An MD&DI October 1998 Column
BOTTOM LINEAlthough the IPO is the best-known way to go public, there are other ways for a company to reach the same goal.
Most U.S. medical device companies are small businesses80% have fewer than 50 employees. One of the most critical decisions these small businesses face is how to finance their research, development, and growth.
Companies may take several approaches to financing. Some choose to enter into licensing agreements with larger companies, sharing product revenues in exchange for funding and strategic alliances. Although such alliances quickly provide the deep pockets a developing company needs to advance its technology, they can also be very tenuous. The smaller company must continually monitor the agreement and protect its interests.
A more traditional but less popular approach is debt financing. However, this technique can be a very expensive proposition for small companies that are trying to commercialize or expand on new technologies. The high level of risk associated with early stages of product development often brings high interest rates.
The most significant source of funds for the medical device industry has been equity financing, which involves the exchange of capital for a percentage of the company. The company's main objective is to maximize the amount of capital raised for a given percentage of equity. Such capital includes funds received from venture capital groups, private placement investors, and direct public offerings.
REASONS TO GO PUBLIC
Regardless of the financing approach a company chooses, raising capital is easier if the company first becomes a public entity. Public companies are generally perceived as much more attractive investments, with greater overall value, than private companies. This is primarily because many private companies, even if they do well, do not provide convenient exit strategies for investors. In addition to worrying about a company failing, investors also worry about a company succeeding but not providing them with the means to cash in on their investment. Publicly trading stock provides this means. A public company increases the amount of its available risk capital and often less equity is demanded in return.
Going public also offers a number of strategic advantages to start-ups and other small companies:
- A public company has further opportunities for raising capital through additional stock offerings or warrants.
- Going public can increase a company's equity base, creating more favorable terms for borrowing additional funds.
- Publicly traded stock can be used as a form of currency when making key acquisitions, allowing a company to make such purchases without incurring further debt or selling assets.
- A public company can offer stock options to attract and retain important employees.
Along with these advantages, several responsibilities come with being a public company:
- Management is obliged to disclose certain information to the public. Generally this involves operational issues and major changes in the structure or activities of the business. Proprietary information and trade secrets do not need to be released.
- Additional resources are often required to satisfy legal, accounting, and filing requirements. Some private companies may already be satisfying these requirements at the request of larger investors, collaborators, or corporate partners.
- Management must consider its obligations to all shareholders. These obligations include preparing and distributing reports and proxies. As part of this responsibility, management must consider the effect various decisions might have on the market price of the company's stock. Occasionally management actions will require shareholder approval.
However, going public can provide substantial gains in prestige and positive exposure. Historically, investors, customers, suppliers, and lenders have a higher degree of confidence when dealing with public companies.
INITIAL PUBLIC OFFERINGS
The most prestigious and best-known method of going public is through an initial public offering (IPO). Businesses that have a good story to tell, a story that will capture the attention of the right audiences within the investment community, may find an IPO to be the most direct route to raising large amounts of capital quickly. But it is not an easy route. To prepare for an IPO, a company must often present a history of successful operation and command the substantial resources necessary to complete the process. An IPO can be very costly and complex with no guarantee of success. The process may be terminated at any point, leaving the company bearing the expense.
Perhaps the greatest concern of any IPO candidate is timing the offering. A typical IPO requires at least three to six months, and sometimes more than a year, to reach completion. During this time, the IPO can be affected by any change in market conditions. For example, if the market falters, the underwriter may decide to pull the plug on the deal. If the technology to be financed receives unfavorable headlines (for example, a similar product fails in clinical trials), investors may shy away.
Although IPOs are prized by companies that wish to guard their independence and tap a large public pool of investors, they remain out of reach for most smaller, developing concerns. However, there are other options for companies that wish to enjoy the advantages of going public but are unwilling or unable to tackle an IPO. Among the simplest of the options are exempt offerings and reverse mergers.
Smaller companies and companies that wish to raise capital in a gradual manner may consider an exempt offering. By taking advantage of Rule 504 under Securities and Exchange Commission (SEC) regulation D, companies can sell up to $1 million in securities to the public in any 12-month period without filing a registration statement. Because this method simply requires notifying the SEC and applicable state agencies, most such offerings can be completed fairly quickly.
Perhaps the most impressive attribute of the exempt offering is that it can be carried out for less than $25,000 in legal, audit, and print feesa price within the reach of most emerging businesses.
Before considering this approach, however, companies must keep in mind that it has limitations. An exempt offering is restricted to $1 million of capital per year, an amount sufficient for some, but not all, companies. A few states also limit the number of investors. For example, in Ohio only 10 investors may participate in such an offering. Including more than 10 investors requires filing a registration statement.
Nevertheless, working within individual state regulations, exempt offerings permit a company to raise capital quickly, offer the initial shares of stock that are the basis for a quotation on the Electronic Bulletin Board, and create a new public entity.
When an active private company acquires a dormant public company and becomes public as a result, the process is usually referred to as a reverse merger. The private company obtains a large percentage of the shell company's stock and changes the shell's name to reflect the new operating business.
A reverse merger offers a number of advantages to companies that wish to achieve public status without an IPO. First, there is no need to convince an underwriter to take the company publiclack of operating history does not ordinarily effect the completion of a reverse merger. The company need only gain the confidence of the people who control the public shell. Often, these stockholders are gratified to see the shell company acquire new life. Second, a reverse merger can be completed in as few as 45 days. As a result, timing and market conditions have little effect on a reverse merger. Third, a reverse merger is relatively inexpensive. Total expenses associated with a traditional IPO, including underwriting discounts and accounting, legal, printing, and filing fees, can be $250,000 to $500,000 or more. A reverse merger can be completed for $60,000 to $100,000.
Although going public through a reverse merger is simpler than going public through an IPO, it is generally not the best option for start-ups that have no operations or intellectual properties. A reverse-merger candidate should have a basis of value in an industry or market segment that is of interest to the investment community. Fortunately, most medical device companies currently enjoy this status.
Companies undertaking reverse mergers may encounter some resistance from very conservative legal and brokerage firms. In addition to finding reverse mergers unorthodox, many of these firms prefer the relatively complex filing of an IPO because greater complexity permits them to charge higher fees. This prejudice is diminishing as reverse mergers become an increasingly well-recognized financing option.
One important point to remember is that completing a reverse merger does not raise capital per se. In order to raise capital after a reverse merger, sometimes a company must devote time and resources to developing a broader market for its securities.
CONTINUING THE PROCESS
As dramatic as the process of creating a publicly traded company may seem, it is only a beginning. The new public entity can place itself on the Electronic Bulletin Board with many other recognized and actively traded stocks. If it is successful, the positive news will usually bring attention to its stock, causing the stock's price to rise and the company's value to increase. As a company's assets grow, so do its opportunities to qualify and apply for higher markets. Each step increases a company's visibility to investors.
For most medical device manufacturers, raising capital is a necessity. In a competitive, technology-driven market, funds may be needed to support product development or to expand the business operations. Going public is often the best way to secure these funds. There are numerous approaches to going public, each with its own benefits and responsibilities. The approach chosen by a company will not affect its success as a public entity. The most important factors for that success are the quality of the business and the vision and determination of those individuals involved in the deal.
Art Beroff is the managing principal at Beroff Associates, Corporate Financial Consultants and Investment Bankers (Howard Beach, NY). Andrew Koopman is the managing director of biomedical and biotech industries at the Beroff Associates office in New York City.
Illustration by Jean-Francois Allaux