The Struggle to Disclose an Issuer’s Intended Uses of Proceeds in Registered Public Offerings

The Use of Proceeds section of an offering prospectus affords investors a window into an issuer’s operational mindset and serves to drive the entire prospectus disclosure. The use of proceeds establishes management’s most important business initiatives, underpins the terms and amount of the offering, provides a snapshot of the issuer’s near-term financial condition and identifies the areas where management may need additional or specialized expertise. From there, the Use of Proceeds section addresses the risk factors involved in the issuer’s execution of its business initiatives, informs the liquidity and capital resources section of Management’s Discussion and Analysis concerning the sufficiency of the issuer’s cash to cover operating expenses for the next 12 months and, of course, is central to the cautionary note regarding the issuer’s forward-looking statements. In fact, the SEC has indicated in its comment letters that, especially in the case of an initial public offering (IPO) by a smaller issuer, the issuer should disclose whether the proceeds from the offering will be used to fund each and every element of the issuer’s growth strategy typically included in an issuer’s offering prospectus summary.    

Item 504 of Regulation S-K requires an issuer to identify the principal purposes for which it plans to use the net proceeds from an offering and the approximate amount intended to be used for each of those purposes.  For example, many issuers intend to use the net proceeds from their offering to fund research and product development, marketing and sales, potential acquisitions and repayment of outstanding loans.

For an issuer that is unable to specify its intended use of proceeds, it must alternatively state that it has no current specific plan for a significant portion of the offering proceeds and discuss the principal reasons for the offering at the time of the filing given this lack of a plan, and include as a risk factor its lack of a specific plan.

Despite the importance to investors of understanding the purposes for which an issuer’s net proceeds are intended to be used, it appears many issuers are routinely providing little specificity with regard to the allocation of their proposed net proceeds.  Instead, the disclosure is often vague without any current specific plan included in the Use of Proceeds section, potentially qualifying the transaction as a “blind pool” under federal and state securities laws, or it is lumped into “general corporate purposes,” the most general term that companies can use in this section.  Indeed, in many recent prospectuses, the Use of Proceeds section is the shortest of all substantive disclosure sections in the prospectus. And, most issuers no longer utilize the once customary Use of Proceeds table that listed each use, its respective amount and percentage of the total net proceeds, and prioritized the uses.

In a June 2021 letter from two U.S. Senators to SEC Chair Gensler and Commissioner Lee providing input on the SEC’s proposed regulation of issuers’ climate change disclosures, the Senators wrote:

The SEC can help address [climate change disclosures] by requiring greater transparency and specificity regarding use-of-proceeds declarations in prospectuses. Issuers should clearly communicate to the market what they intend to finance with the proceeds of debt or equity offerings. If the Commission permits issuers to cite “general corporate purposes” with no accountability, there can be no way of knowing whether capital will, in fact, be dedicated to the transition [to low-carbon business models]. More specificity around proceeds will also go a long way towards ensuring financial firms (whether underwriters or asset managers) are meeting their stated climate commitments.

Perhaps some issuers believe that specific information required pursuant to Item 504 of Regulation S-K forces them to publicly reveal business plans that might put them at a competitive disadvantage or they think that a lack of transparency allows them to keep more of their options open. It is unclear whether such an approach is actually benefitting those issuers. Certain academic studies, described in more detail at the end of this blog post, have suggested that more specific use of proceeds disclosure has the potential to reduce IPO underpricing for issuers and assist investors in evaluating an issuer’s prospects in the early years following their IPO.  

Disclosures in Special Situations

Whether or not an issuer has a specific plan for its offering proceeds in place, there are many instances requiring special Use of Proceeds disclosure under Item 504 of Regulation S-K that an issuer may overlook. A number of special situations are described below.

Repayment of Indebtedness

If the issuer intends to use any of the net proceeds to repay outstanding indebtedness under its promissory notes, loans or credit facilities, the issuer must disclose the interest rate and maturity date of such debt pursuant to Instruction 4 to Item 504. Similarly, if an issuer expects to use a material amount of the offering proceeds to service its debt by paying only the accrued interest on the note, rather than repaying the remaining outstanding amount in full, the same disclosure is required in Use of Proceeds. Frequently, when the indebtedness is incurred within one year, such as in a pre-IPO bridge financing consisting of promissory notes, an issuer must also include a statement as to how it used the proceeds from the previously incurred debt. This requirement, however, does not include short-term borrowings used for working capital. In certain instances where issuers disclose that they have outstanding debt but do not plan to use any of the proceeds to repay it, the SEC may ask the issuer, typically one with negative working capital, to address how it intends to meet its cash needs, including debt obligations, over the next 12 months.

