The Road to IPO: Preparing Essential Documents

Several pieces of documentation need to be completed, and submitted to the relevant offices where necessary, as part of a private company’s journey to going public.

Initially, the focus will be on documents related to agreeing terms with an underwriter, while submitting pre-IPO information to the Securities and Exchange Commission (SEC) is also an important part of the process.

Among the required documents are:

1. Engagement Letter
2. Letter of Intent
3. Underwriting Agreement
4. Registration Statement
5. Red Herring Document

Let’s examine the likely contents of each document in turn.

Engagement Letter

This letter will be written by the underwriter the company wants to work with during the IPO, and generally includes two key pieces of information related to financial compensation: the reimbursement clause and the gross spread.

The reimbursement clause sets out that the company must cover any out-of-pocket costs incurred by the underwriter during the process, even if the IPO is withdrawn at some point, whether early on or at a later stage.

Gross spread refers to the underwriting discount. More specifically, we mean the discount the issuing company grants to the underwriter when the latter purchases securities earmarked for sale to the investing public. In other words, gross spread is the difference between the purchase price and sale price of the securities underwriters sell during the IPO. The discount usually equates to 4 to 7% of the eventual sale price and can translate into a significant source of income for underwriters.

In the event of the company working with a syndicate of underwriters, the “lead” underwriter tends to receive 20% of the gross spread, with 60% divvyed up between other syndicate members, and the remaining 20% earmarked for covering costs associated with the underwriting process, e.g., roadshow expenses.

Letter of Intent

The Letter of Intent is drafted and agreed upon by both parties – the issuing company and the underwriter – and summarizes their shared preliminary understanding of the deal that is being proposed.

In this document:

• The underwriter commits to enter an underwriting agreement with the issuing company.
• The company gives an undertaking that it will provide the underwriter with all necessary information and to offer full assistance in all IPO-related due diligence efforts.
• The potential size of the transaction will be provided. Most likely, it won’t be feasible to offer a precise figure at the time this letter is drafted, but it should be possible to include valuation ranges of stock to be sold and a ballpark figure for the capital likely to be raised.
• It is also common to include a pledge from the company around what is referred to as an overallotment option. This gives the underwriter the leeway to sell additional stock beyond whatever level is ultimately agreed. Typically, the overallotment is set at 15%. The logic here is that having this latitude allows underwriters to react to demand among investors. So, if demand is high and stock is trading above the offering price, the underwriter will have the ability to release additional stock for sale, with a view towards making the most of the higher than anticipated level of interest.

This document effectively governs the relationship between company and underwriter during the period before a final price for the offering is decided. Once that price is set, the formal Underwriting Agreement supersedes the Letter of Intent as the key document between the parties.

Underwriting Agreement

An Underwriting Agreement is a formal contract entered into between the company going public and the underwriter/team of underwriters bringing their know-how and contacts to the transaction. One of the key purposes of the agreement is to ensure that all parties are clear on their role and responsibilities, with this, in theory, reducing the potential for conflict.

In terms of the journey timeline, this document does not come into force until after the IPO has been approved by the SEC and an “effective date” set, i.e., the date on which company stock can first be traded on the stock exchange. On the day before the effective date, the company and underwriter make a definitive decision on the agreed-upon price, the initial resale price, the amount of stock to be sold, and the settlement date. So, while the agreement itself will be finalized well before this point – typically, before the roadshow – it will only be executed at the pricing stage.

Once the price is confirmed, the Underwriting Agreement becomes the pre-eminent document governing the relationship between the parties. For the underwriter, this means they are obliged to purchase the issue from the company at the agreed price. Depending upon the size of the transaction, this could mean that several different financial institutions may have agreed to underwrite specific amounts of shares, with the combined total amounting to the full issue, i.e., X million shares spread among multiple institutions, who then look to sell whatever their percentage of the overall number may be.

It is not unusual for some information on the agreement to appear in the Letter of Intent, but until the Underwriting Agreement is triggered, those details are not “locked in”. One such key detail is the precise form of underwriting arrangement to be pursued. The two most common arrangements are firm commitment and best efforts.

With a firm commitment, the underwriter pledges to purchase the entire stock issue from the company. Here, the issuing company knows from the outset exactly how much money it will raise arising from the IPO, while it then falls to the underwriter to look to sell that stock to prospective investors.

Alternatively, under a best efforts agreement, the company will receive no guarantee from the underwriter on how much capital will be raised from the issue. With this arrangement, the underwriter simply looks to sell the stock on behalf of the company, as opposed to buying that stock first. Whatever stock is not sold in this scenario will ultimately be returned to the issuer.

It is worth noting that the vast majority of IPOs are conducted via firm commitment, with best efforts most common when the flotation is deemed to be particularly risky.

Registration Statement:

Form S-1 Registration Statement Under the Securities Act of 1933 – more commonly referred to simply as the Registration Statement – is the mechanism through which a private company formally asks permission to become a publicly-traded entity.

The statement consists of two parts, with part one focusing on the IPO prospectus and part two dealing with additional relevant information, with the completed document to be filed with the SEC.

The information required on the IPO prospectus element includes the company’s business plan, the nature of the competitive landscape in their industry, company financial statements, executive compensation, background information on management, what they plan to do with capital raised through the offering, and also an acknowledgement of what risk factors may be present. As well as that, the SEC also requires details on the issue price, the number of shares set to be sold, and how many shares are being sold by individual shareholders.

Part two of the form relates to private information required by the SEC, but which will not necessarily be made public, including, for example, the indemnification of directors and officers and recent sales of unregistered securities.

The purpose of the exercise is to ensure that investors have access to necessary detailed and reliable information about the company in question and what is being proposed. With that in mind, it is important to recognize that this is a formal legal document, therefore the issuing company will be made liable in the event of any material misrepresentations or omissions being detected.

Once the statement has been filed, the SEC will then perform due diligence to ensure that all required information has been disclosed in the submission.

Red Herring Prospectus:

However, important as the document is, it will not be possible to file a complete Registration Statement early in the IPO process. Why? Because the company and the underwriter will not finalize plans on the price of the issue or the number of shares to be offered until quite late in the day, so this information cannot be included in the initial Form S-1 submission.

Instead, this preliminary submission tends to be referred to as a Red Herring Prospectus, in reference to the cover page disclaimer, formatted in bold red text, flagging that some of the information provided has not yet been finalized.

In practical terms, the Red Herring Prospectus contains much of the information that will be in the final submission, minus the details mentioned above (issue price and number of shares), and, crucially, assists the company and underwriter in the process of marketing the flotation to potential investors. To cut a long story short, it is this marketing process that will give the company and underwriter an indication of the level of investor interest, which will in turn inform the final decision-making process on issue price and number of shares to be sold, and once that information is on hand, then the definitive draft of the Registration Statement can be submitted to the SEC.

The IPO process can be demanding and time-consuming. The documents referred to above represent merely one strand of the obligations a company on this journey will need to meet. You don’t need to navigate this at times complicated path on your own. Contact Global Shares today to speak to our experienced personnel on all matters IPO-related.

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