Drafting the S-1: Avoiding Common Pitfalls in the ... - FTI Consulting

DECEMBER 2012
DRAFTING THE S-1:
AVOIDING COMMON PITFALLS IN THE
REGISTRATION STATEMENT
Drafting a Registration Statement (Form S-1 or S-1) sometimes is deemed a lowpriority
task or is viewed as a “check the box” exercise. However, much time
and effort by many departments are required to successfully complete and file
an S-1 that ultimately is approved by the Securities and Exchange Commission
(SEC). Without the SEC’s approval, no amount of planning will bring a company
public. Pitfalls exist throughout the entire process. With careful preparation
and guidance, along with the proper planning by a project management office
(PMO), the process will happen within the planned timeline and not become a
gating item to closing the initial public offering (IPO).

THE IPO MARKET
Investors’ appetite for initial public offerings has been erratic over the last year despite a strong
showing by U.S. equity markets. Some high-profile IPOs experienced a variety of issues that
led to poor market debuts or post-IPO performance, temporarily dampening enthusiasm for
new issues. However, while these disappointing IPOs may have attracted most headlines, other
companies have fared well following their IPOs, including LinkedIn, Zillow, Annie’s, Bloomin’
Brands and Workday.
One of the most
challenging
aspects of
drafting the S-1
document is
that it requires
input from so
many different
areas within a
company
50
46
45
41
40
36
35
33
31
30
28
25
25
25
20
22
21
20
15
10
5
4
0
Q4 '09 Q1 '10 Q2 '10 Q3 '10 Q4 '10 Q1 '11 Q2 '11 Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12
Source: Standard & Poor’s Capital IQ
Number of IPOs Closed
Market conditions can change quickly these days. Accordingly, companies preparing for an IPO
must be nimble and flexible in their timing. The process of drafting the Registration Statement
and gaining subsequent clearance from the Securities and Exchange Commission is one of
the more unpredictable aspects of IPO preparation. It is not a process to be taken lightly,
as evidenced by the well-known difficulties encountered by Groupon, Zynga and Facebook
following their IPOs. Groupon did not sufficiently clear its accounting methods with the SEC,
while Zynga was not consistent with its accounting methods leading up to the IPO. Facebook,
for its part, faced claims from investors that it did not consistently and clearly disclose its
growth prospects immediately before the IPO. These missteps likely contributed to the decline
of each company’s stock price from its initial IPO level.
The recently passed Jumpstart Our Business Startups Act has reduced the requirements for
smaller emerging companies. But for companies with revenues of more than $1 billion, resolving
SEC pre-clearance issues, creating multiple S-1 drafts and amendments, and responding to SEC
comments can be time consuming — often taking several months. With a project management
office and a well-planned development process that thoroughly addresses all risks and issues
with the SEC, a company can reduce unexpected delays with its IPO and avoid post-filing SEC
issues, enabling the company to take advantage of changing market conditions on short notice.
MANAGING THE DRAFTING PROCESS
One of the most challenging aspects of drafting the S-1 document is that it requires input
from so many different areas within a company. A core working group should be formed
that is responsible for drafting and reviewing the document, including representatives from
DRAFTING THE S-1 1

