Tip of the Week: Is the House in Order? Getting Ready to go Public

You're excited. You have met an investment banking or law firm. They have suggested that going public might be a logical strategy to help your company grow, raise capital, make acquisitions, etc. But are you really ready? Even assuming going public makes sense, are there any barriers that might make it difficult or a slower process?

In this tip of the week, I outline a few things to do early on in the process, ideally before the due diligence review begins, to ensure that barriers, some of which could be insurmountable, do not get in the way or, at the very least, are found out as soon as possible.

1. Are you auditable? To go public you will need to have your financial statements audited going back two years (three for larger companies). One of the first questions you need to ask is whether your financial records are in good enough shape to be audited. For example, a client in the distribution business, with very clean financial statements, recently discovered he could not go public because 25% of his customers were retailers that he owned or controlled, and that IRS rules appeared to require consolidating the financial statements of the distributor and the "controlled" customers. Unfortunately, the retailers' records were extremely disorganized and unable to be audited, ending the quest to go public. If you are not auditable, you may want to clean up your records going forward and postpone going public until you have two years of good clean financials.

2. Did you issue all shares? In many early stage companies, "corporate formalities" like issuing stock tend to get overlooked in favor of more important things, like survival! It is more difficult to go back and do this as part of the shell's or investment bank's due diligence review of your company. Get a good corporate lawyer to make sure the company's stock records fully reflect what you have always known is the arrangement between the owners but may not have been written down.

3. Is your intellectual property owned by the company? Patents can only be issued in the name of the individual inventor, then he or she has to assign the patent upon issuance to the company. This last step is sometimes overlooked or, frankly, sometimes the inventor waits to see how things are going before giving up his or her rights. Often trademarks were issued in a prior company, or in the CEO's name, and the same need to assign applies. If you are ready to go public, the IP has to be assigned to the company, or some kind of license arrangement giving the company the right to use the technology, is arranged. Again, it's usually better to do this before due diligence by the shell and investment banker begins.

4. Are all affiliated relationships memorialized? It is important to be up front in the due diligence process about any arrangements, understandings or contracts between the company and its shareholders, officers, directors, affiliates and their relatives. This needs to be disclosed once public, there is nothing unlawful about doing this, but some investment banks prefer to avoid conflicts of interest, for example, when the business rents a facility that is owned by the CEO. If these arrangements exist, and you want to retain them, and they are not in writing, you should memorialize them so there is no dispute as to the nature of the relationship.

5. Is there litigation? If you are in any litigation, there may be times that it is better to make it go away rather than have to explain it to an investment bank and shell owners; even if you promise that the case will settle soon, or at a certain price, or that you have a winning case, the existence of the case could spook an investor and they usually prefer to go public with no material outstanding litigation.

6. Are there any issues in management's background? If a member of management, or the board, or even a large shareholder, has civil or criminal legal problems in their background, particularly if it relates to securities matters, examine the issue carefully and very early on. How serious were the problems? How important is this person to keep around and possibly have the embarrassment of disclosing their background? Can counsel advise that the matter may not need to be disclosed? Could it prevent the company obtaining an exchange listing?

7. Have you run the financials as if you were public? Many private companies are run loosely with regard to financial decisions. Maybe the CEO thought it was right to pay for a colleague's vacation because he worked extra hard. Maybe other perks might seem embarrassing if they were publicly disclosed. You should examine whether these types of things should come out, and try to avoid them in the two years before going public.

8. Are your investors on board? Sometimes prior investors in your company have a right to veto transactions such as IPOs and reverse mergers. Check your investment documents to see if that is true before you start the process, and determine the right time to reach out to investors who have the veto power, but generally the earlier the better.

9. Got a good law firm? As early as possible, engage a law firm with experience representing companies going public, to help with all these issues and more. Disclaimer: your humble blogger runs just such a law firm!

John White: New SEC Small Business Proposals Expected to Reach "Finish Line This Year"

That is the headline from today's SEC Small Business Conference, which I attended in Washington along with about 75 others in person and many others listening in a webcast. In his introduction, the Chief of the Division of Corporation Finance made clear he'd like to get the new small business proposals approved and finalized before New Year's. That said, it looks like it could be even quicker than that, because prior to making his pronouncement, he said, "Chairman Cox always tells us, under promise and over deliver." The sooner the better we say!

