how to prepare an initial public offering...

CORPORATE LAW AND PRACTICECourse Handbook Series

Number B-2161

How to Prepare anInitial Public Offering

2015

Co-ChairsRobert A. Freedman

Sophia Hudson

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How to Prepare an Initial Public Offering: The Underwriters’ Perspective (2015)

Eric W. Wooley

Citigroup Global Markets Inc.

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How to Prepare an Initial Public Offering The Underwriters’ Perspective

TOPICS PAGE The IPO Process – The Underwriters’ Perspective………………………… 1

An Underwriter’s Organizational Structure………………………… 1 The IPO Timeline ……………………………………………………...... 2

The Pre-Filing Phase…………………………………………… 3 Pitching the Offering …………………………………. 3 The Organizational Meeting …………………………. 3 Internal Approval Process…………………………… 3 Structuring the Offering………………………………. 4 Conducting Due Diligence…………………………… 5 Structuring the Underwriter Syndicate………….… 5 Syndicate Economics…………………………………. 6

The Pre-Execution Phase…………………………………...… 7 SEC Comments/Response Process……………..… 7 Price Range and Valuation…………………………… 7 Roadshow Presentation Preparation………………. The JOBs Act and its Impact on the IPO Process..

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The Execution Phase………………………………………….. 8 The Roadshow…………………………………………. 8 Bookbuilding…………………………………………… 9 Pricing the Offering……………………………………. 9 The Greenshoe and Stabilization…………………… 9

The IPO Process – The Underwriters’ Perspective The IPO process is long and complex, requiring the coordination of a diverse group of parties with unique and varied roles. Each of these parties have the same ultimate goal; a successful transaction. This brief article is not intended to be a complete review of the IPO process, but instead is intended to review the key steps in the IPO process from an underwriter’s perspective. The underwriter is an essential player in the IPO process who performs a number of critical functions. These functions include recommending the structure of the offering, analyzing the market conditions and advising the issuer on the initial offering price and ultimate allocation of the shares sold in the offering. But the underwriter does not see itself as just one of the players in the process. The underwriter considers itself the “quarterback”: setting the timeline for the IPO process and orchestrating the efforts of each of the other parties involved. An IPO generally requires at least 16 weeks to complete from the time underwriters become involved until the offering is priced, but in many cases the period is significantly longer. An Underwriter’s Organizational Structure

Several groups within an investment bank closely collaborate to assist companies with their corporate finance activities. A brief description of each of these groups follows.

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Investment Bankers – Relationship or coverage bankers. Typically industry focused and product agnostic. Principal function is to provide corporate finance related solutions for their corporate clients. Equity Capital Markets Bankers – A product group that specializes in equity offerings by issuers and large selling shareholders. Typical subgroups within the larger equity capital markets umbrella include:

Origination – Product specialists that frequently have an industry focus. Provide structure advice, comparable analysis and market color for equity issuers. Advisory – Experts that commonly specialize in a product such as IPOs and provides structure and process advice to the issuer and origination bankers. Syndicate – The interface between equity capital markets and sales and trading. The syndicate desk keeps the order book, consolidates investor feedback and coordinates the roadshow during the marketing period for the offering.

Sales & Trading – Sales coverage and traders whose primary focus is providing trading services to the buy-side investment community such as mutual funds and hedge funds. Typical Underwriter Organizational Structure

The IPO Timeline The IPO process can be broken down into three principal time periods: pre-filing, pre-execution and execution. The focus of each time period varies. The focus during the pre-filing period is to prepare the issuer for the filing of its registration statement with the SEC. This involves structuring or setting the terms of the offering (other than share price), positioning the issuer’s story, determining syndicate roles, conducting legal, business and financial due diligence and completing the underwriters’ internal approval process. Once the registration statement is filed with the SEC, the underwriter will focus on the pre-execution phase where the focus is to receive preliminary approval of the registration statement from the SEC, prepare the company and management for the

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roadshow and form a group consensus on the initial offering price range to be included in the prospectus. The final phase is the execution phase, consisting of marketing the offering to investors, collecting indications of interest from investors, pricing the offering, allocating shares to investors and initiating the secondary trading of the shares. The Pre-Filing Phase Pitching the Offering Investment bankers and equity capital markets bankers work together to identify appropriate equity issuance candidates and pitch their services to win a mandate to act as a bookrunner of an IPO. Frequently the pitch process commences with the receipt of a request for proposals from an issuer (also known as an RFP). Investment bankers normally take the lead in organizing a response to the RFP and working closely with equity capital markets bankers. The equity capital markets bankers are responsible for providing guidance on suggested positioning of the issuer, valuation methodology, offering structure, marketing process, co-manager selection, gross spread and economic splits. The Organizational Meeting Once a mandate has been awarded and initial due diligence checks have been conducted, the entire working group typically gets together for an organizational meeting. The underwriters typically prepare the organization meeting materials to define expectations of the issuer for the offering process and to assign responsibilities for all of the parties involved. The organization book typically consists of the following sections:

