In four previous columns I discussed the pros and cons of tech (and other) companies "going public" (essentially, becoming companies that sell their shares into the public market, by having their stock trade on a stock exchange), and the exercise of becoming a public company (focussing largely on the importance of the prospectus document, as a means of informing the investing public about your company). Clearly, the importance of the prospectus cannot be over stated, as it is the primary tool by which investors come to initially learn about your business.
Once you are a public company, the disclosure does not end – indeed it is on-going and quite rigorous. First of all, like clockwork, you have to publish your unaudited quarterly financial statements within 45 days after the end of each of your fiscal quarters, and your audited annual financial statements within 90 days after the end of your fiscal year. Woe betide you if you are late in getting out these financial statements. Investors will lose confidence in your organization very quickly if your regular financial "report card" is not promptly forthcoming when it should be, not to mention that you will be required to pay late filing fees to the securities regulators and potentially be subject to a cease trade order.
In your financial statements one figure will be of particular interest – your earnings. With some tech companies other metrics can be important, at least for a time, such as subscriber growth (or loss) for mobile communications operators. But ultimately, earnings rule, and many a public tech company stock has been punished because earnings were below the market’s expectations.
To Forecast or Not to Forecast
How the market’s expectations about your earnings are set comprises a fascinating exercise in collective soothsaying. Different analysts at the various brokerage houses opine periodically on your company’s immediate past performance, current situation, and most importantly, short and medium term prospects. Then a financial information firm aggregates all these analysts predictions into one composite expectation for your next quarterly results.
Some tech companies (especially smaller US tech companies listed on the NASDAQ exchange south of the border) add fuel to this interesting fire by periodically giving guidance about their own future earnings. This is dangerous activity, and fraught with risk. It requires being ever vigilant about market conditions, and at the earliest signs of softening (or even increasing) sales, announcing further earnings guidance to recalibrate downward (or upward) the previous forecast. If the result is a sell off of your stock, it is not uncommon for the class action lawsuit to follow, alleging on behalf of those who bought your shares just before your latest announcement that had you given the guidance earlier these investors could have avoided losses.
Of course this is an invidious situation for your company, because there will always be a group of investors who purchased your stock before your revised earnings guidance. So, why give earnings guidance at all? Why not just stick to publishing your quarterly and annual financials after the fact, and let the market make its own decisions based on actual results, rather than on predictions about the future?
This is indeed sound advice, and many Canadian tech companies follow it. Those, however, that have their shares listed on the NASDAQ in the US (in addition to the TSX here in Canada) often feel compelled to give earnings guidance because their American counterparts do as well. And these smaller American tech companies seemingly have to give earnings guidance because in the large US investment market they often have difficulty getting analyst coverage if they do not.
Bottom line – public Canadian tech companies would do well to avoid giving earnings estimates. Especially if you are in a particularly volatile space like semiconductor products, where quarterly swings in revenues, and therefore earnings, can be quite pronounced. On the other hand, a software company with a substantial installed base of customers from which it draws a steady and fairly predictable recurring maintenance revenue stream can more easily predict earnings quarter to quarter – nevertheless, even they should avoid the exercise, particularly in Ontario where since January, 2006 we have a stricter legal regime for dealing with material misstatements (or material omissions) by companies and their officers.
Disclosing Material Changes
That is not to say Canadian public tech companies need only disclose quarterly financial results. Far from it. Indeed, every material fact relating to your company and every material change experienced by your company needs to be reported promptly. Hence the practice, for example, of issuing a press release whenever you sign an agreement to acquire another tech company (M&A activity being very common in the tech space).
Indeed, in a recent decision, the Ontario Securities Commission indicated that such a press release (and related material change report) may be required even before the signing of the definitive purchase agreement. For example, in certain circumstances, the disclosure may be required at the stage a non-binding letter of intent is executed between the parties if the parties are committed to proceed with a transaction (as evidenced by their actions) and there is a substantial likelihood that the transaction being discussed will be completed.
As a result of this OSC decision, it is important to record, on an on-going basis, what material issues remain outstanding among the parties in the period leading up to the execution of the definitive agreement, and in particular, whether final senior management and/or board approval has been given by either side. In all likelihood, the widespread practice of only announcing publicly a deal when the definitive merger agreement is signed will continue, but parties will have to remain vigilant for exceptions to this rule.
Moreover, if you are acquiring a large company relative to your own size, then you also have to file a "business acquisition report" within 75 days of closing the deal. This report will generally require you to attach audited financial statements for the target for its last two years, as well as pro forma financial statements of your company which give effect to the acquisition. While often this is not a problem (where the target was a stand alone business and has audited financials), it can be more of a challenge where the target is actually a division of a larger company, and therefore doesn’t have stand-alone audited financial statements. In such a case, you need to address this issue in your purchase agreement for the target.
Disclosing Material Contracts
In addition to disclosing material changes, under a very recent (March 17, 2008) securities law rule change, public tech (and other) companies also have to disclose certain material contracts even when entered into in the ordinary course of business. Most material contracts entered into in the ordinary course of business do not have to be disclosed, but the following types of contracts (in addition to a couple of others) do have to be disclosed:
- a continuing contract to sell the majority of the company’s products or services;
- a license agreement to use a patent, formula, trade secret, process or trade name;
- certain financing agreements;
- a contract on which the company’s business is substantially dependent
It is possible to redact certain provisions of such publicly filed agreements to comply with confidentiality undertakings, or if failure to do so would be seriously prejudicial to the interests of the company. However, you cannot black out provisions relating to: debt covenants and ratios in financing or credit agreements; events of default or other terms relating to the termination of material contracts; and other terms necessary for understanding the impact of the material contract on the business of your company.
You cannot avoid the application of the material contract disclosure regime merely by putting some provision in a "side letter". The rules are quite clear on this, and stipulate that a material contract generally includes a "schedule, side letter or exhibit referred to in the material contract".
The above discussion does not cover all the areas of on-going disclosure for your public tech company. For example, in the context of your annual meeting, you will have to prepare meeting circulars, an annual information form, and a "management discussion and analysis" document, to name a few. Also, while strictly speaking not obligation of your company, certain of your directors, officers and others considered "insiders" will have to report their trades in your company’s shares.
Taken together, these rules requiring extensive disclosure are important and require not insignificant resources within your company to ensure compliance with them. Which brings us full circle, to the discussion about the pros and cons of going public canvassed at the beginning of this series on the public tech company. Some tech entrepreneurs will sell their private tech company to an already public company in order to avoid the various responsibilities of being a public company; while others will find these burdens outweighed by the advantages of being a public company. Whichever way you decide, it’s important you make the decision in an informed manner. I hope this series has helped in that regard.