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Growth Companies Should Disclose Financial Projections In IPO Prospectuses

Spencer Feldman's article first appeared in Law360 (April 9, 2021, subscription required)

Initial public offerings of early-stage and smaller companies — and many times larger emerging companies in quickly evolving industries — are typically focused around an issuer's future growth initiatives.

Ironically, IPO prospectuses of these early-stage and growth companies lack any financial projections quantifying the impact of their initiatives, even while, anecdotally, their investment bankers encourage such projections as a necessary tool to market and price an offering successfully.

The Nasdaq Stock Market, as part of its listing review, frequently conditions its approval on receiving internal financial projections to confirm continuing eligibility following the IPO.

And, in a de-SPAC transaction, in which a previously private company combines with a special purpose acquisition company to become a public reporting company with publicly traded shares, these same issuers are routinely providing financial projections in their proxy and registration statement filed with the U.S. Securities and Exchange Commission in a transaction closely resembling an IPO.

As a legal matter, financial projections are neither required to be included in an IPO prospectus by SEC rules nor considered by the SEC to be material to investors otherwise requiring disclosure.

The SEC's position — almost universally shared by legal counsel — is that newly public companies are untested and uncertain, so that investors have an insufficient objective basis upon which to judge the reasonableness of the assumptions underlying the financial projections.

The SEC's position is also bolstered inasmuch as issuers themselves almost always caution investors not to place undue reliance on their projected financial information.

Based on our review of IPO filings over the past three years, no IPO company has actually provided financial projections, other than vague narrative disclosure in response to the SEC's management discussion and analysis rules regarding trends in liquidity and financial condition.

This is largely due to the SEC's decision to exclude IPOs from the liability safe harbor for forward-looking statements contained in Securities Act Section 27A.

Despite this obstacle, IPO companies might want to consider financial projections in their efforts to complete a successful public offering.

For technology growth companies, which condition their profitability on the proceeds to be raised so that positive earnings follow a successful IPO and not the other way around, the inclusion of projected financial information is particularly material as it provides a deeper level of transparency into their technology and product development operations, go-to-market strategy and commercial partnership prospects.

The SEC should encourage issuers to make this information available to prospective investors in IPOs given the safeguards against potential abuse built into the SEC's guidance, as described below.

It is time for emerging growth companies — an SEC-defined term measured by an issuer's annual gross revenues, not at all by its growth — to finally show their growth trajectory, and not just trailing, historical financial information.

The SEC provides specific guidance for including compliant projections.

The SEC provides specific guidance in Item 10(b) of Regulation S-K for projected financial measures in SEC registration statements and periodic reports.

Item 10(b)(1) requires that management have a reasonable basis for presenting its good faith assessment of a company's future performance. This may include projections that are based on contracted sales and billings along with sufficient production capacity, or historical experience reaching targeted financial levels with similar operating assets.

This may not necessarily include financial projections based on assumptions derived from management's experience in other companies and industries, industry statistics alone or other third-party information.

Item 10(b)(2) provides that consideration must be given to the financial line items to be projected, the period to be covered and the manner of presentation to be used.

Here, issuers are encouraged to present the financial items used by management and external users of a company's financial statements for certain ongoing business purposes, such as to confirm adequate working capital reserves, compete in client bid proposals or comply with bank financial ratios, with the disclosure limited to a period in which the information can be reasonably estimated — usually from the remainder of months left in the current fiscal year, as used in Revlon's 1992 prospectus, to two or three years.

Item 10(b)(3) provides that the disclosures accompanying the projections should facilitate investor understanding of the basis for and limitations of the projections. Accordingly, the financial projections section of a prospectus needs to describe the key qualitative and quantitative assumptions made by the company to support the disclosure, such as growth capital expenditures, availability of capital and unused credit lines, cash flow from existing assets and business activities, and the prices of commodities and labor.

Based on SEC comments and other guidance in the field, issuer management would need to disclose that it will furnish updates to the projected financial information when management believes the projections no longer have a reasonable basis or management discovers errors regarding assumptions underlying such projections.

This responsibility to update may not be disclaimed. In the event of a material change in an issuer's business, operations or capital resources that affects the projections, the issuer should update the projections or withdraw them altogether.

Absent such update, subsequent periodic SEC reports may serve to effectively reaffirm the projections.

The safe harbor for forward-looking statements, however, excludes IPO projections.

Financial projections and other forward-looking information contained in SEC registration statements and periodic reports are afforded the benefits of Section 27A of the Securities Act, which provides issuers with a safe harbor from private legal actions based on allegations of a material misstatement or omission.

However, projections used in IPOs are specifically excluded from the safe harbor's protection from liability, notwithstanding compliance with the SEC guidance described above. Since 1979, when the SEC adopted a safe harbor for release of forward-looking information, the SEC has several times considered and declined when adopting other securities offering reforms to amend the safe harbor rule to apply to IPOs.

Each time, the SEC expressed concern that first-time issuers would use forward-looking information without a sufficient public filing history on which investors in a securities offering could assess the reliability of an issuer's prior forecasts and estimates.

For early-stage and growth IPO issuers that base their valuation largely on anticipated future growth, the impact of this exclusion may be more significant on them rather than on larger issuers with more significant assets and a longer operating history.

In our experience, it is believed that issuers and underwriters of microcap and small-cap IPOs would be in favor of including financial projections in IPO prospectuses if only such information were accorded a safe harbor from liability.

This result could be highly beneficial to bringing a larger number of growth companies successfully into the regulated public markets in the highest protective manner for investors.

Cautionary statements for financial projections are still limited.

All assumptions underlying unaudited financial projections are subject to some degree to uncertainty due to the unknown impact of projected events and circumstances. Providing meaningful cautionary language around these projections can be tricky.

