SEC extends “test-the-waters” option to all companies

Has your company ever considered issuing public stock? The Securities and Exchange Commission (SEC) has adopted a rule that might make the process easier.

Broader scope

The SEC voted in September to finalize a rule that would extend the “test-the-waters” provision of the Jumpstart Our Business Startups (JOBS) Act to all companies planning to go public. Release No. 33-10699, Solicitations of Interest Prior to a Registered Public Offering, allows all companies that want to gauge market interest in a possible initial public offering (IPO) to have confidential discussions with institutional investors before filing a registration statement.

Currently, only emerging growth companies (EGCs) are permitted to do so. Under the JOBS Act, EGCs are a class of companies that have less than $1 billion in revenue. They’re also eligible for a host of regulatory breaks for five years after going public.

The rule generally will allow issuers to “evaluate market interest in a contemplated registered securities offering before incurring the costs associated with such an offering, while maintaining adequate investor protections.” It will take effect 60 days after publication in the Federal Register, which normally occurs a few weeks after a rulemaking document is posted on the SEC’s website.

Release No. 33-10699 adds Rule 163B under the Securities Act of 1933 to let any issuer test the waters. In particular, the rule exempts a company’s verbal or written communications with potential investors from the restrictions imposed by Section 5 of the Securities Act either before or following the date of a registration statement. Section 5(b)(2) establishes the requirement that a prospectus be issued before securities can be sold to investors.

The fine print

The test-the-waters provision still sets some boundaries that companies must follow. For example, potential investors must be qualified institutional buyers (QIBs) or institutions that are accredited investors as defined in Rule 144A and Rule 501(a) of the Securities Act. A QIB is a company that owns and invests a minimum of $100 million in securities not affiliated with the company on a discretionary basis. For a broker-dealer, the QIB threshold is $10 million.

In addition, companies that are subject to Regulation Fair Disclosure (Reg FD) must consider whether any information used when gauging investor interest would trigger disclosure obligations under the regulation or whether an exemption would apply. Reg FD requires public disclosure of any material nonpublic information that has been selectively disclosed to certain securities market professionals or shareholders if the issuer has a class of securities registered under Section 12 of the Securities Exchange Act of 1934 or is required to file reports under Section 15(d) of the act.

More successful IPOs

Extending the test-the-waters rule is part of the SEC’s broader effort under Chairman Jay Clayton to encourage more companies to go public. Regulators have been concerned in the past several years about the declining number of IPOs. The test-the-waters provision will give companies contemplating an IPO the opportunity to fix any shortcomings in their disclosures before releasing them to the public — or they may decide not to go public after all. Either way, the confidential process protects these companies from lengthy scrutiny from investors, the media, and competitors.

The U.S. Chamber of Commerce welcomed this decision.

“The U.S. is home to half of the public companies that existed two decades ago, said Tom Quaadman, the chamber’s executive vice president, “and this step by the SEC will now help make it easier for new companies to go public.”

Seeking outside input

SEC Chair Clayton believes that “investors and companies alike will benefit from test-the-waters communications, including increasing the likelihood of successful public securities offerings.” But going public isn’t right for every business.

Giving firms the ability to “test the waters” with professional investors will certainly encourage more exploration of the benefits of public offerings. In our experience, the costs of IPOs are often deemed prohibitive, and an early insight from the investment community will add a valuable data point for management teams weighing the relative risk/reward of this decision.

The team at 2nd Generation Capital, a KraftCPAs affiliate, can help answer your questions and discuss the pros and cons of an IPO.