Boosting Exit Opportunities For Premium Payoffs “Dual Tracking” Keeps a Company’s Options Open

With the major market indices up for the year, and the rally from last year still holding, the initial public offering market is showing significant signs of recovery. But despite the healthy returns made on IPOs last year and a rosy outlook for the economy and the stock market this year, the exit mechanism for most emerging companies will still likely be a sale. One often-successful method for maximizing corporate liquidity is “dual tracking” – initiating the IPO process while simultaneously canvassing the market for sale opportunities with significant deal premiums. Dual tracking is designed to obtain the best exit opportunity possible by maximizing potential liquidity alternatives. To successfully pull off the dual tracking strategy, it’s important to retain an investment banker who has capability and depth in both capital markets and m&a. With the dual track approach, the Form S-1 Registration Statement filed with the SEC serves a dual purpose: On the offering side, it initiates the registration process under the Securities Act of 1933; on the dealmaking side, the prospectus included in the Registration Statement acts as a public, high-quality m&a offering circular. The magic of the dual track strategy is that it establishes a firm timeline for the liquidity transaction. It is widely understood that the normal timing for consummating an IPO is 45 to 75 days after the date of the initial filing of the Form S-1. This forces potential acquirers to quickly determine their level of interest and ability to move expeditiously to beat the clock on the offering. The target is in a strong position to insist on public-company metrics when establishing a valuation as opposed to private-company metrics, which typically lead to a lower valuation. In addition, the target is in an excellent position to require an acquisition agreement that contains few outs or contingencies. The target will only be derailed from the offering to the extent that the merger or acquisition opportunity is almost a certainty. Ten key points to consider in the context of preserving the ability to pursue a dual track strategy and obtaining the best liquidity transaction possible include: Limit the number of stockholders. In a pinch, entrepreneurs may be tempted to issue shares of stock to satisfy many types of company obligations such as payments to consultants or trade payables. Over time, this could result in the company having a large number of small stockholders. This creates a large drag on any liquidity transaction and could end up precluding some transactions. It’s best to have fewer than 35 stockholders at the time of a transaction. Use a stock option plan. To help control the number of stockholders and comply with applicable securities laws, use a stock option plan as incentive compensation for employees and consultants. The federal securities laws provide a convenient safe harbor for the granting of options to employees and others under a written stock option plan. Stock option plans also provide a convenient organizational mechanism to control the issuance of shares of capital stock. Protect your intellectual property. Acquirers and underwriters may not ascribe significant value to your intellectual property unless you have taken steps to protect it. You should implement a trade secret protection program that includes employee confidentiality agreements (see below), customer and vendor nondisclosure agreements, and physical and electronic security systems. Develop a patent strategy that asks employees to identify and assign patentable inventions to the company, and then file patent applications on the best inventions. Register trademarks used by the company and file copyright applications for all source code, marketing materials, and documentation. Employee agreements. Be sure all of your employees are party to an agreement providing for maintaining the confidentiality of proprietary information and assignment of inventions. As part of due diligence, most buyers and underwriters will want to establish that the company has obtained such agreements from all its employees from inception. Keep in mind that it’s far more difficult to obtain such agreements from former employees. Avoid preclusive strategic relationships. If you have a choice, avoid strategic relationships or entanglements that will preclude your alternatives upon exit. It’s important to be aware that strategic partners often push for a right of first refusal on the sale of the company. These provisions should be resisted as they often have the effect of limiting choices in the exit process – thereby depressing exit values. Pay your taxes. While this may seem obvious, many entrepreneurs have cut corners on payroll taxes and/or income taxes. Failure to pay taxes is often a difficult and time-consuming problem to fix, even if the company later has adequate resources to satisfy the delinquent obligations. Many acquirers and underwriters will walk away from a transaction rather than getting involved in a tax mess. Keep good corporate records. Keeping good corporate records allows a buyer or underwriter to quickly establish that the company’s corporate actions have been properly authorized and that the company has a handle on the identity of its stockholders. Failure to keep good corporate records may preclude using the target as an IPO platform or certain beneficial acquisition structures where the corporate form continues as a subsidiary of the buyer. Pay attention to licenses. Be certain to obtain the proper licenses for the software and technology you use in your development process and in your products and services. Review these from time to time to ensure that they continue to meet your needs. When licensing products to customers, make sure you are using state-of-the-art license agreements that limit liability and reflect the latest developments in the law. Financial statements. Underwriters and acquirers require audited historical financial statements. Given the current emphasis on corporate governance, this requirement will likely become even more stringent in the future. This means that emerging companies should have at least reviewed financial statements so these can be easily converted into audited financial statements in short order. Brace yourself! Dual tracking is a challenge for managers. It’s nearly a full time job for a management team to manage an IPO as a unitary liquidity strategy, and the dual track strategy requires the same people to be simultaneously involved in marketing the company to potential buyers. The dual track approach also can create tremendous uncertainty for the management team because the anticipated destiny of the company may change – going public versus being acquired – on a weekly or even daily basis. The team needs to be prepared for the potential emotional ups and downs that often result from pursuing the dual track strategy. But by creating choices, dual tracking likely will result in the best possible exit opportunity for the company and its shareholders. Lawrence Yanowitch is a Partner at Shaw Pittman LLP who focuses his practice on emerging companies at every stage of development and m&a. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com