Going private may be the answer in today's market

April 07, 2003

North Bay Business Journal

Business Law: Going private may be the answer in today's market

The post-Enron world is an expensive, complicated place for public companies. Equity markets have collapsed, choking off anticipated sources of capital and reducing the value of stock options. The Sarbanes-Oxley Act mandates additional reporting and shortened deadlines, increasing the cost of regulatory compliance. Public company directors' and officers' insurance premiums are soaring.

While large public companies with hefty legal budgets can shoulder these new burdens and wait for the recovery of financial markets, what's a small-cap public company with a languishing stock price and low liquidity to do? The answer for some may be to "go private."

Going private is the opposite of going public. It typically involves the repurchase of a company's publicly held stock by an existing principal investor or management (as in a leveraged buyout). Going private, however, is no easy solution. It can be expensive and time-consuming, demanding detailed disclosures to the SEC and enhanced fiduciary duties that often invite shareholder litigation. Nevertheless, going private may be an appropriate option for the right public companies, and a properly structured transaction can lessen the risks to the participants.


The public company treadmill

Companies ordinarily go public to access public capital markets to fund research and development and capital expenditures. Tradable stock provides public currency for acquisitions and a tool to motivate employees through equity compensation. In theory, public companies also enjoy intangible benefits such as prestige and market visibility.

Many small-cap companies are in no position to reap these benefits for a variety of reasons: Lackluster stock performance, low trading volume, lack of attention from equity analysts, and depressed markets. Additionally, small-cap companies often find themselves stuck on the quarterly treadmill: When attempting to attract or retain analyst coverage, missing a single quarter's results may be catastrophic, leading to disproportionate attention on quarterly results.

By going private, small-cap companies may be able to focus on a more appropriate mix of short-term and long-term goals and restructure without worrying about the impact on stock prices. Private companies also avoid the regulatory burdens of being a public company and so reduce their legal, accounting, and public relations expenses.

In today's economy, going private might appear to be an attractive solution for struggling public companies. In reality, it is feasible only for those companies with a viable business, capable management, established customers, stable cash flows, low debt, and sufficient cash to carry them in the short term. Without these elements, few investors will commit the substantial funds needed to buy out the publicly held stock.


Pick the right structure

Taking a company private creates inherent conflicts of interest, because it involves a transaction between shareholder groups or with management. This attracts regulatory scrutiny and shareholder lawsuits. The ability to survive these challenges can vary significantly depending on how the deal is structured.

A recent case from Delaware -- the leading source of corporate law -- is resulting in increased use of cash tender offers for going-private transactions. Under this structure, going-private proponents make a cash tender offer conditioned on their acquiring at least 90% of the company's stock. Any shareholders remaining after the tender offer can be cashed out in a "short form" merger without shareholder approval.

The structural advantage of a tender offer is that each shareholder can decide whether or not to sell at the tender-offer price. As long as the proponents do not structure the tender offer to coerce shareholders to tender, courts will uphold the transaction in deference to the shareholders' right to decide whether to tender.

The Delaware case identified three indications of a noncoercive tender offer: It is conditioned on the receipt of a majority of the unaffiliated stock; the proponents agree to cash out remaining shareholders at the tender offer price; and there are no threats of retribution.

In contrast, in a challenge to an alternatively structured going-private deal -- a cash merger for example -- the proponents will need to prove both the fair process and the fair price of the transaction. This is a much higher standard inviting increased shareholder claims.


Power to independent directors

Going-private proponents are not the only parties who must fulfill obligations to the company and minority shareholders. The company's independent directors must take an active role in reviewing the going-private transaction. They must evaluate the terms of the proposed tender offer and make a recommendation to the minority shareholders as to its advisability.

Consequently, the independent directors should be vested with real bargaining power to simulate an arm's length transaction and be insulated from pressure from directors affiliated with the proponents. Receipt of an investment bank's fairness opinion is also strongly advised.


Be prepared to disclose

Detailed, specific disclosure rules apply to going-private transactions, even at the earliest stages of considering whether to propose such a deal. It is all too easy to prematurely trigger a disclosure obligation that, in turn, exposes a proponent to threats from disgruntled minority shareholders. Both the proponents and the company (through its independent directors) must, among other requirements, describe in detail all contacts and dealings between them that led to commencement of the going-private transaction. In addition, where the independent directors have received a fairness opinion, shareholders are entitled to not only a copy of that opinion but also a summary of the bankers' valuation analysis.

Despite the stringent reporting, enhanced duties, and threat of litigation, going private can be an attractive option for freeing the right public companies from the hazards and burdens of today's public markets.

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Matthew Lewis is a partners at Farella Braun + Martel; 415-954-4924.