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IPO Basics: Due Diligence

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During the due diligence phase, the company, its underwriters, and their attorneys will focus on the registration statement. This phase will require the company to thoroughly review its business and to substantiate all claims in the registration statement. For example, if a company claims that it "will have significant first-mover and time-to-market advantages as a software-based solution in the Internet postage market," the company must be able to back up that claim. Indeed, the Securities and Exchange Commisssion may ask for such data. This review may also uncover additional information that needs to be addressed or disclosed.

Besides inspecting the registration statement, the underwriters and counsel for both parties will also question company officers and key employees. This will include a thorough discussion of the company's business and marketing plans, revenue projections, product development road map, and intellectual property portfolio, with an emphasis on identifying potential pitfalls. The due diligence team will also speak with third parties, such as customers, retailers, and suppliers. After all, problems with partners in the supply and distribution chain can cascade back to the company itself. For example, a financially troubled customer may tie up a company's inventory in a bankruptcy court proceeding, or a supplier of a key component may face an extended shutdown as it irons out Y2K-related problems with its factory automation software.

This attention to detail is required for both brand-new dot.com companies and well-seasoned corporations alike. Even Goldman Sachs, a veteran investment banking firm, provided this litany of risk factors in its registration statement.

Example: Goldman Sachs Registration Statement

  1. MARKET FLUCTUATIONS COULD ADVERSELY AFFECT OUR BUSINESSES IN MANY WAYS
    ·Losses from Trading and Investment Activity
    ·Lower Revenues from Investment Banking Activity
    ·Lower Revenues from Commissions and Asset Management Fees
    ·Concentration of Risk
    ·Ineffectiveness of Hedges
    ·Prolonged Market Downturn
    ·Other Risks Increased by Market Risk
  2. OUR RISK MANAGEMENT POLICIES AND PROCEDURES MAY LEAVE US EXPOSED TO UNIDENTIFIED OR UNANTICIPATED RISK
  3. LIQUIDITY RISK COULD IMPAIR OUR ABILITY TO FUND OPERATIONS AND JEOPARDIZE OUR FINANCIAL CONDITION
    ·Continuous Borrowing Needs
    ·Dependence on Access to Short-Term Debt Markets
    ·Dependence on Ability to Sell Assets
    ·Dependence on Credit Ratings
  4. CREDIT RISK EXPOSES US TO LOSSES CAUSED BY FINANCIAL OR OTHER PROBLEMS EXPERIENCED BY THIRD PARTIES
    ·Increased Credit Exposure in Recent Years
    ·Country Risk
    ·Systemic Risk
    ·Uncertainty in Managing Credit Risk
  5. FIRM AND THIRD-PARTY COMPUTER SYSTEMS MAY NOT ACHIEVE YEAR 2000 READINESS -- YEAR 2000 READINESS DISCLOSURE
  6. OTHER OPERATIONAL RISKS MAY DISRUPT OUR BUSINESSES, RESULT IN REGULATORY ACTION AGAINST US, OR LIMIT OUR GROWTH
  7. LEGAL AND REGULATORY RISKS ARE INHERENT AND SUBSTANTIAL IN OUR BUSINESSES
    ·Exposure to Legal Liability; Rising Litigation Costs
    ·Extensive Regulation of the Firm
    ·Legal Restrictions on Our Clients
  8. EMPLOYEE MISCONDUCT COULD HARM THE FIRM AND IS DIFFICULT TO DETECT AND DETER
  9. THE FINANCIAL SERVICE INDUSTRY IS INTENSELY COMPETITIVE AND RAPIDLY CONSOLIDATING
    ·Trend toward Consolidation and Increasing Competition
    ·Increased Need for Capital
    ·Competition in Non-U.S. Markets
    ·Competition from Alternative Trading Systems
  10. WE ARE EXPOSED TO RISKS IN EMERGING AND OTHER MARKETS
  11. OUR CONVERSION TO CORPORATE FORM MAY ADVERSELY AFFECT OUR ABILITY TO RECRUIT, RETAIN, AND MOTIVATE KEY EMPLOYEES
  12. THE FIRM WILL BE CONTROLLED BY ITS PRINCIPAL SHAREHOLDERS AND WILL BE SUBJECT TO ANTI-TAKEOVER PROVISIONS
  13. OUR SHARE PRICE MAY DECLINE DUE TO SHARES ELIGIBLE FOR FUTURE SALE
  14. THERE HAS BEEN NO PRIOR MARKET FOR THE COMMON STOCK, AND THE MARKET PRICE OF THE SHARES WILL FLUCTUATE
  15. INVESTORS IN THE OFFERINGS WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION

The third leg of the due diligence review involves an audit of company records. Again, the team will be looking for hidden problems in the company's corporate documents, licenses, and material contracts.

Finally, the company and its employees should be sensitive to personal matters that may affect an initial public offering. For example, a confidential settlement between a senior executive and a plaintiff for a fraud-related case, even if it had no merits, may affect public perception of the company and its leadership. Accordingly, a frank discussion with counsel is encouraged.

Copyright 1999 Findlaw Inc.

Last updated: Nov 1, 1999




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