Organizational Meeting Agenda – The schedule for the organizational meeting process and any related due diligence discussions to take place at the meeting Process Overview – An outline of key steps in the IPO process for the client and to highlight the key decisions that need to be made along the way Timetable and Responsibilities List – A schedule with the key milestones, target dates, and responsibilities for the IPO Due Diligence Request - List that serves as guidance for the due diligence discussion that will take place Working Group List – Contact information for all of the parties involved in the offering

Internal Approval Process Each underwriter typically has a series of internal reviews that must be completed to participate in an underwritten offering. While each underwriter’s process is unique, this process typically consists of the following requirements:

Conflicts Clearance - Each transaction must be reviewed for potential conflicts of interest as soon as practical before pitching (or upon receipt of a mandate). Mandate Review - When an underwriter receives a mandate, the banking team normally notifies the internal approval committee of a pending transaction. This notification is to identify any reputational, legal, due diligence, structural, or internal

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issues that this committee may need to review early in the process prior to final approval to avoid possible issues late in the process. Committee Process - Prior to filing, marketing or otherwise publicly disclosing an underwriter’s involvement in a transaction, the banking team is normally required to make a presentation to an internal approval committee (frequently referred to as a “Commitment Committee”). A senior investment banker along with the applicable equity capital markets banker normally makes the presentation to this committee. This presentation is conducted when the offering has been structured, diligence is substantially complete and the offering related documentation has been prepared so that any issues that may need to be address before marketing the offering will have been identified.

Structuring the Offering As part of preparing the registration statement and the related prospectus, the key structural components of a transaction are decided such as:

Size of the Offering and Use of Proceeds - The ultimate size of any offering will depend on capital needs of the issuer and the existing owners’ desire to sell stock in the offering. Shares offered in an IPO typically represent a minority of the pro forma market capitalization of the issuer. The goal of sizing an offering is to ensure that the issuer has a rational capital structure after the offering. Selling Primary vs. Secondary Shares - Primary secondary mix must be designed to accommodate capital structure needs as well as existing owners’ desire to obtain immediate liquidity. Investor concerns also need to be taken into consideration. Without a justifiable rationale, a legacy shareholder cashing out at the IPO would not be seen as a positive to IPO investors. Frequently the Greenshoe can be used to allow incremental demand to be satisfied by selling shareholders. Dividend Policy - A company’s initial dividend policy is closely dictated by the operating strategy. A high growth company in a capital intensive industry would normally not be expected to pay dividends while a yield story investment would be required to do so. Lockups – A standard lockup for an IPO is 180 days (issuer, officers, directors and all pre-IPO stockholders are normally locked-up). The lock-up restricts these shareholders and the issuer from selling shares during the 180 days following the IPO. The purpose of the lock-up is to protect IPO investors from large overhang of potential selling pressure immediately after the IPO. Underwriter Economics - Underwriter economic discussions and decisions are not limited to just the percentage discount that the underwriters will pay the issuer. These decisions also include answers to how the aggregate economics will be divided among the different syndicate members.

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Example Transaction Structure Issuer Company X Size 10,000,000 Shares of Common Stock Primary Secondary Mix 100% Primary Over-Allotment Option 1,500,000 (15%) secondary Filing Range $17.00 - $19.00 Dividend none Post Offering Lock-up 180 days Underwriter Spread 7%

Conducting Due Diligence The Securities Act of 1933 imposes potential liability on persons who sell securities by means of a prospectus. “Due diligence” is a verification process performed by underwriters and their counsel. The specific purpose of the due diligence process is for underwriters to have the “due diligence” defense available. This defense requires underwriters to show that they have performed a “reasonable investigation.” A more general purpose of the due diligence process is to ensure the accuracy and completeness of the financial and business description provided in the prospectus. Through this process the underwriters are better able to assist the issuer in describing its business to potential investors and setting the price of the offering. The due diligence process is conducted before, and in conjunction with, drafting the registration statement and prospectus. Structuring the Underwriter Syndicate An IPO is commonly underwritten by a group of underwriters, either because no single firm wants to take on the exposure of an entire deal or, more commonly, because each underwriter is able to incrementally provide unique resources to the offering’s success. The principal roles in a typical syndicate structure are the bookrunners, the co-managers and selling group members.