accounting, financial planning and analysis, investor relations and human resources. From an
external perspective, the company also should rely on its outside counsel and underwriters for
assistance and support. Depending on the company and its situation, the outside counsel and
underwriters could play a significant role in both the creation and revision of the S-1 document.
However, the company’s internal legal team, which will be writing many of the sections, should
be the ultimate owner of the document. It is important that executives appoint a clear leader of
the process who is empowered to drive and monitor the progress. The legal team should ensure
that the document is written in a consistent tone and that it follows the SEC’s guidelines for
writing in “plain English.”
Another
useful way of
determining
where the SEC
may find fault
is to review
the history of
amended S-1
forms
With so many teams involved, an IPO PMO can assist the legal team with developing milestones,
establishing review processes and coordinating communications. The PMO should be familiar
with the sections of the S-1 and the broader IPO preparation process so the group can
effectively prioritize steps in the drafting process and coordinate the rest of the project.
S-1 DRAFTING: WHERE TO BEGIN
In preparing for an IPO, a company frequently can look to its competitors or peers to see what
reporting standards are prevalent within the industry. Often, much of the content will be
similar, and the layout of certain sections and reporting metrics will be consistent across an
industry. Past S-1 filings and annual financial statements can provide insight and guidance into
what kinds of information are needed for investors and the SEC.
Another useful way of determining where the SEC may find fault is to review the history of
amended S-1 forms. Most companies will file several amended S-1 documents in response to SEC
comments and feedback. Each of these amended S-1s, along with correspondence between the
company and the SEC, is publicly available through the SEC. This should provide additional
examples of how peers have responded to SEC comments and have avoided numerous amendments.
SEC CORRESPONDENCE
One of the biggest risks a company faces is accounting issues raised by the SEC. Every company
has its own unique accounting nuances and “gray areas” so it is essential to work with an audit
partner early on to thoroughly understand them. This should be done in parallel with the drafting
of the S-1; the earlier that issues are resolved, the sooner the S-1 can be finalized and filed.
Prior to an IPO, there can be numerous interactions with the SEC during the ordinary course
of business or in the process of obtaining formal or informal input on accounting, financial
reporting and disclosure positions. Therefore, it is critical to recognize the different divisions
and groups within the SEC and appropriate contacts. A company seeking an IPO (the Registrant)
may correspond with three main groups within the SEC prior to, or during, the IPO:
1. Division of Corporation Finance, Chief Accountant’s Office (DCAO) – Responsible for
interpretation or waiver requests (relief) on financial statement and disclosure requirements
(typically pre-filing).
2. Division of Corporation Finance, Assistant Director Groups 1-12 (AD Groups) – Responsible
for reviewing the filed S-1 and providing the Registrant with a Comment Letter, which
includes comments on how the Registrant applies SEC rules, securities laws and accounting
standards. All Registrants typically receive a Comment Letter, and correspondence occurs
directly between the Registrant and the AD Group(s).
DRAFTING THE S-1 2

3. Office of the Chief Accountant (OCA) – A standalone office within the SEC that advises on
accounting and auditing concerns associated with interpretive or complex questions on
specific accounting standards. Correspondence often happens prior to the filing of the S-1 to
ensure no restatement of financial statements occurs.
Below is a summary of common issues and causes for communication with the three primary
SEC groups:
SEC GROUP ISSUE DESCRIPTION
DCAO
DCAO
DCAO
AD Groups
OCA
OCA
OCA
Predecessor
Financial
Statements
Significant
Business
Acquisition
and Significant
Subsidiary
Rules
Separate
Financial
Statements of
Guarantors
Comment
Letter
Transfer of
Assets under
Common
Control
Compensation
Arrangements
Revenue
Recognition
The availability of or difficulty in preparing financial statements
in situations where a new legal entity structure is employed by
the soon-to-be Registrant. The financial statements must show
the financial results of the Registrant as if it had existed in prior
periods.
The availability of or difficulty in preparing separate financial
statements for business acquisitions or equity method
investments of the Registrant. This often includes challenges
associated with access to financial information controlled by
third parties.
The availability of or difficulty in preparing full financial
statements for all entities that guarantee the debt of the
Registrant.
Issues, comments or questions posed by the AD Group specific
to the Registrant’s Form S-1.
Pre-clearance related to situations where a new legal entity
is created for the IPO, and assets and liabilities must be
transferred to the new IPO entity. This often is a significant
issue for real estate companies.
Accounting issues related to complex compensation
arrangements, particularly arrangements that vest upon
completion of the IPO.
Accounting issues related to new or complex types of business
transactions that may require new interpretation of existing
revenue recognition guidance. This often is an issue for companies
with new technologies or unconventional business models.
FINANCIAL INFORMATION AND MD&A: A SPOTLIGHT ON ACCOUNTING
For many companies, the financial tables and Management’s Discussion and Analysis (MD&A) will
attract the most investor attention, as investors are able to see the financial results for the IPO
company for first time. Perhaps more important, this section will be scrutinized very closely by
the SEC. In Groupon’s case, the SEC forced the company to revise its accounting policies, which
significantly impacted its reported revenues. After the IPO, Groupon had to restate its financial
results due to accounting issues. These missteps led to ongoing inquiries by the SEC, shareholder
lawsuits and, ultimately, a decline in Groupon’s stock price. The online gamer Zynga also ran
into issues affecting investor confidence leading up to its IPO by creating new accounting
metrics and revising another. Therefore, it is imperative that a company provide accurate and
SEC-compliant information early in the process.
DRAFTING THE S-1 3