In general, the day was a true love fest between the regulators and the panelists and audience (not always the case at these things!). Clearly most of us in the hustings are extremely pleased that the Commission has made a priority of passing a number of the recommendations of the Advisory Committee on Smaller Public Companies, and while any criticisms generally were limited to issues around the edges, all the panelists were very positive with regard to these changes.

Some other highlights from the event:

1. SEC Chairman Cox spoke eloquently about the importance of small business in America, and the fact that government is often "getting in the way" of smaller companies. He views the mission 0f encouraging and promoting capital formation in these businesses as "vitally important."

2. A panel spoke about the proposed Regulation D changes, in particular the beginning of allowing limited advertising to a newly defined group of "super-accredited investors." Many hoped they'd go further, but the panel indicated this is a "first modest step" in moving away from banning all general solicitation, with the hope it could go further down the road.

3. That same panel supported reducing the integration safe harbor from 6 months to 3 months.

4. Then a panel convened on the Rule 144 and Form S-3 changes, led by White and Advisory Committee member Steven Bochner. Bochner described this as an "extraordinary time" in securities regulation. White said he had never seen the Commission so focused on the needs of small business. They had taken, with the Chairman's help, a realistic approach to making proposals that could actually get done in a reasonable time frame.

5. With regard to the S-3 proposal, panelists were mostly pushing to go higher than the 20% of public float limit on how many shares can be registered on S-3 for smaller companies. White's answer/non-answer seemed to suggest that was not going to change. Then they suggested S-3 be available not only for primary offerings, but for resale registrations as well, and with a limit. White did not address or challenge this point, leading one to think maybe, just maybe, they might reconsider this.

6. In their discussion of the Rule 144 changes, the challenge, as indicated in many comment letters, related to tolling the proposed 6 month period for the period of time that a holder is hedging the stock. Again, not sure this is going to change in the final.

7. Commissioner Paul Atkins, a Bush appointee to the SEC, spoke at lunch about some of the same things that Chairman Cox relayed in the morning.

All in all, a good day and very positive feedback to the SEC, which hopefully will lead to a smooth and near-term process for moving to action on these proposals.

Feldman Weinstein & Smith SEC Comment Letter re Smaller Reporting Company Regulatory Relief and Simplification

This is our firm's comment letter to the SEC's proposed elimination of Regulation S-B and migrating all current S-B reporters to a scaled disclosure version of Regulation S-K:

FELDMAN WEINSTEIN & SMITH LLP

420 Lexington Avenue

New York, NY 10170

Telephone: 212-869-7000

Facsimile: 212-997-4242

www.feldmanweinstein.com

September 17, 2007

Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090
Attention: Nancy M. Morris, Secretary
Via e-mail: rule-comments@sec.gov

Re: File No. S7-15-07, Securities and Exchange Commission Release Nos. 33-8819 34-56013 39-2447, RIN 3235-AJ86, Smaller Reporting Company Regulatory Relief and Simplification

Ladies and Gentlemen:

Feldman Weinstein & Smith LLP has the following comments on the Staff's proposed Smaller Reporting Company Regulatory Relief and Simplification.

Our law firm represents issuers, investment banks and institutional investors primarily in business combination and financing transactions, including reverse merger and PIPE transactions, giving our attorneys a front-row seat in observing the challenges which the current rules impose on smaller public issuers. Overall, the proposal appears to further the Commission's goal of helping smaller public companies raise necessary capital on a timely basis and at a lower cost of capital than the current regulations permit. We believe that the following points could result in further improvements:

Raise the Cut-Off for Definition of Smaller Public Company

We agree with other commenters that the Commission should consider adopting the proposal of the Advisory Committee on Smaller Public Companies to allow scaled disclosure for those with up to $787 million of equity market capitalization. These companies represent the lowest six percent (6%) of all companies in terms of market cap. Many of these companies are involved in rapid growth, and the ability to reduce the costs of compliance would seem to be appropriate.

Give Smaller Public Companies a Choice of Forms

It has always been true that a small business issuer had the choice of using the forms specified in Regulation S-B or S-K. Over the last 15 years professionals and executives in smaller companies have grown comfortable with the S-B forms. If an issuer chose to use the S-K forms, however, it was subject to the broader disclosure requirements of that regime.

