Preparing for a Pharma/Biotech IPO
Are you involved with a pharma/biotech company whose investors are starting to talk about taking the company public? These companies face many common challenges related to finance, accounting, IT infrastructure and project planning. So read on if you want to see what to expect over the next 12-18 months… it is likely to be a wild ride!
1. An ever-changing timeline
Taking a company public is a massive effort that will require input from many teams within and outside of the organization. For example, the process requires a significant financial investment, the science needs to be at the right point developmentally, there are legal and structuring issues that need to be addressed, the financial statements necessary for the IPO may need to be revised to meet public company requirements, and a lot of documents need to be created (projections, prospectus, initial filing document, etc.) in order to fully engage prospective investors. And last but not least, the initial filing document (usually an S-1) needs to be declared effective by the Securities and Exchange Commission (the SEC). That process requires an initial filing with the SEC, the SEC staff sends the Company comments on the S-1, and the Company must file amended versions of the S-1 until the SEC believes it includes everything necessary to be declared effective. This process can take 6 weeks at best but more typically is 8-12 weeks.
As with any project of this magnitude, planning is everything. Most companies designate someone at the organization to put together a timeline so that all of the participants–employees, consultants, underwriters, etc.–know the deadlines and are working together towards the same result. While this sounds like a one-time activity, in reality it is a process requiring constant updating. The leaders of the company and investors may set an initial deadline, but because the science is developing faster or slower than anticipated, or the economic climate is not ideal, the timeline has the potential to accelerate or decelerate frequently.
The Company’s Board of Directors will want comfort that the team can handle these changes. An important part of being prepared for these changes is having an adequate IT infrastructure. Companies that are going public often consider implementing upgraded ERP/general ledger systems, financial planning and analysis, and SEC reporting systems. Having the right systems in place will allow the finance team to quickly update required financial information while minimizing manual intervention.
Once the investment bankers determine there is enough interest in the offering to proceed, they will hold an “Organization Meeting” or “Org Meeting.” This meeting will include the Company’s executive team, attorneys, auditors, and any consultants assisting in the process. At the meeting, the investment bankers will present more information about the offering (type of shares being offered and estimated amount being raised), details of necessary internal and external due diligence, roadshow presentations required, the timeline and roles and responsibilities going forward.
Before the Org Meeting, discussions around timing are aspirational at best. Once the Org Meeting happens, all the parties involved understand the path forward and will work together towards the endpoint.
2. Additional debt or equity investments prior to going public
The public markets will require the science to have progressed to a certain point in order to invest in the company. This is typically initial clinical trial results showing that the drug is successful in treating an illness in a small group of human patients with no significant safety concerns. Oftentimes, the Company will have cash on-hand (received from grants or an initial series A equity raise), but may need additional cash to conduct additional research and/or the required clinical trials and to be ready for the IPO.
To address these needs, some private companies issue a “crossover round.” This is an additional private funding effort to raise the required cash. As with any capital raise, this process in itself will require the preparation of updated financial and scientific forecasts, and the issuance of additional debt or equity instruments (which require legal involvement and determination of the accounting treatment of the newly issued capital). Some private pharma companies may issue “tranched preferred stock.” In a tranched preferred offering, the investors obtain a certain number of preferred shares when they initially invest, and the company makes a commitment to issue additional preferred shares to the same group of investors, oftentimes at the same price per share as the initial preferred. This obligation to issue preferred may be required to be treated as a liability for accounting purposes. In that case, a valuation is required to determine the value of the obligation, and the proceeds from the initial preferred is allocated to the preferred (an equity instrument) and the obligation (a liability). Subsequent to the initial issuance, the liability may be required to be measured at fair value at each reporting date.
The Company’s capitalization table will need to be updated for any additional debt or equity investments issued. If the capitalization of the company is complex, companies consider implementing software that tracks outstanding equity instruments, supports calculations and disclosures regarding earnings-per-share, and eventually will interface with the Company’s registrar and transfer agent.
