Capitalization strategies… keeping your house in order
By R. Scott Tobin, Esq.
In the May issue of Modern Woodworking, we outlined the pitfalls inherent in a company’s pursuit of the “Field of IPO Dreams.” Yet, it is a fact of modern business life that notwithstanding the pitfalls of public scrutiny and ownership and the harsh realities of recent market volatility, many of our industries’ businesses will continue to operate with an eye toward eventual sale.Almost everyone in the furniture business has gone global. Thanks to the worldwide reach of the Internet, if you have a web site, you have a global business, even if you have never otherwise considered international expansion.
Toward that end, growth minded companies must strive to get their houses in order as they are being built. Don’t wait for the first wave of lawyer due-diligence to delay or deter the hoped for public investment in your companies. Because mistakes made in issuing equity securities (whether it be to family, friends, angel or venture capital investors) can be amplified as the value of a business grows, great care should be taken up front.
Watch out for percentages
To be avoided is the casual kitchen table discussions, which result in trading percentages of company ownership for the funding of operating expenses. It is far too easy in a series of such conversations to promise ten percent of a company to eleven different people. Instead, adhere to corporate formalities in issuing shares, and avoid the use of percentages in discussing or documenting equity stakes. A company always should issue a specific number of shares to reflect the internally contemplated percentages of ownership. This way companies avoid the problem of an early stage ten percent investor who claims on the way to an IPO that he owns an undilutable ten percent of a now much larger and more valuable company.
Obtain lockup agreements
There are also positive steps that can be taken upfront to minimize problems on the eve of an IPO. One such step is to obtain lockup agreements from your shareholders. Under such agreements, the shareholder agrees to refrain, at the request of company underwriters, from selling shares into public markets for a set time period (often180 days) following a public offering. Such agreements are highly valued by underwriters since they limit the sale of stock, and therefore the opportunity to depress value and public confidence in the inherently volatile months following initial public sale. By obtaining such agreements early on when they are perceived to be of little importance, you minimize the risk that minority stakeholders will refuse to sign, or if not refuse to sign, at least attempt to leverage the underwriter’s demands at company expense at the time of a public offering.
Keep control of shareholder base
Additionally, the company should strive from the beginning to maintain control over its shareholder base. This is accomplished by retaining a right of first refusal over its stock in the event of a third party purchase offer directed to any of its shareholders. This mechanism permits the company or its designees the right to buy shares on the same terms as an offering third party, if for any reason it does not wish third party participation in the company. These rights should of course be structured to terminate in the event of a public offering, which marks the voluntary surrender of the company control to the public markets. Furthermore, when companies rely upon outside private equity financing, they must temper the outside investors’ preference for senior securities, often convertible preferred stock, with the recognition that a future underwriter will insist that a company’s securities be convertible into common stock upon completion of a public offering. This insistence is grounded in the notion that the continued existence of preferred stock, which usually carries with it special control rights and privileges, will depress the willingness of public stockholders — who themselves want to control the company’s board and its daily operations — to buy a company’s stock.
Accordingly, preferred stock financing terms should include a provision for mandatory conversion of preferred stock to common upon a public offering. Alternatively, such terms should grant the company a repurchase option at an agreed upon price or formula for its determination. Employing the capitalization strategies and financing mechanisms described above should preserve and enhance corporate ability to attract private and eventual public financing. Keep in mind, however, that this discussion is not intended to be exhaustive, and may not be applicable to your company’s situation. What can be said without equivocation is that for any company with public aspirations, it is important to involve the company’s legal, tax and investment advisors in your earliest consideration of your capital structures to insure and enhance the company’s future liquidity.
Scott Tobin, a principal of Synergy Ventures, LLC, can be reached through Modern Woodworking at 336-882-0120 or 770-667-1282.
Scott Tobin, a principal of Synergy Ventures, LLC, can be reached through Modern Woodworking at 770-399-5114 or 336-882-0120
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