Drug Development and Clinical Trials

In the biotechnology space, if an issuer intends to use any of the net proceeds for clinical trials of its drug candidates, the issuer must disclose whether it will be able to complete those trials with the offering proceeds or, alternatively, how far the issuer expects to reach in the clinical development process for each of the drug candidates with the proceeds from the offering.  In many instances, the biotech issuer cannot describe in greater specificity how far it expects the net proceeds from the offering to reach in the development of its drug candidates due to the uncertainty of timing for FDA marketing and other regulatory approvals, but it is nonetheless required to provide the reasons why that is the case. If the proceeds from the offering are insufficient to cover each specified purpose (which may include not only conducting trial but also clinical and development milestone payments), the issuer must state the amounts and sources of other funds needed for each specified purpose and the sources for additional funds as required by Instruction 3 to Item 504 of Regulation S-K.  Additionally, the SEC has indicated in comment letters that, where the issuer is progressing with multiple drug development programs, proceeds should be allocated by individual development program, rather than disclosed in the aggregate.  In some cases, issuers have aggregated their use of proceeds by stage of development or clinical phase rather than by development program, indicating that this is the appropriate allocation for investors to understand how far the funds from the offering will allow them to proceed with the continued development of their programs.  

Beyond the biotechnology industry, this use of proceeds disclosure also applies to issuers in other industries that develop new products or service offerings, where capital is needed to fund discrete development projects over time. 

Business Acquisitions

If the issuer intends to use any of the net proceeds from the offering to fund the acquisition costs of a specific pending or future business, the issuer must identify and describe the business, describe the material terms of the acquisition agreements, file the agreements as exhibits to the registration statement, and add risk factors to address any risks associated with the acquisition. Moreover, if the acquisition is probable at the time of the offering, the issuer must include audited historical financial statements of the business to be acquired and pro forma financial statements showing the effect of the acquisition on the issuer, pursuant to Instruction 6 to Item 504 of Regulation S-K. Under the Use of Proceeds section of the prospectus, the issuer must disclose the approximate dollar value of the amount of net proceeds expected to be used in connection with the acquisition, including a percentage breakdown of the amount for such items as earn-out cash payments, integration-related expenses and other similar matters. If the issuer intends to use the offering proceeds for acquisitions but it does not have any current plans, arrangements or agreements in place for such acquisitions, it must disclose this fact. In the extreme example of an IPO by a special purpose acquisition company (SPAC), which is specifically formed for the purpose of effecting a future business combination with one or more unidentified businesses, the usual prospectus cover page prominently states that the company has not selected any specific business combination target and it has not, nor has anyone on its behalf, initiated any substantive discussions, directly or indirectly, with any business combination target.

Best-Efforts Offerings

If the public offering is structured as a best-efforts offering with minimum and maximum aggregate offering amounts, the issuer must show its use of proceeds information in multiple scenarios assuming varying levels of proceeds raised and number of shares sold in the offering pursuant to Instruction 1 to Item 504 of Regulation S-K. Typically, the disclosure would indicate the use of proceeds from the offering based on 25%, 50%, 75% and 100% of the offering being completed, with a discussion of the issuer’s priorities for the proceeds at each level. If there is a minimum amount of offering gross proceeds that must be raised to hold an initial closing for the offering, the minimum amount of the gross proceeds should also be reflected among the differing proceeds allocations.  

Proceeds Benefitting Related Parties

If the issuer intends to use any of the net proceeds from the offering for a purpose that would benefit an executive officer, director or principal shareholder of the issuer, disclosure of the transaction and the total amount of the offering proceeds that such related party will receive must be included in the Use of Proceeds section of the prospectus. Examples of these transactions include the repurchase by the issuer of its shares, warrants or other securities from a related party, repayment of an issuer’s third-party indebtedness that was guaranteed by a related party and repayment of a related party for advances made in connection with the upfront expenses of the offering. Cross-references to disclosure under Certain Relationships and Related Party Transactions should be made to explain any associated conflicts of interest.