The Bookrunners – These are the lead underwriters of the offering and will act as the quarterbacks of the offering process, from the organizational meeting to the pricing. Large IPOs commonly have two or more bookrunners. The name bookrunner comes from an important responsibility of the bookrunner: keeping or running the “book” of demand while the offering is on the road. The bookrunners will also act as representatives of the other underwriters with respect to negotiating and signing the underwriting agreement, structuring the offering and providing after pricing support such as market making and stabilizing. The Co-managers – Co-managers are also underwriters, but they are not normally materially involved in the structuring or marketing of the offering beyond the obligation to stand behind their respective underwriting commitment. Co-managers are frequently chosen because of a unique industry expertise, such as research capabilities or regional investor relationships. The Selling Group - Selling group members are not underwriters. They earn a selling concession for shares they sell and are typically brought into a syndicate based on their ability to access a unique pool of demand.

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Syndicate Economics With a better understanding of the different roles, it is worth briefly discussing how these roles are compensated. In a syndicate the underwriters typically purchase the shares sold in the offering from the issuer at a discount to the price the shares are sold to investors. This discount is the gross underwriting discount. The gross underwriting discount is composed of the following components:

The Management Fee - Normally 20% of the gross underwriting discount. This amount is earned by each of the managers (bookrunners and co-managers) of the offering. The split between the managers of this amount is pre-determined by the issuer before launching the offering. The Underwriting Fee - Normally 20% of the gross underwriting discount. This amount is earned by each underwriter (bookrunners, co-managers) and is based on the individual underwriting levels. Syndicate expenses such as counsel fees and travel expenses are deducted from this amount. The split among the underwriters of this amount is pre-determined before launching the offering. The Selling Concession - Normally 60% of the gross underwriting discount. This amount is used to compensate retail and institutional sales personnel involved in the offering. The selling concession for retail investors is allocated based on the amount of retail sales that any entity actually makes. Since there are frequently multiple sales coverage relationships for institutional investors, it may be difficult to credit any particular institutional sale to an individual underwriter. As a result, this amount can either be pre-determined by the issuer before launching the offering or allocated on a competitive basis. For competitive institutional economics the selling concession is referred to as “jump ball” and may be paid to underwriters based upon designations by the institutional investors that purchase in the offering. Example of Syndicate Economics

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Cover Placement For the underwriters the size and location of their name on the prospectus is important. A typical offering will include the bookrunners above and in larger font with the co-manages below in smaller font. A unique role attributed to an underwriter such as structuring advisor or global coordinator for a large international offering may also be described above their name on the front and/or back cover.

The Pre-execution Phase The Pre-execution phase refers to the period from the initial filing of the registration statement with the SEC to the launch of the transaction. During this period, the issuer and the underwriters focus on clearing the registration statement with the SEC, preparing the issuer’s management for marketing the transaction and, most importantly, determining the price range to be included in prospectus when the transaction is launched. SEC Comments/Response Process The SEC will normally provide the issuer comments on the registration statement approximately 30 days after the date of the initial filing. This timing can vary depending on the work load of the SEC, the complexity of the offering and on the existence of any prior filings by the issuer with the SEC. Once the initial comments are received, barring some other reason such as stale financials or a change in the business objections of the issuer, the comments should be promptly addressed so that an amended registration statement can be re-filed with the SEC. The typical IPO process generally requires at least three amendments to be filed with the SEC. After receipt of the initial comments from the SEC, as much as six or more additional weeks may be required to clear the registration statement with the SEC. Price Range and Valuation The price range on the preliminary prospectus is the result of determining the underwriting firms’ consensus view on the equity value of the issuer, then applying an IPO discount to that valuation and then dividing the discounted valuation by the number of shares to be outstanding at the IPO. In most cases the goal is to have a $2.00 price range with a per share price between $10 and $20, which is accomplished through adjusting the number of shares to be outstanding at the IPO by means a share split. Roadshow Presentation Preparation The roadshow presentation is an important document used in the offering process. IPO investors frequently have many investment opportunities presented to them. Before a great deal of time is invested in reading each prospectus in detail, institutional

