With the reopening of the capital markets to equity IPOs over the past several months, there have been an increasing number of IPO filings for private-equity backed issuers. Portfolio companies considering an IPO need to address a number of organizational and governance issues in connection with preparing for a potential IPO.
The sponsor should consider the need for an internal reorganization prior to filing the IPO registration statement, since in some cases there may be legal, tax, accounting or securities law reasons to take actions before filing the initial S-1 registration statement, before commencement of the road show, before the effective date of the registration statement and/or before closing. Sometimes, a new holding company will be created or various entities in the family merged or reorganized in contemplation of the IPO, in which case consents may be required under existing credit and other agreements. A subsidiary of the new public company may already file reports with the SEC as a result of a prior debt financing, in which case, subject to any contractual limitations, the public company can issue a guarantee and eliminate the subsidiary’s separate reporting requirements.
Board of Directors and Committees
While many of the NYSE and Nasdaq rules relating to Board and Committee composition do not apply to “controlled” companies, the composition of the Board will likely need to change in connection with the IPO. A company generally qualifies as a “controlled” company so long as the sponsor (or a group of sponsors) holds more than 50% of the voting power.
NYSE and Nasdaq rules both require that a listed company have a majority of independent directors unless it is a controlled company. Even if the company is controlled, however, SEC rules relating to the composition of a listed company’s Audit Committee (which must have at least three members) require that the Audit Committee include at least one independent director at the time of the IPO, at least two independent directors within 90 days of the IPO and at least three independent directors by the first anniversary of the IPO.
Under NYSE rules, an individual is “independent” if the Board concludes that he or she does not have any material relationship with the issuer (directly or as a partner, stockholder or officer of an organization that has a relationship with the company). For Nasdaq-listed companies, the individual must have no relationship which, in the opinion of the Board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. In addition, the director must satisfy a number of additional tests. While affiliation with a controlling stockholder would not, in itself, disqualify an individual from being considered independent, certain financial and other arrangements between the sponsor and the portfolio company (such as the payment of management fees) in the period prior to the IPO may disqualify such a person from serving as an independent director. In addition, SEC rules governing Audit Committee independence prohibit affiliates from serving on the Audit Committee and, as a result, senior officers of the sponsor will generally not be considered independent directors for purposes of the Audit Committee rules.
Audit Committee Financial Experts
Each member of the Audit Committee must be financially literate or become so within a reasonable period of time (NYSE), or must be able to read and understand fundamental financial statements (Nasdaq). In addition, at least one Audit Committee member must be an “Audit Committee financial expert” at the time of the IPO, which requires that the member (1) understand GAAP and financial statements, (2) be able to assess the application of GAAP to accounting for estimates, accruals and reserves, (3) have experience preparing, auditing, analyzing or evaluating financial statements (or experience supervising persons engaged in such activities), (4) understand internal controls, and (5) understand Audit Committee functions. In addition, an Audit Committee financial expert must have (a) education as a CFO, CAO, controller, accountant or auditor, (b) experience actively supervising a CFO, CAO, controller, accountant or auditor, (c) experience overseeing or assessing the performance of companies or accountants with respect to the preparation, auditing or evaluation of financial statements, or (d) other relevant experience. While an individual associated with the sponsor may, subject to the SEC’s Audit Committee independence requirements, serve on the Audit Committee and qualify as an Audit Committee financial expert, the increased potential liability associated with serving on the Audit Committee may make it preferable to select unaffiliated Audit Committee members (and, in any event, to select a non-sponsor director as the Audit Committee financial expert). Indeed, many sponsors, as a policy matter, prohibit their investment professionals from serving on Audit Committees.
Compensation Committee, Rule 16b-3 and IRC §162(m)
A controlled company does not need to have a Compensation Committee and, if it does have one, there are no requirements relating to its composition. However, if the issuer will not be a controlled company, then, subject to post-IPO transition rules, NYSE rules require that there be a Compensation Committee consisting solely of independent directors, and Nasdaq rules require either a Compensation Committee consisting solely of independent directors or that compensation decisions be determined only by independent directors. Legislation recently passed by the U.S. House of Representatives would require public company Compensation Committees to consist solely of independent directors. It is not clear if this provision will ever become law or, if it does become law, whether there would be an exception for controlled companies.
In order to comply with SEC Rule 16b-3 and Section 162(m) of the Internal Revenue Code, some companies establish a subcommittee of the Compensation Committee consisting of at least two independent directors. Rule 16b-3 exempts certain common stock-related transactions between the company and a director or executive officer from the short-swing profit recapture provisions of Section 16(b) of the Securities