Partner Anna Pinedo discusses lock-up agreements in a recently published Lexis Practice Advisor® Practice Note.
In a paper titled, “IPO Lockup Expirations: A Persistent Anomaly of Scale,” author Kevin Green reviews the decline in stock prices following the expiration of lockup agreements relating to initial public offerings. Green reviewed all IPOs from 1988 to 2014 and then observed the trading activity around the lockup expiration. Despite the availability of information to market participants regarding the timing of IPO lockup expirations, trading activity around the time of lockup expirations still is anomalous. Trading activity significantly increases following lockup expiration. The stock price for non-VC backed IPOs declines modestly leading up the the lockup expiration compared to VC-backed IPOs, and rebounds in a five-day window following lockup expiration. However, for VC-backed IPOs, there was a substantial decline in the period immediately prior to the lockup expiration. Short selling activity spikes immediately prior to lockup expirations (which demonstrates, among other things, borrow availability) and then falls below average pre-lockup expiration levels. Short sellers do not appear to be able to predict correctly which VC-backed IPOs will decline post-IPO expiration. Green concludes that market inefficiencies play a role but the abnormal returns are sensitive to the size of the capital investment. Limits on the capital deployed or on the scalability of the investment may explain why the abnormal return patterns persist.
Although Securities and Exchange Commission Chair Clayton has made clear that the Commission does not intend to focus on addressing mandatory arbitration provisions in the near term, the controversy regarding action in this regard remains active. A coalition of bipartisan state treasurers (California, Illinois, Iowa, Oregon, Pennsylvania and Rhode Island) delivered a letter to the Commission expressing their “serious concern” that the Commission may consider allowing IPO issuers to adopt mandatory arbitration provisions. The letter repeats many of the arguments made by investor and consumer protection groups in their letters to the Commission, noting that the cost for individual pension plan members, including teachers, municipal workers, and other individual investors associated with bringing an individual action on securities law claims would be too costly. This would mean, according to the state treasurers, that securities regulators would be left responsible for all oversight, without private shareholder litigation to police the capital markets.
The House Financial Services Committee met last week and approved eight capital formation-related bills. The bills require the Securities and Exchange Commission to take action to change certain of its definitions in its rules and provide guidance on a number of securities-related issues. These include amending the definition of a qualifying investment; requiring a study on IPO underwriting fees with the Financial Industry Regulatory Authority; and requiring a study on expanding investments in small-cap companies. Committee Chairman Jeb Hensarling noted that these bills “…will help our small businesses gain capital, help entrepreneurial ventures, and help companies in America go public and stay public.”
Below we provide a summary of the principal bills:
H.R. 6177, the “Developing and Empowering our Aspiring Leaders Act,” requires the SEC to revise the definition of a qualifying investment to include equity securities acquired in a secondary transaction.
H.R. 6319, the “Expanding Investment in Small Businesses Act,” requires the SEC to study whether the current diversified fund limit threshold for mutual funds of 10% constrains their ability to take meaningful positions in small-cap companies.
H.R. 6322, the “Enhancing Multi-Class Share Disclosures Act,” requires issuers with a multi-class stock structure to make certain disclosures in any proxy or consent solicitation materials.
H.R. 6324, the “Middle Market IPO Underwriting Cost Act,” requires the SEC, in consultation with FINRA, to study the direct and indirect costs associated with small and medium-sized companies to undertake initial public offerings.
H.R. 6320, the “Promoting Transparent Standards for Corporate Insiders Act,” requires the SEC to consider certain amendments to Rule 10b5-1 and directs the SEC to consider how any amendments to Rule 10b5-1 would clarify and enhance existing prohibitions against insider trading while also considering the impact of any such amendments on attracting candidates for insider positions, capital formation, and a company’s willingness to operate as a public company.
H.R. 6323, the “National Senior Investor Initiative Act of 2018,” creates an interdivisional task force at the SEC, to examine and identify challenges facing senior investors and requires the Government Accountability Office to study the economic costs of the exploitation of senior citizens.
On February 2018, the Securities and Exchange Commission (“SEC”) approved the New York Stock Exchange’s (the “NYSE”) proposal to permit qualifying private companies to use “direct listings” to list their shares on the NYSE so long as the direct listing is accompanied by a concurrent resale registration statement under the Securities Act of 1933. To accommodate these direct listings, the NYSE modified its Rules 15, 104, and 123(d). In March 2018, the NYSE issued an information memo highlighting the changes.
NYSE Rule 15 sets forth the requirements for a pre-opening indication, which is the price range within which the opening of trading for a security is anticipated to occur. When the opening transaction on the NYSE is anticipated to be at a price that deviates by more than the “Applicable Price Range” from a specified “Reference Price,” then the Designated Market Maker (“DMM”) must publish a pre-opening indication before a security opens. Under amended Rule 15, the reference price for directly listed securities is defined as: (i) the most recent transaction price if the security had recent sustained trading in a private placement market or, if none, (ii) a price determined by the NYSE in consultation with a financial adviser to the issuer of such security.
Rule 104 sets forth the responsibilities and duties of a DMM. Changes to Rule 104 require that the DMM first consult with the financial adviser to the issuer before a direct public offering (DPO) for securities that do not have a recent sustained history of trading in a private placement market. This consultation aims to promote a fair and orderly opening of such security. Last, the SEC approved an amendment to NYSE Rule 123(d) and granted the NYSE discretion to declare a regulatory halt in a security that is the subject of an initial pricing on the NYSE if that security has not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing. This regulatory halt would be terminated when the DMM opens the security. The NYSE Information Memo on Direct Listings can be found in full here.
