The Jumpstart Our Business Startups Act (the “JOBS Act”) has altered in certain fundamental ways the landscape of the federal securities laws. One such change permits portfolio companies of private equity sponsors that qualify as emerging growth companies (“EGCs”) and their authorized representatives to “test the waters” with investors both before and after the filing of a registration statement to determine investors’ level of interest in a securities offering contemplated by such portfolio company. This type of pricing discovery should prove especially useful to EGCs and their significant shareholders (including private equity funds) when assessing process, valuation and timing considerations in connection with the initial public offering (“IPO”) process.
Background
The Securities Act of 1933 (the “Securities Act”) generally makes it unlawful for any person to make any offer to sell a security unless a registration statement with respect to the security is on file with the SEC. Similarly, while oral offers are permitted following the filing of a registration statement, written offers are generally prohibited unless made by means of a compliant prospectus.
In a significant departure from long-standing U.S. federal securities law, rules and regulations designed to prevent “gun-jumping” (i.e., making an offer before legally permitted to do so), the JOBS Act amends the Securities Act to permit—either before or following the filing of the registration statement with the SEC—an EGC (i.e., a company with less than $1 billion in annual gross revenues during its most recently completed fiscal year that has not, during the previous three-year period, issued more than $1 billion in non-convertible debt1), and any persons authorized to act on behalf of the ECG, to make oral or written communications with certain institutional investors regarding those investors’ interest in a securities offering that the ECG is contemplating.
Conducting Pricing Discovery
Freed from these gun-jumping restrictions, EGCs and their authorized representatives (which could include their primary shareholders, including private equity firms, and underwriters) may now conduct pricing discussions and better calibrate the timing of a potential securities offering (including an IPO) before investing a significant amount of time and money preparing for an offering process that may not result in a successful offering. Similarly, after the filing of the registration statement, EGCs and their authorized representatives may continue to meet with investors as frequently as desired to continue pricing discovery and further calibrate market timing. However, in order to comply with the Securities Act and other applicable restrictions, certain rules of the road should be observed.
Process Matters. Distribution participants may test the waters only with qualified institutional buyers (“QIBs”), as defined in Rule 144A under the Securities Act, and institutional accredited investors (“IAIs”), as defined in Rule 501 under the Securities Act. Consequently, pre-marketing outreach must be limited to these institutions only, and policies and procedures must be implemented to ensure that targeted investors fall within the permissible categories. Failure to limit the dissemination of pre-marketing communications to QIBs and IAIs could result in a gun-jumping violation if any such communications make their way into the hands of unqualified investors or the public at large. As such, EGCs and their representatives should take reasonable precautions to ensure that pre-marketing communications are not broadcast or otherwise transmitted in a way that makes them susceptible to being recorded, retransmitted or rebroadcast, and investor participants in meetings should not be permitted to retain written pre-marketing materials.
Potential Anti-Fraud Liability for Selective Disclosure. All pre-marketing communications will be subject to potential anti-fraud liability for material misstatements and omissions under Section 12(a)(2) of the Securities Act and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. In addition, even in the absence of a technical filing requirement, the SEC has begun to request that all written pre-marketing materials be submitted as supplemental information in connection with SEC review of the registration statement. If pre-marketing materials are inconsistent with disclosure included in the registration statement or include additional information not contained in the registration statement, the SEC may request that the registration statement be amended (thus exposing the issuer and other distribution participants, including significant shareholders as control persons, to potential anti-fraud liability with respect to the new information included in the registration statement under Section 11 of the Securities Act). In order to mitigate the potential for liability related to pre-marketing communications, such communications (both oral and written) should be materially consistent with: (1) disclosure that would be expected to be included in the registration statement, if the communication occurs pre-filing or (2) disclosure included in the registration statement, if the communication occurs post-filing.
Non-GAAP Measures. The requirements of Regulation G and Item 10 of Regulation S-K governing the use of non-GAAP measures (including the GAAP reconciliation requirements) do not apply to pre-marketing communications. However, for the reasons discussed above with respect to potential anti-fraud liability, EGCs and their advisors should think carefully about creating any material information asymmetry between pre-marketing communications and the registration statement, including by: (1) disclosing different non-GAAP measures from those included or to be included in the registration statement or (2) omitting the GAAP reconciliation and other related disclosure.
What About Confidentiality? With market practice in the gestational stage, it is difficult to know what processes will be adopted to address confidentiality concerns. EGCs are likely to want their pre-marketing communications with potential investors to remain confidential. In addition, to the extent that an EGC has previously issued any outstanding securities, a confidentiality agreement would address selective disclosure concerns. However, potential investors may be unwilling to restrict their trading activities by subjecting themselves to a confidentiality undertaking.
Final Thoughts
There is no doubt that the ability to test the waters will prove a useful tool for EGCs and their significant shareholders, including private equity sponsors. However, given the unchartered waters of the post-JOBS Act era, potential SEC regulatory action and guidance and the future development of market practice, it would be prudent to wade into the water carefully.
[1] “Non-convertible debt” means any non-convertible security that constitutes indebtedness, whether issued in a registered offering or not. SEC registered debt securities issued in an A/B exchange offer do not count towards this debt limit.