We propose offering smaller public companies a choice. We suggest leaving Regulation S-B and the S-B forms in place, allowing an issuer to continue to use those forms if it chooses. In addition, the Commission can go forward with the amendments to Regulation S-K to permit scaled disclosure on S-K forms if the issuer chooses. Assuming the Commission did not intend to make any changes to the substantive disclosure requirements for smaller companies, it should not be difficult to harmonize the changes. If a concern exists, a default can be that to the extent there is a conflict between Regulation S-B and the amendments to Regulation S-K, one or the other would control.

Our experience is that issuers we deal with generally do not feel tainted by using the S-B forms. In truth, moving everyone back to the S-K forms but then requiring that a box be checked on those forms indicating the company is a smaller public company would likely have the same risk of taint as using the S-B forms.

In addition, respectfully we do not agree with the argument that this relief is necessary to avoid having lawyers and accountants learn two disclosure systems. By retaining scaled disclosure, even within Regulation S-K advisors will effectively still have to learn two systems.

This concern, apparently based on anecdotal reports, to our knowledge is not widespread, and does not seem to justify requiring all small and microcap market participants to learn a new system.

If the Commission is not inclined to allow two systems, maybe a trial period of three years with both would make sense, after which it could be determined whether in fact issuers voluntarily migrate back to Regulation S-K. If a significant number in fact do so, then the Commission's theory would be proven. If not, it might consider going back to the current S-B regime.

For Real Relief, Allow Exclusion of Non-Material Information

In our Managing Partner David Feldman's testimony to the Advisory Committee in 2005, he suggested replacing Regulation S-B with a Regulation D-type disclosure for unaccredited investors. This would mandate retaining the forms, and including all the information that would be required to be in the comparable report or registration statement, but could exclude information which is not material. We still believe this is worth considering.

The Commission might be concerned that this leaves issuers in charge of deciding what information is material. But there are many instances within current Regulation S-B where issuers must do exactly that, in places where the issuer must disclose, for example, litigation if material.

One could still retain the requirement on certain items to retain all information, such as in Management's Discussion and Analysis of Financial Condition or Plan of Operation, or in Executive Compensation. But the slavish requirement to answer every item, regardless of whether a reasonable investor would consider the information important, is one of the ways smaller issuers waste time and money in their compliance obligations.

Limiting disclosure to material information would be a major step forward in recognizing the unique needs of smaller issuers, making it more attractive for them to consider going public and obtaining all the benefits thereof, make capital formation easier, make the U.S. securities markets more competitive and in no way jeopardize investor protection, as the only information not provided is that which is not material.

Conclusion

We are extremely pleased to see the Commission turn its attention to adopting a number of the recommendations made by the Advisory Committee on Smaller Public Companies. In general, the proposal (as well as its five companion proposals which relate primarily to implementation of the Committees recommendations) will provide an extremely significant advance in striking a more appropriate balance between careful regulation and removing unnecessary impediments to capital formation. From the proposed shortened holding periods for Rule 144, to the suggested improvements in Regulation D and broader availability of short-form registration, these are truly the changes that all participants in the small and microcap markets have been awaiting at least since the establishment of the Committee.

Thank you for your consideration of our comments in this matter.

Respectfully submitted,

Feldman Weinstein & Smith LLP 420 Lexington Avenue, Suite 2620 New York, NY 10170 www.feldmanweinstein.com

SEC Small Business Forum next week..

"The SEC hosts an annual forum that focuses on the capital formation concerns of small business. Called the SEC Government-Business Forum on Small Business Capital Formation, this gathering has assembled annually since 1982, as mandated by the Small Business Investment Incentive Act of 1980. A major purpose of the Forum is to provide a platform for small business to highlight perceived unnecessary impediments to the capital-raising process."

This quote from the SEC website describes the annual meeting I will be attending next week in Washington. This forum is particularly notable for its ability to forecast future action by the SEC as it relates to small business. For example, at last year's forum, then Corporation Finance Associate Director Marty Dunn suggested the possibility of shortening the Rule 144 holding periods and making Form S-3 available for some smaller companies on a limited basis. Sure enough, 8 months later the Commission proposed those very two changes.