3. Accounting for Stock Options (or Similar Instruments)
Historically, some private pharma/biotech companies may historically prepared their financial statements on a cash basis. In this case, there will be no recognition of the issuance of stock options (or similar instruments, referred to hereafter as stock-based compensation, collectively). Under U.S. GAAP, companies must determine the fair value of stock-based compensation issued to employees, directors and service providers and recognize that fair value of the stock-based compensation as an expense over the period that the stock options vest.
The accounting for stock-based compensation can be complex. Performance-based vesting (rather than simply vesting over time) and modifications to stock options are two features that can drastically increase the complexity of accounting for stock-based compensation. Further, the issuance of stock-based compensation may require a valuation to be performed at the issuance date. The valuation methodology may be different than that required for tax purposes. If companies have not previously had valuations performed when they issued stock-based compensation, they may need to have valuations performed for historical dates when they issued significant quantities. Many companies consider implementing software that tracks outstanding stock-based compensation, calculates the related expense, and provides required disclosure information.
4. Transitioning to Public Company Reporting Requirements and Disclosures
One of the challenges of starting the IPO process and eventually becoming a public company is complying with SEC reporting requirements. The financial statements included in the initial registration statement filed with the SEC must meet the form and content rules of the SEC. These requirements are set forth in the SEC’s Regulation S-X and Regulation S-K. Additional guidance can be found in the SEC’s financial reporting manual. The following summarizes some of the requirements:
- Annual financial statements must be audited by, and interim financial statements must be reviewed by, an independent audit firm registered with the Public Company Accounting Oversight Board (PCAOB), and the audit must be performed in accordance with PCAOB audit standards.
- Required financial statements:
- Companies that do not qualify with the SEC’s Emerging Growth Company (EGC) or Smaller Reporting Company (SRC) rules must provide three years of annual audited financial statements and the most recent interim period and the comparative interim period in the prior year.
- Companies that qualify as EGCs may provide only two years of annual audited financial statements and the most recent interim period and the comparative interim period in the prior year.
- Companies may file their initial S-1 confidentially with the SEC and exclude periods of financial statements that likely won’t be required when the S-1 becomes effective1.
- The SEC’s rules require additional disclosures in the financial statements and other parts of the S-1 that private companies do not typically provide to their investors. For example:
- Earnings per share footnote disclosures.
- Segment footnote disclosures.
- Mezzanine/temporary equity classification of certain equity instruments.
- Certain tax disclosures.
- Pro-forma financial information reflecting the issuance of the securities in the offering, the cash to be received, and the conversion of any preferred securities into common shares.
- Management’s discussion and analysis (MD&A), selected financial data, contractual obligations table, etc.
- SRCs may be eligible for scaled disclosure requirements2.
- New accounting pronouncements are typically required to be adopted sooner for public companies than for private entities. However, EGCs are not required to accelerate the adoption of new accounting standards and are allowed to adopt the new or revised accounting pronouncements as of the effective date for private companies.
- Once the company is public, it will need to file quarterly and annual financial statements with the SEC. The deadlines for filing these financial statements are typically much sooner than those for private companies. The company may need to enhance and accelerate its financial statement close and reporting process to ensure preparedness for these deadlines.
- As a public company, an entity may change an accounting policy after adoption only if management can justify that the new accounting principle is both acceptable and preferable. Once a company is public, a change in accounting policy may result in the need for a preferability letter. A preferability letter is issued by the entity’s independent auditors and is included in an SEC filing stating that the auditor has also concluded that the accounting change is preferable. If a change in accounting is made in conjunction with an IPO, the preferability letter is not required because the entity was not yet public on the date the change was made.
5. Reverse Stock Splits
Pharma/Biotech IPOs may involve a reverse stock split when the pre-IPO stock price is less than the targeted IPO price range. The initially filed S-1 will typically include share amounts pre-reverse split. In a subsequent filing, once the reverse split ratio has been determined, the financial information is revised to include share figures on a post-reverse split basis. Although conceptually simple, this can be a very time-consuming task, and companies should plan ahead based on when it will be expected to be incorporated in the S-1 filing. Since the financial information will need to be retrospectively restated for all periods presented, the process will involve a large volume of revisions in the S-1 document, and not just within the financial statements (F-pages).
