The Challenges of Going Public
(As originally published in the Director Journal, June 2012)
By Bill Demers, Partner and Canadian IPO Leader, EY
Given the economic uncertainty prevailing in global stock markets, many companies are delaying their decision to go public.With a large wave of initial public offerings (IPOs)anticipated once the market stabilizes, savvy directors are asking: “What are the most important things I need to consider as we make the transition from a private to a public company?”
Carefully planned and executed, an IPO can be a valuable step in raising capital and driving expansion.But successfully managing the transition from private to public can be a significant challenge, requiring strategic acumen that’s not always found within the management teams of what have previously been thriving startups. To ensure that the directors of private companies understand the pros and cons of going public, we convened a panel of three IPO experts to explore the most commonly asked questions about this transformational opportunity.
As the following primer shows, they agreed that directors can play a hugely important role as agents of transformation, successfully guiding companies at this exciting time of growth. But there are critically important factors to consider long before the IPO reaches the market.
Our three experts:
David Fabian, Partner and Co-leader, private mid-market
practice (GTA), Ernst & Young LLP;
Lawrence Wilder, Partner, Corporate Securities, Cassels
Brock & Blackwell LLP;
Eric W. Slavens, FCA, ICD.D, corporate director
and chair of the Audit Committee of Altus Group Ltd.,
Titanium Corporation Inc., TransGlobe Apartment REIT
and NexGen Financial Corp., and Lead Director and Chair
of AC, The Effort Trust Company.
Bill: What is the difference between a director of a private company and that of a public one?
David: As a business grows and changes, so does the nature of its board. In the early stages as a private company, entrepreneurs seek out people who can contribute startup funds and expertise to the new enterprise. These directors act as an advisory board which may evolve over time, and may include founders, venture capitalists, managers, or even customers. While an important resource for managers, private directors are not legally accountable for the performance of the firm, do not generally have direct managerial oversight, and have no independence requirements.
Lawrence: Later, as the business grows and funding is needed to drive the next stage of growth, private businesses seek out venture capitalists and investors to become part owners in the business. Once the company goes public, the nature of board involvement changes dramatically. According to the provision of TO SC National Policy 58-201 (Corporate Governance Guidelines), “The majority of the directors must be independent from the company, and must be financially literate.” After all, public directors are legally accountable for overseeing management, CEO performance, budgets and compensation. Also, a public board is expected to establish a minimum of three independent committees:
Eric: Directors on a public board do not execute, but they do ask a lot of questions. Think of it as a “noses in, fingers out”’ approach; it is an immensely important part of their responsibilities. They also help guide the strategic direction of the business, shaping and approving the corporate philosophy and mission. Finally, a significant distinction from private boards is a greater emphasis on the role of a public director in hiring – and sometimes firing – the CEO.
Bill: How important is having an appropriate board of directors for companies looking to go public?
David: With so many companies competing for the attention of institutional investors, an appropriate board is an important signal to the investment community that the company is positioned for successful growth over the long term. This is more important than ever, as we see the nature of corporate governance evolving, and growing demand for transparency and risk management in the wake of the recent financial crises.
What does “appropriate” mean? Among other factors, investors want to see that the board is of an appropriate size based on the company’s stage of growth. Also, directors need to be capable of not only monitoring corporate performance against business and financial plans, but also successfully representing shareholders’ interests.
Eric: A good board features directors who bring a wide range of perspectives and experience to the table, and a demonstrable commitment to fostering a culture of ethical behaviour. It’s also normal to seek directors with public-company experience who can add profile to the company and to seek directors with strong industry knowledge and contacts. Above all, you’re looking for people with the right mix of strategic expertise and leadership to oversee management and ask the hard questions. These are the kinds of factors the market will evaluate carefully when it comes time to go public.
Bill: How do directors improve a company’s effectiveness?
Eric: Directors’ fiduciary responsibilities are to shareholders, not to management. This independence enables them to challenge management on business decisions and corporate strategy. Plus, they bring an external focus, as well as new skills, knowledge and background relevant to the growing business and the industry within which it operates.
Lawrence: Directors are most effective when they bring broad-based industry or public-company expertise to the job. For example, directors are most effective when they employ their expertise to evaluate executive remuneration plans, assist senior management assessing risk, and executing the business plan in the context of the industry-wide competitive and economic environment. As the business evolves from a private venture into a larger public entity, directors serve to keep management focused on strategy and challenge them to develop as executives alongside the company.
Bill: To what extent are directors involved in the management of a public company?
Lawrence: When companies are private, the CEO and directors generally have a very open relationship, in which directors often become involved in day-today matters. Sometimes, during the early growth of a company, directors may assume a management role as well.
David: Once a company becomes public, the relationship becomes more formal and structured. Management now reports to the board rather than using it solely as a source of funding or advice. Directors must remain completely independent, and they assume strategic oversight without becoming directly involved in the day-to-day.
Eric: Exactly. Directors have to know enough about the business to effectively evaluate and guide the strategic vision and management performance, asking tough
questions, but not getting into the actual operations.
Bill: What are the liabilities that directors may face, particularly in the mid-size sector?
David: When a company is private, there is little personal liability for directors, who act primarily in an advisory capacity and for whom the line between their role and that of executives is often blurred. Once a company is public, however, scrutiny increases, and directors suddenly face some very real liability scenarios.
Lawrence: There are many statutes, both provincial and federal, that impose these personal liabilities on directors. For example, depending on the province or jurisdiction,directors may have significant personal exposure in several areas: paying dividends to shareholders or redeeming shares in the case of insolvency, failure to pay employee wages or to remit GST or provincial sales taxes.