The SEC staff uses the forum as a way to get a sense of market reaction to their possible actions. Of course they have other methods of gathering that information as well, and since there is no charge for the forum, it certainly attracts, shall we say, a wide range of audience members. My impression is there are some on the staff who are slightly annoyed that there is a statutory mandate for them to hold this conference, whereas most see it as an opportunity to connect with those "in the hustings" getting things done to gauge their concerns. SEC Chairman Cox also will be speaking.

After the conference I'll come back and report if anything exciting took place. For example, I'm hoping they might announce a timetable for when the various small business proposals (144, etc.) may be set for final approval.

Virgin Shell Creation Escalating; They're Easy to Set Up - Right?

Here's the good news. The pace at which virgin shells are being created is escalating, as the market continues to recognize the value of these straightforward vehicles. And that value is increasing with the potential elimination of the so-called Worm/Wulff restrictions; the SEC will shortly approve a rule making Rule 144 resale of shell shares available six months after a reverse merger and release of information (currently shell shares can never be resold under the Rule 144 exemption from registration).

Many clients who have already created virgins are "running out," and making more. Others who were on the fence have moved forward. More and more mergers with virgins have closed, and are trading. This thing works, especially when a private company is seeking to close a contemporaneous PIPE with a reverse merger, rather than wait for a self-filing, which can take time and is appropriate when a company has that luxury.

To recap, a virgin shell (so dubbed by the Reverse Merger Report, in my book I simply called them "Form 10-SB Shells"), is created when a corporation set up to be a shell (typically in Delaware, but I have seen other states) goes public with the filing of Form 10-SB with the SEC. After the effectiveness of the filing, the company becomes fully reporting with the SEC, but its stock cannot trade prior to a reverse merger and subsequent registration of shares with the SEC. (Disclaimer: I personally own an interest in six virgin shells.)

Why is this better than a self-filing? It's all about timing. If you know you don't need to raise a large PIPE for 5-8 months, a self-filing might make sense. If you need to raise a larger PIPE sooner, a merger with a shell allows that PIPE to be raised upon closing the merger, which takes only a few months. This is the value of merging with a shell.

Why is this better than a trading shell? In a prior post which you can find at http://www.reversemergerblog.com/2007_04_01_archive.html, I outline the pros and cons of each. There are situations where a trading shell makes sense, but frankly, less than you might think. If there's an urgent need for a shareholder base (such as if you wish to go right to Nasdaq or Amex immediately) or an investor who insists on trading going on even though his securities will not be tradable until registered, there may be no choice. But the costs and risks associated with trading shells are significant compared to virgins, hence the attractiveness. Plus we know the SEC disfavors shells that trade, and favors those that don't. The proof is the fact that our Form 10-SB filings are now greeted with a hard to obtain "no review."

Here's the bad news (which is also sort of good). More and more people are setting up virgin shells with either limited or no legal assistance and in some cases with auditors who charge low fees but have very limited SEC experience. I believe our firm has set up more than any other (we've been hired to create over 120 virgin shells in the last 2 years), so of course we have the flattering problem of seeing our carefully developed Form 10-SB copied by others. Amazingly, even when that happens people make mistakes, are careless, etc. Copiers don't realize how many things are going on behind the scenes to make our virgin shells truly pristine.

I do not wish to catalog the various issues and problems we have encountered with virgins created by those with little experience. I simply wish to warn the marketplace that, while the process of creating these is very straightforward for someone who has done quite a bit of it, there are a variety of issues to deal with if you are doing it for the first time, and there are several traps that the uninitiated fall into that in some cases are not reparable.

My very very strong advice is: don't do this at home. If you are thinking about setting up virgin shells, please make sure you hire competent auditors and counsel who have real experience in doing this, even if there is a slightly higher cost. My mother always said, "You get what you pay for."

To those of my brethren observing, I wish you all a Happy and Healthy New Year. And to all, Happy Fall!

