Share Structure Concerns in IPOs

The Canadian Securities Administrators recently issued Staff Notice 41-305 concerning share structure issues in initial public offerings.

The purpose of the notice is to put issuers and insiders on notice of the issues that the various commissions will consider when deciding whether issuing a receipt for a prospectus is in the public interest. The primary concern is companies that have issued large amounts of shares for nominal cash consideration (or as payment for assets or services where the value cannot be easily or objectively determined). This is particularly true if the issuer has a limited history of operations and thus is difficult to value and the number of cheap shares issued is large compared to the number of shares to be issued in the IPO.

These issues persist despite the fact that both the TSX Venture Exchange and the Canadian National Stock Exchange have policies that address some of these issues and the CSA itself has an escrow policy that acts to lock up cheap shares issued prior to an IPO.

The notice states that the commissions will consider a number of factors when determining whether a share structure is objectionable. The main consideration is whether public shareholders are getting a disproportionately small ownership stake in the company relative to the amount of money raised in the IPO. On the other hand, staff recognize that management and insiders may have spent considerable time and resources in building the business, and they will consider factors such as whether the value of the shares issued to the insiders can be corroborated by factors such as arm's length pre-IPO financings.

The takeaway is that persons acting for companies that have a lot of cheap or free stock outstanding should have a discussion with commission as well as exchange staff early on in the IPO process.