Companies commonly engage in one or more rounds of private financing before an initial public offering. Pre-IPO companies need the cash and venture capital firms need the substantial and more certain returns commonly associated with late round financing. However, a late round investment in a company that never consummates its initial public offering presents a variety of concerns to such investors, including timing of returns and liquidity. With this risk present, firms continue to develop creative ways to tie the pre-public financing with the IPO, believing that such arrangements effectively “hedge the bet” that the investment will be successful.
The problem from the perspective of the Securities and Exchange Commission is that if the pre-public round is too closely related to the IPO, then the first offering will not be deemed completed at the time the IPO commences, and both offerings could be “integrated.”1 Integration would result in the loss of the private placement exemption for the first offering. Often, the only cure to an integration problem is to delay the public offering.2 Obviously, this type of “cure” is not likely to be well received by issuers, venture capitalists or the markets. In fact, the cure itself may have the effect of jeopardizing the offering.
Historically, Rule 152 and a well-established line of SEC no-action letters were all that were necessary to provide guidance for companies to structure a private offering of securities in close proximity to a public offering without an integration problem. Although the SEC has set forth a five factor test to determine if two offerings should be integrated,3 as a practical matter, issuers rely on the application of Rule 152 when structuring pre-IPO private placements.
However, the SEC appears to be looking very closely at the relationship between unregistered and registered offerings occurring within six months of each other. This is perhaps a response to issuers and venture capitalists who aggressively structure pre-IPO financing so that the two inter-operate as closely as possible while staying within the technical confines of Rule 152. Integration analysis may no longer be as simple, easy or as clear as in the past, and issuers should carefully plan their pre-IPO financing to withstand the SEC’s scrutiny on this issue.
Typically, pre-IPO investments are structured to comply with Section 4(2) of the Securities Act of 1933, which exempts “transactions by an issuer not involving any public offering” or Regulation D thereunder. Rule 152 provides that “the phrase transactions by an issuer not involving any public offering’ in Section 4(2) shall be deemed to apply to transactions not involving any public offering at the time of said transactions although subsequently thereto the issuer decides to make a public offering and/or files a registration statement.” No-action letters interpreting this rule indicate that even where the issuer contemplated the subsequent registered offering at the time of the private placement, the two offerings would not be integrated if the first offering was completed prior to the registered offering.4 A previous private placement will be considered “complete” even when the securities have yet to be issued if the investors are “obligated to purchase such securities subject only to satisfaction of specified conditions, which will not be within the control of the purchasers.”5
The authors are aware of a number of late round financings employing (or proposing to employ) techniques or pricing mechanisms conditioned on a subsequent public offering. One example included a request by a venture capital firm (VC) that the relevant documents and funds be held “in escrow” until the filing of the registration statement to minimize risk should the filing not occur. Presumably in this situation, the funds would be returned and the deal “unwound” if the filing of the registration statement is not made within a certain time frame. In another example, convertible preferred stock is proposed to be issued to the VC where the conversion ratio is not fixed at the time of issuance but is determined only by reference to the initial public offering price. In addition, warrants may be issued to the VC, also containing a pricing mechanism and conversion formula that references the IPO price. In this instance, the number of warrant shares will be a function of the number of shares to be received upon full conversion of the preferred stock.
In the first example, most practitioners would conclude that the escrow arrangement is inappropriate because it too closely links the two offerings and expressly conditions the completion of the private round with the completion of the IPO. The foundation for the SEC’s current interpretation of the Rule 152 safe harbor is that investors in the prior offering must be unequivocally committed if the private transaction is to be deemed closed before the public offering commences. The obligation of the VC to purchase must be unconditional and not “subject to any conditions precedent within their direct or indirect control.”6 The very advantage of utilizing an escrow arrangement to avoid the risks attendant to the registration statement not being filed would also arguably make the Rule 152 safe harbor unavailable. The issuer in such circumstances would, we believe, have difficulty arguing that the private offering was complete if the investors were not at risk prior to the filing and if the financing could be unwound should the filing never be made.
The SEC’s scrutiny of the second type of transaction focuses on the interrelationship between the private placement and the IPO price. The shares of convertible preferred stock to be issued in the private offering are linked to the IPO in two very direct ways. First, the preferred stock converts automatically upon the completion of the IPO. This first characteristic is not unusual. Second, and of more interest to the SEC, is the fact that the number of common shares into which the preferred stock converts is to be determined by a formula that references the IPO price. The effect of this formula is to provide that if the purchase price for the preferred stock ultimately exceeds a fraction (to be negotiated) of the IPO price for common stock, then the amount of common stock preferred shareholders receive upon conversion would ratably increase. This locks in the pre-IPO premium and protects a VC’s investment. This way, the VC can complete the prior offering and hedge its risk that the IPO might sell at a price below its expectations.
To avoid integration, the private placement must be structured squarely within Rule 152 and not explicitly or implicitly conditioned upon or dependent on the completion of the initial public offering. All of the investors must be “obligated” to purchase the securities. All conditions should be satisfied and all obligations on the part of the purchasers and the issuer should be fulfilled. There should be no mechanism to reverse the transaction if the IPO does not occur. If possible, the securities should be issued and the funds delivered. In other words, the offering should be complete.
Even if the safeguards set forth above are implemented, the SEC will nonetheless likely raise concerns that the offering has not been completed because the preferred stock is convertible into a number of shares of common stock based upon the IPO price. If such concerns are raised, counsel for the issuer, in correspondence with the SEC, should note that Rule 152 applies even when the issuer contemporaneously plans a registered public offering and a Section 4(2) private placement.7 Moreover, in prior no-action letters the SEC staff has declined to integrate offerings notwithstanding substantial interrelationships between offerings,8 and many of those private offerings were not as “complete” as the preferred stock issuance described above. In addition, since in most instances the purchasers of the preferred stock will be “accredited investors”9 or “qualified institutional buyers”10 an alternative argument is available notwithstanding the interrelationship issue and should be raised by counsel.11
If the SEC is not persuaded by this traditional analysis of counsel, it may ask the issuer a series of questions outside the typical Rule 152 inquiry. Specifically, the SEC may be interested in the number and percentage of shares to be beneficially held by the private investors after the public offering, whether the private investors intend to participate in the public offering, and whether they intend to exercise the common stock purchase warrants contemporaneously with the public offering. All of these questions are aimed at determining whether there is a substantive interrelationship between the offerings outside the four corners of the documents. If preferred shareholders intend to participate in a subsequent public offering, the SEC might view the public and private offerings as integrated. The issues raised by the SEC in these novel transactions are such that counsel for the issuer should expect that the SEC will require an opinion with respect to the integration of the offerings.
Venture capitalists engaging in pre-IPO financing and implementing novel techniques to safeguard planned returns on investment if an IPO is not consummated should be aware that the SEC is taking a close look at how unregistered and registered offerings relate to one another. The SEC’s scrutiny of novel late round financings may be an early signal of a change in the Commission’s position on Rule 152, particularly since the SEC may inquire into areas typically not part of the Rule 152 analysis.
The SEC may be revisiting its position on Rule 152 in general or may be in the process of revising the way it determines when it should be available, especially in light of such novel pre-IPO financing techniques. A change in the availability of or the requirements for the Rule 152 safe harbor would represent a fundamental shift in SEC policy and would certainly effect the way a company structured its pre-IPO financing activities. Pre-IPO financing structures that push the envelope in an attempt to reduce risks may actually increase the likelihood that the SEC will integrate the offerings and jeopardize the success of both the private and the public offerings.