The more an issuer distances itself from the projections by disclosing significant business, economic, regulatory and competitive uncertainties or by seeking to disclaim the accuracy of the projections, the more the SEC will question the appropriateness for inclusion of such information in the first place.

In SEC comment letters, the SEC has made clear that an issuer may not disclaim responsibility for, or any association with, the financial projections. The issuer must state that the projections are based on assumptions that it believes are reasonable as of the date of the prospectus in which the projections are contained.

Acceptable boilerplate disclaimers by an issuer may, however, include: there can be no assurance that the projected financial results will be realized, the projected and actual results will vary, and those variations may be material and likely to increase over time, and the inclusion of the projections in the prospectus should not be regarded as a representation or guarantee by the issuer or any other person that the projections will be achieved.

Further, the issuer's independent accountants will typically request a statement preceding the disclosure that the financial projections have not been examined, compiled, reviewed or audited by them and, consequently, the accountants assume no responsibility for the financial projections.

The disclosure rules for management discussion and analysis already call for financial projections.

Despite the inapplicability of the safe harbor for forward-looking statements made in connection with an IPO, disclosure required in a company's management's discussion and analysis of financial condition and results of operations filings in an IPO prospectus must include a discussion of certain forward-looking information bearing on a company's liquidity, capital resources and results of operations.

The instructions to Item 303(a) of Regulation S-K require that the issuer focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.

For example, if management of a growth company knows that material capital expenditures will be required as a result of reasonably likely demand for its products and services, such as to maintain its growth trend, the company must disclose the need for those expenditures whether or not the company has any commitments, contractual or otherwise, to make them.

Regardless of the distinction between prospective management discussions and analysis disclosure requirements and voluntary forward-looking information like financial projections, the SEC safe harbor from liability excludes both in an IPO prospectus. This approach has been criticized by several large accounting firms.

Projections are used widely in connection with IPOs, but not in a prospectus.

There are studies from other countries including Canada and certain European nations where financial projections by IPO companies are required by the countries' securities regulations.

It appears that, when mandatory, issuers systematically bias profit forecasts downward as they opt for the safety of accounting conservatism as a form of insurance against possible criticism and subsequent legal actions. In the U.S., projections are commonly used in a number of situations in connection with an issuer's IPO readiness.

The Nasdaq Stock Market, for instance, typically requests a projected income statement by month for the one-year period following the expected closing date of the IPO to determine the issuer's net cash burn. With this information, Nasdaq will increase the minimum stockholders' equity listing requirement by the amount of the annual cash burn to be sure the issuer can maintain its listing for the foreseeable future.

Underwriters, too, regularly ask for financial projections from IPO companies to determine pre-money valuation, offering size and pricing, allocation of proceeds and other terms of an offering, especially for smaller companies relying on a discounted cash flow valuation.

Underwriters also serve to mediate overly optimistic forecasts to maintain their reputation by associating themselves with more accurate disclosure information and attainable future results for their loyal customers and retail investors. Even large institutional investors in IPOs seem to have roundabout access to financial projections. In an article appearing in Barron's from May 2012, discussing the Facebook Inc. IPO, the author Andrew Bary wrote:

One of the challenges of investing in an IPO is that prospectuses contain little, if any, forward-looking information in a document that can run hundreds of pages. Road-show presentations typically are devoid of much useful information and mainly are boilerplate caveats to protect the company issuing the securities and their underwriter.

Yet many institutional investors looking to buy Facebook or any IPO are desperate for financial projections about earnings and revenues. To them, the prospectuses are of limited value because the information is historical.

Perhaps a solution is to include financial projections in IPO prospectuses so that all investors can benefit from the information that has been available in the past only to relatively few big investors.

Existing constraints on projections do not apply to de-SPAC transactions.

An April 8 public statement from John Coates, acting director of the SEC's Division of Corporation Finance, takes aim at current liability protections for investors in de-SPAC transactions and initial public offerings, noting particularly the protections in private litigation that are available to de-SPAC participants but are not available in a conventional IPO.

From there, Coates makes a surprising statement by suggesting that the term "initial public offering" in the Private Securities Litigation Reform Act is not defined and that the phrase may include a de-SPAC transaction.

In other words, the transaction in which a private operating company itself goes public, or engages in its IPO, is the de-SPAC, not when the SPAC shell company, as an altogether different company, initially offers its redeemable equity to the public. As such, Coates suggests that the de-SPAC transaction is the real IPO.

The SEC should be mindful of the increasing number of private operating companies going public through the SPAC process. The SEC safe harbor from liability does not apply to a de-SPAC transaction as it is not technically defined as being an IPO or part of the SPAC IPO, although the SPAC offering serves as a prefunding mechanism for the future new issuer.

As a result, the ability to provide projections to investors in a de-SPAC filing with the SEC is thought to create a major advantage over a traditional IPO. This appears to be especially attractive for companies that attribute a large part of their valuation to their future financial growth and prospects for significant revenue and profitability, in contrast to an IPO which has been referred to as backward-looking.

It is time for the SEC to encourage issuers to voluntarily make projected financial information available to investors by allowing IPOs to qualify for safe harbor protection under Section 27A.

It is difficult to identify any countervailing benefit to investors of denying investors meaningful disclosure about an issuer's estimated post-IPO financial results given the SEC's specific guidance for presenting projected financial measures in Item 10(b) of Regulation S-K, which is already recognized by the SEC as sufficient in other securities offerings and in de-SPAC transactions.

Smaller IPO companies whose value is based more on their future operating performance than past may find a greater chance for a successful IPO with properly prepared financial projections.

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