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Capital structure and tax considerations for an IPO

by contributors Eric C. Sibbitt, K. Peter Ritter and Evan T. Pickering | Published September 13, 2011 at 3:30 PM

In the run-up to an initial public offering, directors and officers of a company contemplating an IPO face a number of strategic decisions crucial not only to the success of the IPO, but also to the longer-term success of the company. In many instances, a private company's capital structure will need to be modified pre-IPO not only to achieve a successful offering, but also to facilitate operation and management as a public company, to address tax considerations and to be positioned to effectuate future corporate goals. Because these items are impossible, difficult or time-consuming to change post-IPO, it is critical that these items be considered at an early stage in the IPO planning process. Below are several fundamental capital structure and related tax considerations that private companies should contemplate when preparing for an IPO.

Private companies often have capital structures designed to accomplish purposes different from those of a public company. For example, preferred stock may have been issued to initial investors or founders to preserve voting control, or to provide a mechanism for paying preferential distributions to select stockholders. While such practices may be crucial to managing and raising money for closely held companies, they are largely inconsistent with the expectations for public companies and can adversely affect the pricing of stock in the offering. Preferred stock may also have certain characteristics with unfavorable accounting and financial reporting implications. A company may need to simplify a complex capital structure by redeeming any preferred stock, converting those shares into common stock and/or amending the company's organizational documents. The company's organizational documents or documents from earlier investments may provide for this to occur automatically upon a qualifying IPO, but often amendments, waivers or consents may be required or such redemptions or commissions must be privately negotiated.

While a simple capital structure is attractive to IPO investors, this may be outweighed for certain issues by a need to have preferred stock or special classes of common stock intended to preserve control rights. An issuer will have greater flexibility to amend its articles and implement these capital structure changes pre-IPO. In addition to the post-IPO requirements to obtain approval from public stockholders and comply with Securities and Exchange Commission regulations and listing requirements, post-IPO changes will draw greater scrutiny from institutional investors and proxy advisers (which have specific voting guidelines and governance expectations) and the SEC. In addition to regular preferred stock, a company may wish to consider the following:

"Blank check" preferred. It can be advantageous to have a class of "blank check" preferred stock (which allows a company's board of directors to determine the rights, preferences and privileges of the preferred stock at the time the company issues the preferred stock in the future) authorized at the time the company goes public to prevent unwanted takeover attempts or raise capital.

Dual-class stock structure. A dual-class stock structure (for example, where one class of stock is retained by insiders with disproportionate or special voting rights, and the other class is issued to the public) can be implemented to help ensure a founder or manager keeps control of the company following an IPO. If the class also results in majority voting power, it can allow a company to qualify for "controlled company" exceptions, thereby exempting the company from various governance requirements such as the requirement for a majority independent board. Dual-class structures have become more prevalent in recent technology company IPOs. Stock exchange rules and policies preclude establishing such a dual-class stock structure post-offering.

Other protections. In addition, there are a variety of other protections ranging from the adoption of special charter provisions or a rights plan (or poison pill) to reincorporating in another state that can be hardwired more easily pre-IPO.

The certificate of incorporation provides a maximum limit on the number of shares a company is authorized to issue, and such number cannot be changed without stockholder approval. If the number is exceedingly high, investors in the IPO may be concerned with how easily their ownership can be diluted without stockholder approval, which could adversely affect pricing. On the other hand, issuers have an incentive to make sure there are a sufficient number of shares not only for the IPO, but also for future post-IPO capital raises, issuances pursuant to current and future employee incentive plans (the IPO may be motivated in part by a desire to provide liquid equity compensation to promote loyalty and encourage performance) and as a currency for mergers and acquisitions (liquid common stock of a listed company can be used as a source of funding for a currency in future deals). While the number of authorized shares may be changed post-IPO with stockholder approval, this is generally a much more difficult, expensive, uncertain and lengthy process than for a private company.

The price per share in the initial offering will be set based on a number of factors, including the company's market value, the number of its shares outstanding, placing the stock within a similar trading band as its competitors and public perception of the company. Investors may view too low a share price as a sign of weakness, and market volatility may force a low-priced stock below minimum price per share requirements of the exchange it is listed on. Conversely, too high a share price may limit liquidity and trading in the stock. To reach an ideal price, the number of outstanding shares may need to be adjusted through a pre-IPO forward or reverse stock split.

While equity holders may benefit from the leverage obtained through debt financing, excessive debt may dampen enthusiasm for the IPO. Many closely held companies have outstanding "venture" or leveraged acquisition debt or other debt with very restrictive covenants and other terms for the benefit of the company's lenders. For example, certain covenants may contain restrictions on changes in control, which, depending upon the definition, may occur regularly as part of the public's ownership of a company's stock. These covenants can be so restrictive that compliance may be difficult or impossible in connection with an IPO, and one of the uses of proceeds of the IPO may be to reduce or retire such debt. These debt agreements may need to be amended, and the process of obtaining amended covenants should begin early. By entering into negotiations with lenders before the offering process, it will be easier to avoid breaches or delays needed to negotiate waivers.

There are also a number of tax considerations relating to the capital structure that may implicate the restructuring of the entity that goes public.

Impact of offering on net operating loss carryforwards. If the IPO entity is organized as a C corporation (as is typical), and if the company has net operating loss, or NOL, carryforwards (which are beneficial in that they can generally be carried forward 20 years, and carried back two years, so as to offset income in those years), the IPO may result in a so-called ownership change, which can limit the use of such NOL carryforwards. In certain circumstances, restrictions in the organizational documents may be used to try to mitigate this risk.

Tax status conversions. If the pre-IPO entity is organized as a partnership (including a limited liability company taxed as a partnership), it generally will want to convert to a C corporation prior to the IPO in a tax-free manner (to the pre-IPO investors), which necessitates careful tax planning. For tax purposes, there are different methods that can be employed to effect the conversion, and the tax results may vary greatly depending on which method is chosen (including, for example, differences in the amount and character of any gain, as well as differences in resulting tax basis to the former investors and the new corporation). In connection with the conversion, the pre-IPO investors may wish to have the partnership make a final pre-IPO cash distribution in connection with the conversion, such that they are able to fund any corresponding tax liability resulting from the deemed liquidation and termination of the partnership.

Directors and officers of closely held companies will want to begin contemplating the above capitalization considerations well before beginning the offering process. These are by no means the only considerations, and private companies should consult with their counsel, underwriters and other financial advisers to determine how to best position their company not only for a successful IPO, but also for longer-term success as a publicly traded company.

Eric C. Sibbitt and K. Peter Ritter are partners and Evan T. Pickering is an associate in O'Melveny & Myers LLP's San Francisco office. Sibbitt and Pickering are members of the corporate finance and capital markets practices, and Ritter is a member of the tax practice group.

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