Special IPO Bonuses

If the issuer intends to use any of the net proceeds from the offering to pay a one-time bonus to an executive officer, for example, upon the closing of the issuer’s IPO if the offering size reached a certain level, the issuer must include this payment in its Use of Proceeds discussion (ideally under a separate line item, rather than working capital), as well as other sections including Executive Compensation.

Secondary Offerings for Selling Shareholders

In a secondary offering, where a resale shelf registration statement involves the sale of securities by selling shareholders, the registrant must disclose that it will not receive any of the proceeds from the offering. However, if the selling shareholders acquired their securities in a pre-IPO private placement or a PIPE offering that included warrants and would be required to exercise the warrants they received for cash prior to the sale of the underlying registered shares of common stock, the registrant must disclose the use of proceeds that it may receive from those selling shareholders who exercise their warrants.

Warrant and Option Exercise Proceeds

If the public offering includes units consisting in part of warrants to purchase common stock for cash, the issuer must disclose the use of proceeds, if any, that it may receive from those investors who exercise their warrants. Similarly, if the proceeds from an underwriter’s exercise of its over-allotment option to purchase additional shares in the offering will be used for purposes other than those already delineated for the offering, that disclosure would also be required.

Changes to the Use of Proceeds

Even if an issuer has a current specific plan for its offering proceeds, an issuer is not committed to that particular course of action and may reserve the right to change its stated use of proceeds, provided that such reservation is due to certain contingent events that are discussed specifically and the alternatives to any such uses in those events are indicated, according to Instruction 7 to Item 401 of Regulation S-K. Additionally, where the issuer indicates that it may draw funds from certain less important business objectives if more funds than estimated are required to complete more pressing objectives, the issuer needs to disclose how it will prioritize the order of the objectives for purposes of deciding from which ones to draw funds. Following an issuer’s initial registered offering, Securities Act Rule 463 and Item 701(f) of Regulation S-K require periodic disclosure of the use of offering proceeds so investors can try to follow an investor’s changed plans and priorities.

Pending the Use of Proceeds

At the bottom of the Use of Proceeds section, issuers typically indicate that pending application of the stated uses of the offering proceeds, they intend to temporarily invest the net proceeds in “short-term, interest-bearing obligations” or, in other words, “safe” investments. Investing offering proceeds in a highly leveraged hedge fund pending the use of those proceeds would normally not be considered a safe investment.  

Use of Proceeds Misstatements and Litigation

In a number of recent enforcement actions, the SEC has indicated that material misstatements and misleading omissions regarding an issuer's use of offering proceeds are violations of the antifraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. While public companies may believe that they have the benefit of the Private Securities Litigation Reform Act's safe harbor for forward-looking statements when making their disclosures, the SEC has alleged that because the issuer knew that the statements were false when made, the issuer does not get the benefit of the safe harbor's protection. In particular, the SEC has brought complaints against issuers and executive officers relating to the failure to disclose that funds raised in the offering would be used for stock promotion activities (SEC v. GPL Ventures LLC, 1:21-cv-06814 (S.D.N.Y.)) and commissions to be paid to brokers in a Regulation A+ public offering (SEC v. Davenport, 8:21-cv-01427 (C.D. CA)), and seeking penalties to make investors whole.

.   .   .   .   .

It appears lately that many issuers are struggling with use of proceeds disclosures. Issuers are routinely providing little specificity with regard to the allocation of their proposed net proceeds. This may not necessarily be benefitting those issuers.

A number of academic studies have been conducted over the past ten years on the impact of an offering’s use of proceeds disclosure on valuation. The studies looked at use of proceeds disclosures relating to the intended uses of the proceeds (e.g., growth, production or financing) and amount committed to specific purposes. These variables were then related to IPO underpricing, survival prediction and expected and realized prospects of the IPOs. The results suggested that the use of proceeds disclosure has an incremental impact, perhaps more than any other source of information, for underpricing, for predicting firm survival and, in the case of some disclosure categories, for investors’ evaluation of the issuer’s prospects and risks in the early years following their IPO. One study documented substantial variation in the specificity of this disclosure and found that an increase in such specificity was associated with reduced IPO underpricing. Overall, the results suggested that IPOs with more specific use of proceeds disclosures allow investors to more aptly and confidently estimate secondary market stock performance.

It is likely that as the SEC rolls out additional disclosure requirements centered on items like climate change and cybersecurity to which issuers will be required to dedicate capital, issuers will be expected to provide even greater transparency to investors about the use of their offering proceeds.

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