The Week that Hell Brought

I was driving my daughter and her friend to school on a sunny Tuesday morning when it came over the radio. We thought it was a joke on the top 40 station. “A small plane has hit the World Trade Center.” When we realized it was real, I said, well that’s downtown, my office is midtown, I should be able to still head in. I dropped off my daughter and found myself right next to JFK Airport when they reported the second plane hitting. At that moment, all traffic on this normally busy thoroughfare came to a dead halt. As I sat there very confused about what was happening (although immediately Howard Stern said “we’re being attacked”), I remembered the ’93 Trade Center bombing and immediately called the office and closed it, telling everyone to get home and get safe. After 20 minutes of inability to move, I turned around and went home, worried about my daughter at that point. She came home about an hour later.

Our staff first gathered at the restaurant next door to our then office to watch the TV and then realized they needed to scatter. My assistant at the time walked home to Queens over the 59th St. bridge. An associate was worried about his Dad, thinking he was downtown (he was not). A partner's wife came up out of the subway down there and saw everything (she managed to turn around and get out). Another associate walked up to the upper east side to his mother’s and did not get home to Jersey until the next day. My family and I were worried about my brother-in-law next door to the Trade Center at World Financial Center (we did not hear from him until 2pm telling us he was in the hospital treated for smoke inhalation, he got home around 1 am that night after thinking he was not going to make it as the building fell very close to him).

I spent the day watching the TV and emailing basically every person I knew to see if they were OK (it took 3 scary days to find one friend who was out of the country). The next day, with all bridges and tunnels closed, almost all of us made it in anyway. There was no point, as our phones had gone out. We sent an email to everyone we could with our cell phone numbers and such, but no one was calling. We all went for a very long liquid lunch and then went home. That afternoon I reached an old friend who worked at Marsh & McClennan on the 107th floor. Thankfully he was in Florida at a conference. He could barely speak. He told me he supervised a team of 12 people, and had ordered all of them to come in early that day, and they all died.

Then Thursday, more people on the streets, but by noon there were over 100 bomb threats in the city and rumors the trains might shut down, stranding everyone in the city. Still no phones. We closed again and said we’d stay closed until Monday. I remember literally running from the office to the Long Island Rail Road's Penn Station with an associate, stopping only for a moment to pay $2 for a small American flag which still sits in my office. Good thing we stayed closed because hundreds more bomb threats on Friday.

I spent Friday at home wondering what to do. Our phone provider said they had no idea when the phones would be back. Their transformer was at the Trade Center. It wasn’t like you could just call Verizon and ask them to come put new lines in. The city was a mess.

Miraculously, around noon just for fun I called the office and the phone lines suddenly were working. On Monday we all came back, still shaken up but determined. Clients started calling. That deal we were working on before this, let’s get it done. It took a month or so but then things were back to humming as always.

I allowed employees to volunteer down at the site during work time if they wanted to. I offered space in our suite to attorneys whose offices had been destroyed or inaccessible. We did all we could. But we could not bring back the thousands who perished, including so many who died trying to save others.

Now that Osama has discovered Grecian Formula, you can bet he’s determined to do it again. I hope you will take a little time on Tuesday, both to remember the bravery of those who died and those who risked illness to work on the Pile for months, and to remember our need to stay vigilant and resolute in our desire to rid the world of this horrific evil. And also, to remember the wonderful things that happened as the city and our nation came together in those difficult days.

I will remember two that I knew who did not make it that day, Dave Weiss of Canter Fitzgerald and Neil Levin, head of the Port Authority.

And the Rule 144 proposal comments are in...

This past Tuesday was the deadline to submit comments to the extremely fantabulous SEC proposal to shorten the holding periods for restricted securities under Rule 144 in most cases to six months. As we all know, this change (along with the changes to Form S-3 availability and other things) has already had a major impact on deal and market activity in the small and microcap worlds.

And the verdict is, other than one former SEC staffer who thinks some abuses will occur, every other commenter (there are several dozen) is very positive on the proposed changes to Rule 144, viewing them as a reasonable balance between investor protection and ease of capital formation. This from very large law firms, the influential Jesse Brill of the Corporate Counsel, and several law firms working heavily with smaller public companies. This means it seems very likely that the proposals will be adopted, and hopefully without too many changes. We also hope this will happen soon!

