Companies going public in the United States have come to expect the SEC to challenge the pricing of pre‐IPO stock and options. However, until recently so‐called "cheap stock" has not been a top of mind issue for companies going public in Canada. Canadian securities regulators now appear to be cracking down on cheap stock, as signalled by the recent publication by the Canadian Securities Administrators (CSA) of CSA Staff Notice 41‐305 Share Structure Issues.
With Staff Notice 41‐305, the CSA has raised a red flag for companies that have "already issued an unusually large number of shares for nominal cash consideration (or for assets or business development where the value is not readily supportable)". Where nominal value shares have been issued, the CSA warns that securities commission staff may question whether the company's share structure is "contrary to the public interest". The CSA has stated that they are on alert for capital structures that could create a platform for market manipulation (i.e., pump and dump schemes), or that mean that IPO investors receive an "unconscionably low percentage of ownership" compared to the amount of capital they are investing. In certain situations, CSA staff may recommend against receipting the IPO prospectus, effectively barring the IPO.
Interestingly, the CSA has not published quantitative measures that would provide certainty on the acceptability of a given capital structure. Instead, the CSA's position is that it has broad wiggle room to consider many qualitative and quantitative factors. According to Staff Notice 41‐305, factors that CSA staff will consider include the following:
- whether the IPO price "significantly exceeds" the average price paid by the founders;
- whether IPO purchasers are being invited to contribute an amount of capital that is "significantly disproportionate" to their equity interest on the completion of the offering;
- time, effort or resources expended by the founders on the development of the business;
- whether traditional valuation techniques or third party valuations support the capital structure; and
- whether the founders have invested cash and how long that cash has been actively used in the business.
Generally, "founders" means anyone who is a director, officer, promoter or insider (10% shareholder) of the company. Arm's length investors such as venture capital funds may be insiders and therefore qualify as "founders". VCs should be alert to the possibility that pre‐IPO down rounds and recapitalizations may in theory result in a cheap stock issues.
Companies that have a limited operating history and/or are planning a small IPO financing may encounter extra scrutiny. Options and warrants may be included in the cheap stock analysis, if strike prices are below the expected IPO price.
Our take‐away from Staff Notice 41‐305 is that companies planning an IPO need to be prepared to justify the pricing of pre‐IPO stock and options, and may for example want to consider obtaining third party valuations for new issuances if an IPO is imminent.