the resolution of the
company's board of directors and the filing of an amended certificate of
incorporation (which typically requires stockholder approvals).
Syndicate. A group of underwriters selected by the managing underwriters to market and sell shares in a registered public offering.
Ticker Symbol. A three or four letter abbreviation used to identify a
security whether on the floor, a TV screen, or a newspaper page. Ticker
symbols are part of the lore of Wall Street and were originally developed
in the 1800s by telegraph operators to save bandwidth. One-letter symbols

G-18

Glossary

were therefore assigned to the most active stocks. Railroads were the
dominant issues at the time, so they retain a majority of the one-letter designations. Ticker symbols today are assigned on a first-come, first-served
basis. Each marketplace the NYSE, the Amex, NASDAQ and others
allocates symbols for companies within its purview, working closely to
avoid duplication. A symbol used for one company cannot be used for any
other, even in a different marketplace.
Transfer Agent. A Transfer Agent keeps a record of the name of each
registered stockholder, his or her address and the number of shares
owned, and ensures that the certificates presented for transfer are properly cancelled and that new certificates issued in the name of the new
owner.
Underwriter. An investment bank that offers or sells securities to
investors in a public offering on behalf of the company in either a firm commitment underwriting (which is most typical) or a best efforts offering. The
Securities Act defines underwriter much more broadly, so as to encompass
many other participants in a distribution of securities.
Underwriting Agreement. In a registered offering, the principal agreement between the company and the underwriters stating the relationship
between the parties. The underwriting agreement contains an agreement
to sell and buy the offered shares, the underwriting discount and commission,
representations and warranties of the parties, certain covenants, expense
allocation and indemnification provisions.
Underwriting Discount and Commission. A percentage of the gross
proceeds of an initial public offering that constitutes the compensation paid
to the underwriters for marketing and selling the offering.
Waiting Period. The period of time between the filing of the registration statement and the effective date.
Working Group. Consists of key company executives and employees,
the companys board of directors, the managing underwriters, the companys counsel, the underwriters counsel, the companys auditors, the
financial printer and other parties. Members of the working group have
various responsibilities in connection with preparing the registration statement, including the prospectus, and marketing and selling the companys
stock to investors.

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(http://www.wsgr.com)

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6/10/04

11:21 AM

Page 1

THE INITIAL PUBLIC OFFERING Second Edition

SecuritiesConnect
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WILSON SONSINI GOODRICH & ROSATI

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008485 IPO Handbook cvr

THE INITIAL
PUBLIC OFFERING
A Guidebook for Executives and
Boards of Directors
Second Edition
>

PATRICK J. SCHULTHEIS
CHRISTIAN E. MONTEGUT
ROBERT G. OCONNOR
SHAWN J. LINDQUIST
J. RANDALL LEWIS
WILSON SONSINI GOODRICH & ROSATI, PROFESSIONAL CORPORATION