Here are some interesting suggestions from the commenters that I think are worth noting:

1. Cash/Cashless exercise. One of my friendly competitors has suggested that there should be no difference in availability of Rule 144 in warrant exercises based on whether or not the warrants are "cashless." Some warrants have to be exercised for cash, others allow you to trade some "in the money" warrants as the purchase price for others, without cash. The SEC has in the past suggested that the 144 holding period can tack in a cashless but not cash exercise. The commenter says there is no reason for the difference, and I agree. A large law firm suggested a middle ground, proposing that there be no tacking in a cash exercise only if the cash purchase price is de minimis, i.e. less than 1% of the market value of the shares.

2. Shells that are not blank checks. Another of my friendly competitors represents small, even pre-revenue, pre-asset type companies that go public. The SEC proposes allowing holders of shares of a shell company to be able to sell under 144 generally six months after the reverse merger and availability of the "super" Form 8-K. This is a major change from their prior position that 144 is never available for holders of shares of a shell, that the shares must be registered to be sold. A shell company is defined as having no or nominal assets (other than cash) and no or nominal operations. The problem is some of his clients fit this definition but yet are real start-up or early stage companies with real business plans and no intention to market themselves as a shell. Under current rules, 144 is available to them, but the proposal will inadvertently sweep them in and require them to wait six months after the going public event, even if they have held their shares for several years.

I believe this is a logical recommendation and I hope the Commission will address it. My impression is that the staff seeks to move away from the old definition of "blank check" company (a development stage company with no business plan, or whose business plan is to acquire another business) and use the shell company definition above in all its regulation of the reverse merger and IPO alternative world. Hopefully this inconsistency can be addressed.

3. Regulation S. As mentioned in an earlier posting, a number of commenters are suggesting the SEC change the holding period for securities acquired in an offshore offering pursuant to Regulation S. This makes sense. A group of large law firms from London put in a letter strongly supporting this.

4. Voluntary Filers. An interesting comment that I have a little problem with came from big law firm Fried Frank. The proposed rules require longer holding periods for companies that are not required to file reports with the SEC under the Securities Exchange Act of 1934. But the law firm points out that many companies file voluntarily, in many cases because of contractual obligations or provisions of trust indentures. Some companies that trade on the Pink Sheets also file voluntarily. Their proposal is to treat voluntary filers the same as mandatory ones.

Here I respectfully disagree. Voluntary filers are not subject to the other investor protection features of the '34 Act, such as insider filings by affiliates, proxy regulation, the requirement to file Forms 8-K when material events happen between filings and the like. Voluntary filers generally just file 10-Q and 10-K forms and nothing else. I'm not sure that substitutes for the additional protection of all these other requirements. And it would seem a bit unfair for these companies to benefit from the shorter holding period without having to satisfy these other obligations. And finally, I find that voluntary filers are more likely to be a little less careful in preparing the forms, knowing that the filing is not technically subject to SEC review or scrutiny.

5. Form 4/144? Leave it to brilliant man Jesse Brill of the Corporate Counsel. The SEC had asked if somehow filing of Form 144 by affiliates could be combined with filing of Form 4 which is required two days after any sale or purchase by an officer, director or 10% holder. Brill suggests a new form, called Form 4/144, to be used to satisfy both obligations together. It takes Form 4 and adds a few features from the Form 144, but not everything. He suggests requiring it to be filed by 10 pm on the day of the sale, earlier than Form 4. He even attached his idea of what the form could look like. Seems like a good compromise to me.

6. More "no tolling" comments. Good news that more law firms, including major firm Cleary Gottlieb, put in a strong disagreement with the SEC's proposal to limit availability of Rule 144 when a holder has been hedging the stock. Maybe, just maybe, the SEC will take these comments to heart and realize there is no reason to have this restriction that will simply erase many of the benefits they are seeking to achieve from these proposals.

7. Retroactive? One commenter requested that the SEC make clear that the operation of the shorter holding period would be retroactive, rather than randomly picking a date after which the rules would apply. I agree. As the commenter pointed out, a company conducting multiple closings of an offering could actually have some investors with one Rule 144 application before the effectiveness of the rule and another application after, which obviously makes no sense. Hopefully they will make it retroactive.

All in all, good stuff. Now let's hope the staff will sharpen their pencils quickly so we can have certainty that the opportunity to implement these great ideas will not be lost.