Joint Book-Running Managers Bookrunner A Bookrunner B

_________________ Co-Managers

Co-Manager A Co-Manager B Co-Manager C

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investors will use the roadshow presentation to filter their investment opportunities. The information in the roadshow presentation is based on, and consistent with, the more detailed information in the prospectus. As a result of securities offering reform of 2005, electronic roadshow presentations are made available to both retail and institutional investors on the internet at www.retailroadshow.com. The JOBS Act and its Impact on the IPO Process The Jumpstart Our Business Start-Ups (JOBS) Act was passed in April 2012 with the goal of making it easier for smaller companies to access the IPO market. The JOBS Act has resulted in some changes in the pre-execution phase for a class of issuers referred to as Emerging Growth Companies. These are companies with revenue less than $1bn in their last fiscal year before going public. Thus far, the freedom to file the S-1 confidentially appears to be the most popular aspect of the JOBS Act. This has allowed companies to move through the SEC process with reduced public scrutiny and to keep competitive information private longer. The S-1 must be filed publicly at least 21 days before launching the roadshow. Companies may choose to file more than 21 days in advance in certain circumstances. For example in the case of a dual-track process or the desire to put information in the public domain to facilitate a “testing of the waters” process are both reasons for making a public filing in advance of the 21-day proviso. Additional freedom around “testing the waters” is another popular feature of the JOBS Act. The JOBS Act provides EGCs greater flexibility in communications with investors prior to IPOs. Market practice is still developing around these meetings. The utility of “testing the waters” is specific to the facts and circumstances of the issuer and industry. For example “testing the waters” can be particularly helpful for issuers / sectors with few comps or ones that require significant diligence (e.g. biotech). The Execution Phase The IPO execution phase begins with filing a prospectus with an offering price range. This prospectus is often referred to as the “red herring”. The offering is launched by management conducting live presentations of the roadshow with the salesforces of each of the bookrunners. Then management will commence a roadshow consisting of one-on-one meetings with institutional investors, group lunches and possibly presentations to retail branches. The execution phase concludes with the registration statement being declared effective by the SEC and the underwriters offering a transaction to the issuer and its board of directors. After the transaction is accepted by the issuer, the underwriting agreement is executed, the shares are allocated to investors and the stock will commence secondary trading. The Roadshow Promptly following the filing of the red herring with the SEC, management will normally commence a two week roadshow consisting of one-on-one meetings with institutional investors, group lunches and, in some cases, presentations to retail branches. Below is a sample roadshow schedule and an illustrative single day schedule.

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Sample Roadshow Schedule

Bookbuilding The underwriters’ salesforce approaches investors and relays indications of interest to their respective syndicate desks. An indication of interest is typically composed of an order size and in some cases a price limit. These indications of interest are received by the syndicate desk along with other feedback collected by the salesforce. The book-building process evaluates institutional and retail demand for the offering and ultimately determines the final size and pricing of the offering. Pricing the Offering No sales of the IPO shares are permitted until the registration statement has been declared effective by the SEC. Typically the underwriters will request that the registration statement be declared effective by the SEC in the early afternoon of the day of pricing. This way the offering can be priced immediately after the market close. Working with the issuer’s management, the underwriters will recommend a price at which the shares can be sold to the market. Only after the issuer’s board of directors (or more commonly a designated pricing committee) has approved the offering price will the underwriting agreement be signed and the underwriters will have agreed to purchase the shares. At this time the underwriters will, with consultation from the issuer, make allocation of the IPO shares to investors against their indications of interest. The objective of the allocation process is to balance the interest of the issuer in receiving the highest price for its offering against placing the offering in the hands of investors which are likely to be high quality holders for the long term. The Greenshoe and Stabilization Underwriters anticipate short-term volatility of the selling supply and buying demand when an IPO initially starts to trade. This may be the result of many reasons such as an

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investor not receiving a sufficient IPO allocation to justify owning the security, an investor wishing to hold a larger position and, in some cases, speculative investors hoping to make a quick profit. To assist the trading through this period until trading stabilizes to normal levels, the Greenshoe or the "over-allotment” option gives underwriters the right for 30 days after the IPO to purchase up to 15% of additional shares from the issuer. These additional shares purchased can only be used to cover “over-allotments” which are sales made to investors at the time of the initial offering in excess of the shares printed on the cover of the prospectus (also known as “short sales”). These shares will have been sold only if demand for the offering exceeded the total amount of shares printed on the cover of the prospectus. The Greenshoe option permits a designated underwriter to stabilize the price of the IPO when it initially begins to trade. For example, assume the underwriters initially oversells (or sells short) 15% of the offering. When the offering starts trading, this additional 15% of shares are part of the float and trade in the secondary market. If the immediate selling supply exceeds the buying demand, then the trading price will begin to fall. To mitigate this price decline, the underwriter designated as the stabilizing agent is able to buy shares in the secondary market and use the shares purchased to cover the existing short position. If, however, the immediate buying demand exceeds selling supply and the price of the stock immediately goes up and stays above the offering price, the underwriters then have the ability to exercise the Greenshoe option with the issuer and purchase from the company the additional shares at the offering price to cover the short. Also, the Greenshoe does not have to be exercised in full. For example if a selling and buying mismatch rapidly stabilized, then the underwriters may only have a portion of its original short position remaining after the share price has stabilized. In this case they could exercise a partial Greenshoe for the amount of the remaining short position. Greenshoe Examples

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