One way to prepare for the reverse split is to start setting up the spreadsheet that will calculate and support the post-reverse split figures. It will be important to have the spreadsheet ready ahead of time since the timeline can become very tight once the reverse split decision is made. Here are some further tips in preparing the spreadsheet:
- The calculations may be required by issuance/grant – therefore, incorporate the capitalization table and stock option listing in the spreadsheet.
- Some shareholder agreements require that shares (and convertible instruments such as convertible preferred stock and stock options) calculated from the reverse stock split be rounded down for each shareholder. This is a legal question, so the attorneys should have input if there is any question or ambiguity in the wording.
- Prepare the model so that inputs are kept in one place and outputs are formula-based. This will enable you to easily change the model if the reverse split ratio changes at any point, which is very common.
- Track the before and after for all shares to make the “tie-out” process easier for both the accounting group and the external auditors.
One of the great challenges of the IPO process is the tight timeline for the accounting team and the auditors. Planning ahead and lining up time-consuming tasks, such as the reverse stock split, can allow the process to go much more smoothly.
6. SEC Comment Process
About 30 days after the initial filing, the SEC will send a comment letter to the Company with a list of comments on the filing. The Commission may have comments on any part of the document. Common areas of comment are as follows:
- Comments on the Description of Business section, which typically includes an overview of the Company’s state of development of its products, may ask the Company to be more measured about its confidence in the success of the development and approval;
- Comments on the Risk Factors section, which gives investors insights into the risks involved in investing in the Company’s securities; and
- Comments on the financial statements and MD&A section may ask the Company for additional disclosure to comply with the US GAAP and SEC rules.
The Company will need to prepare a letter responding to each of the SEC’s questions and indicating whether the Company changed any of its disclosures. The Company will file this letter and an amended S-1 with the SEC. Typically, the Company’s executive team will draft the responses to comments and make edits to the S-1 for comments on the Description of Business Section, the legal team will do the same for the Risk Factors Section, and the finance and accounting team for the financial statements, MD&A and other financial parts of the filing. Most companies receive at least two and sometimes 3-4 comment letters on an S-1, but the subsequent comment letters are received 1-2 weeks after each subsequent filing.
7. How Marcum Can Help
Marcum has extensive experience providing all types of services to companies in the pharma/biotech industry. Marcum’s Financial Accounting and Advisory Services team can help all members of your finance team through an IPO. Here are just a few of the areas with which we can provide assistance:
- Introducing your team to the process and determining roles and responsibilities,
- Audit readiness including review of technical accounting areas to ensure aligned with GAAP and creating, reviewing and implementing accounting policies,
- Enhancing and expediting the monthly close process,
- Determining the periods of financial statements required in the Initial Offering Document,
- Creating US GAAP and SEC-compliant financial statements and footnotes,
- Writing the required Management Discussion and Analysis,
- Completing other financial parts of the Initial Offering Document (Selected Financial Data, Use of Proceeds, etc.),
- Assistance in selecting and implementing systems such as general ledger/ERP, equity and equity-based-compensation, SEC reporting, and financial planning and analysis,
- Supporting your controllership and SEC reporting team in establishing efficient processes that can be easily repeated by the internal team on a go-forward basis, and
- SOX readiness including documenting and implementing the necessary internal control environment.
In addition, Marcum is registered with the PCAOB and can perform audits in accordance with PCAOB standards. Marcum’s tax team is skilled in ensuring the structure of the Company maximizes tax advantages. Using Marcum’s services will ensure that you are well-prepared for the challenges and growth that lie ahead, allow your core team to focus on running the business.
- See the SEC’s Compliance and Disclosure Interpretations Questions 101.04 and 101.05.
- The scaled financial statement disclosure requirements for SRCs are set forth in Regulation S-X, Article 8.