David: Directors also are personally accountable for complying with disclosure requirements. These requirements of the Canadian Securities Administrators (CSA) also mandate a definitive line between the scope of directors’ duties and those of the executive management. Remember that public directors are also liable for oversight of the work done by outside firms,such as management-compensation specialists, proxy advisors and other consultants.
Eric: There’s also what’s called fiduciary duty, or “Duty of Care.” This is a statutory duty to act “honestly and in good faith with a view to the best interests of the corporation.” These obligations are very broad and need to be carefully considered before accepting a public company directorship, as there may be conflict-of-interest implications if the director’s interests conflict with those of the corporation. It’s important to remember that directors will not be held responsible for mere mistakes made honestly. However, a director can be held responsible where he or she did not exercise due care in making his or her decisions.
Bill: What are some of the other risks of being a director of a public company?
David: We’ve covered some of the personal liabilities, but there’s more than that. There is a potential risk to one’s reputation if the business performs poorly or fails entirely. And there’s the responsibility of overseeing executive management and compensation – knowing when to stay out and when to step in. Lawrence: There’s also the potential reputational risk associated with being a director of a public issuer that does not satisfy its disclosure requirements.
Eric: Between the liability issues and reputational risks, it’s important that IPO planning include a rigorous process for educating any directors making the transition from the private board to the public board, and that all directors and officers have appropriate liability insurance in place. It’s also important to ensure key contracts are clearly disclosed in the prospectus. Directors may require third-party consents to disclose the existence of such contracts and they should ensure that those permissions are in place well in advance of the IPO. Ensuring that everything is in place to enable directors to meet regulatory requirements is essential to ensuring a smooth IPO and to protecting future directors against liability and reputational impact.
Bill: Should directors be able to buy shares in businesses where they currently sit on the board?
David: The purpose of a public board is to remain independent and protect the interests of all shareholders. That means, other than directors’ fees, a director cannot receive money from the business. That said, investing in the organization can be seen as a vote of confidence, and actions taken as director could be interpreted to be supporting one’s investment.
Lawrence: I agree, but active trading by board members in securities of issuers on which they serve as board members is often problematic. Firstly, as an insider any changes in beneficial ownership must be promptly disclosed, and secondly, a director must always be mindful of the issuer’s blackout policy, which imposes “no trading” or “blackout” periods several times a year where there may be material undisclosed information pertaining to the issuer that would restrict trading. The best policy for board members to follow is to check in with the chief compliance officer before trading. Before joining a board, a potential director has to determine what’s more important: serving as a director, or being able to actively trade shares. If it’s the latter, then it’s often best not to join the board. Another way of dealing with this issue is to have a pre-arranged trading program in place with a broker that provides for automatic sales/purchases at pre-determined times during the course of the year.
Bill: What are the risks and opportunities of going public?
Lawrence: An IPO can be a useful tool for funding growth and utilizing relatively low-cost capital. Accessing public capital allows companies to fund acquisitions either through cash or the use of publicly traded shares as “currency.” Completing an IPO usually raises public profile and credibility in the marketplace with customers and suppliers, and also allows for increased employee equity ownership, which may be used to attract the best talent.
David: True, but going public is not for everyone. The potential pitfalls are numerous and the stakes are high. Companies – and directors – should think carefully about their business fundamentals before embarking on the costly and time-consuming IPO process. Once a company goes public, management usually has less flexibility. The process may also cost management controlling interest, something founding shareholders in particular can find hard to accept. And as we’ve mentioned, there are often cumbersome reporting and disclosure requirements, which sometimes require revealing competitive information. Directors and officers are now responsible to multiple shareholders and regulatory bodies, and there are the personal liability issues, too. All of these factors place new constraints on the time and decision-making ability of directors and management.
Lawrence: Don’t underestimate the time that must be spent on investor relations. Public shareholders who are the new stakeholders in the business represent a new constituency that requires constant attention and must be kept informed through accurate, disciplined disclosure and regular communications with the investment community. Savvy companies will be sure to have their communications strategy in place and well resourced with outside professional expertise or a senior officer experienced in the area who shall serve as the spokesperson for the company. Becoming public exposes the management and directors to increased scrutiny, and directors must always be mindful of how what they are doing would look on the front page of the newspaper. Management and the board must always be mindful of the maxim, “under-promise and over-perform,” when disclosing information regarding future expectations.
Eric: But it’s not all bad news. An IPO can be an excellent avenue for securing the financial viability of the business and, for an entrepreneur, it can be the next step in growing their business. It might even be a successful exit strategy, allowing them to move on to their next big idea. Our panel of IPO experts shared these final recommendations for those considering going public:The IPO transformation is a multi-phased process which takes anywhere from 18 to 24 months to plan. Firms considering an IPO within the next two years should immediately begin board discussions to ensure the right directors are in place to make the transition successfully. Meanwhile, directors should encourage their firms to approach it as a transformational process rather than just a financing event, and work to anticipate and address future investors’ concerns. While markets will continue to evolve, those companies that are fully prepared for these changes will be most successful at leveraging the windows of IPO opportunity, whenever they open. Directors have a critical role to play in helping companies be prepared for this exciting stage of growth.
Bill Demers, FCA , is Partner and Canadian IPO Leader, Ernst & Young LLP. He has worked extensively in assurance and advisory roles over the past 31 years, and has advised a number of companies through the IPO process. Bill has served on a number of non-profit boards, including the Burlington Art Centre. This article is adapted from a live webinar conducted by the ICD and EY on June 4, 2012: Going Public? What directors need to consider before an IPO.