Given the importance of this section, the MD&A needs to be started earlier than any other part of
the S-1. As the company interacts with the SEC on potential accounting issues prior to filing, the
S-1 can be adapted accordingly. The company’s audit partner and outside counsel should review
all aspects of this section. Some common issues that may complicate the drafting process include
international reporting impacts, new metrics and refreshed financial data on a quarterly basis.
While the accounting team is responsible for drafting the financial tables and the MD&A, the
legal team and PMO should remain involved in the process, ensuring coordination among all the
teams and external advisors.
The number of
risk factors to
include varies
by company
and industry,
but the list
often spans
several pages
THE BUSINESS SECTION: TELLING THE STORY
The business section of the S-1, which requires a description of the company’s business and
operations, can be the most time-consuming section to draft. It requires strategic input from
investor relations, corporate strategy and communications/marketing to develop a prospectus
consistent with the company’s strategic plan. If the strategic plan is not thorough or up to date,
company executives likely will need to actively provide direction on the messaging.
While it may be tempting to incorporate existing marketing materials or messaging, writers
must be objective and take care to exclude any statements believed to be factual that cannot
be substantiated. Underwriters can assist with finding the appropriate balance. Further, the
underwriters can use their expertise of the industry to help highlight a company’s competitive
strengths and provide an industry overview.
RISK FACTORS: HOW MUCH IS TOO MUCH
The SEC requires the Registrant to provide investors with a list of potential risks associated with
the offering. The number of risk factors to include varies by company and industry, but the list
often spans several pages. The challenge lies in providing enough information for investors to
consider all reasonable risks without overwhelming investors and raising false alarms.
The first step in drafting this section is to review the risk factors included in peer company
filings. Many companies, regardless of industry, share similar risks, and these frequently can be
adapted by another company. Then the legal team should consult with various operating areas
within the business to understand what risks they each face. Input also should be sought from
the internal audit team, external auditors and outside counsel.
EXECUTIVE COMPENSATION: AVOIDING SURPRISES
Upon filing the S-1, executive compensation details will be available to the public. In the time
leading up to the IPO, the company will want the public to be talking about the business’ attractive
growth prospects, not the potentially distracting aspects of executive compensation. Further, the
SEC will be reviewing the compensation section to ensure the appropriate disclosure of executive
compensation details. With the enactment of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, a number of provisions were adopted by the SEC in January 2011 concerning
shareholder approval of executive compensation and “golden parachute” executive compensation
arrangements. In June 2012, the SEC adopted rules requiring independence among each member of
a company’s compensation committee. Overall, executive compensation has become a hot-button
issue in Washington and as a result, is receiving greater focus and scrutiny by the SEC.
DRAFTING THE S-1 4

It is vital that
the company
resist any
external
pressure
to stretch
projections
If an IPO is on the horizon, great care should be taken to structure executive compensation
packages appropriately. Every aspect from salary and bonuses to benefit plans and other perks must
be disclosed. Planning ahead can ensure that potentially embarrassing surprises are avoided as the
big day approaches.
PROJECTIONS AND VALUATION
When developing financial projections in advance of the IPO, a company must ensure that the
numbers support the underlying business story and provide a reasonable basis for its growth, as
the valuation will be tied to these projections. However, it is vital that the company resist any
external pressure to stretch these projections.
The projections will be referenced throughout the marketing and road show process, and
analysts will use these statements as a starting point when initiating coverage of a company.
A lack of transparency and consistency in the forecast can lead to confusion in the market, as
evidenced by Facebook’s actions in the days prior to its IPO. By revising the outlook so late in
the process, Facebook caused analysts to reduce their revenue forecast for the company. This
adversely impacted Facebook’s momentum leading up to its IPO, and also resulted in shareholder
lawsuits.
Early agreement in the projections and their underlying assumptions among management,
equity owners and underwriters will ensure a consistent message when releasing numbers to the
public. A strategic communications firm, working with the investor relations director, also can
manage the communication of consistent forecasts and storylines.
CONCLUSION
The amount of time and effort that goes into S-1 drafting and SEC communications can vary
widely by company. If a prospective filer already has a clearly defined strategic plan and
SEC-compliant accounting policies and reporting, completing the process should be relatively
straightforward and not require an extraordinary amount of effort and resources. But for
companies with little of this in place, it is important to begin the planning process as soon as an
IPO decision is made. Several internal departments will need to coordinate with each other and
with external advisors. A project management office often can help effectively manage the work
and prioritize the various steps.
Two of the most significant aspects of going public are presenting a compelling story to investors
and ensuring SEC compliance, culminating in a successful S-1 filing. By avoiding some common
pitfalls presented herein, a company can efficiently manage this aspect of the IPO preparation
process and be better prepared to execute an initial public offering when the moment is
opportune.
DRAFTING THE S-1 5

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PLEASE CONTACT:
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OfficeoftheCFO@fticonsulting.com
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