Despite the NYSE accommodations for DPOs, the Financial Industry Regulatory Authority, Inc. (“FINRA”) advises its member firms to exercise caution when recommending and entering unpriced customer orders at and around the opening on the first day of trading of a direct listing of a security. FINRA notes that there is potential for substantial variance in the opening price of a direct listing and in the subsequent prices at which trading on the secondary market occurs on the first day of trading. As a consequence, FINRA is concerned that without the use of a limit price, customers may receive execution at prices that are not in line with their expectations. Instead, FINRA encourages its member firms to consider using and recommending priced, customer limit orders. FINRA Regulatory Notice 18-11 can be found in full here.
The U.S. IPO market has kept a steady pace through the second half of 2018, according to EY’s quarterly IPO trends report.
54 IPOs were completed in the second quarter of 2018, raising $12.9 billion, which amounts to a total of 101 IPOs, raising $29.9 billion for the first half of the year. This is a 20% year-over-year increase in proceeds, and a 30% year-over-year increase in volume compared to the second half of 2017.
The median deal size for IPOs in the second quarter was $124.2 million, with only one IPO raising over $1 billion in proceeds.
The technology sector saw both the highest number of IPOs completed and the most proceeds raised in the second quarter of 2018, with 17 transactions, raising $5.1 billion. Many of these tech sector-IPOs were done by unicorn companies. Below we provide a graph of the top five sectors by number of IPOs based on EY’s data.
In addition, EY reports that 39 of the newly public companies chose to list on the Nasdaq, while 15 listed on the NYSE during the second quarter of 2018.
For more, see EY’s Global IPO trends: Q2 2018 report.
Authors Brian Broughman and Jesse Fried study founder control in their paper titled, “Do Founders Control Start-Up Firms that Go Public?” In their paper, the authors observe that many founders of startups lose control through the process of raising capital from venture capital funds. The authors debunk the notion that founders regain control over their companies in connection with their companies’ IPOs (referred to as the “call option on control” theory). The research shows that the frequency of founder-CEO control at the IPO is around 20% during the sample period considered. After three years following the IPO, 25% of founder-CEOs exit the CEO position for the companies that are still public. The authors also considered voting control held by the founder-CEO. Their research showed that the average founder voting power is 11.1% at the time of the IPO and 6.3% three years following the IPO. Founder voting power was higher for those companies that had received less pre-IPO financing, had undertaken fewer rounds of VC financing, undertook an IPO more quickly from receipt of initial VC financing, and had dual-class structures. Based on the review of more than 18,000 startups that received initial VC financing between 1990 and 2012, the authors concluded that it is highly unlikely that a founder will reacquire even modest control at the IPO that would be durable (lasting more than three years).
On June 12, 2018, Partner Anna Pinedo participated in a panel discussion titled “Hello Private Capital” at the Wall Street Journal’s CFO Network 2018 Annual Meeting in Washington D.C., which focused on the trend of companies toward deferring their IPOs and remaining private, the public policy concerns arising as a result, the effect on the IPO market, the availability of investment opportunities for retail investors, new legal challenges for large private companies, and valuation considerations.
There are a number of legislative proposals making their way through the House, including: H.R. 5054, the Small Company Disclosure Simplification Act of 2018, which provides EGCs and smaller reporting companies an exemption from xBRL requirements (referred to in our prior blog post), H.R. 6035, the Streamlining Communications for Investors Act, which is a measure that would direct the Securities and Exchange Commission to amend Rule 163 under the Securities Act in order to allow underwriters and dealers acting by or on behalf of a WKSI to engage in certain communications, and a measure that would direct the Commission to increase and align the smaller reporting company definition and the non-accelerated filer financial thresholds, and a measure requiring the Commission to conduct a study with respect to research coverage of small issuers before their initial public offerings.
All of these bills emanated from the recommendations contained in the report prepared by SIFMA and other trade associations titled “Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public,” which we blogged about previously.
The Financial Services Committee has passed H.R. 6035 with some bipartisan consensus. This measure is similar in scope to the amendments to Rule 163 of the Securities Act that the Commission had proposed a few years ago and never adopted. Given the fact that most follow-on offerings are conducted on a wall-crossed basis these days, it would make sense to allow underwriters acting on a WKSI’s behalf to approach investors even prior to the WKSI filing an automatic shelf registration statement.
At the Wall Street Journal’s CFO Network annual meeting held in Washington DC on June 11, 2018, Securities and Exchange Commission Chair Jay Clayton provided some insights on areas of focus for the Commission. Chair Clayton noted that the Commission remains focused on measures designed to promote capital formation without sacrificing investor protection. Chair Clayton noted that the Commission continues to work on disclosure effectiveness reforms. He also noted that the Commission is working on amendments to the definition of “smaller reporting company,” and anticipates that the amendments will be released before October. The moderator asked Chair Clayton to comment on the increasing significance of private capital. Chair Clayton noted that the Commission is focused on the decline in the number of U.S. public companies and on the state of the U.S. initial public offering market. He noted that retail investors are being shut out of investment opportunities given that most private placements are available only to accredited investors. He noted that the Commission is looking at the private placement framework, and noted that, at present, the private placement is quite binary—if you are an accredited investor, you are able to participate in a private placement and potentially face significant losses, and if you are not an accredited investor, you are largely foreclosed from participating in the private placement market. Chair Clayton also discussed proposed Regulation Best Interest as well as a number of other priorities.