Despite economic distress and a global pandemic, 2020 brought an unprecedented 480 initial public offerings (IPOs)—more than double the previous year’s total. Thus far, 2021 has already surpassed last year’s record, with more than 700 IPOs by mid-August.
From a risk perspective, an IPO marks the end of one company and the birth of a new one. Once a company goes public, so do the details of its finances and business operations. This exposes management to government and public scrutiny, including exposure for the personal assets of a company’s directors and officers.
All too often, directors and officers of both entities are unaware of the new level of risk they face and are confident they are covered against liability. Many long-time directors have gone their entire careers without a hint of litigation or other risk, hence the overconfidence. However, D&O liability is common, especially in the wake of an IPO, and claims can often cost tens of millions of dollars and take a long time to settle.
An IPO creates several unique risks for any business entity. The following are three critical exposures management needs to consider ahead of an IPO:
1. Conflicting risks: During the roadshow process with investment bankers, C-suite executives make representations and forward-looking statements to ensure that institutional investor demand is high. These disclosures increase the level of risk because investors can use them to allege misrepresentation if shares drop or projections do not materialize. In addition to serving as the C-suite for the new public company, leaders of a pre-IPO firm are often functionally selling their shares in the private company and exchanging them for shares in the public company, and may be doing so at the increased value resulting from their representations. This dual capacity creates a conflict and introduces a new material risk for management during the IPO process.
2. Legal disclosures: During the IPO process, management will regularly draft and re-draft the offering documents. Those documents are required to disclose business risks, as well as all material items that would be of interest to future investors. If the documents are later found to have misrepresentations or inadequate disclosures, management can be held liable and financially or legally responsible.
3. Regulatory disclosures: Becoming a public company also creates scrutiny from regulatory bodies like the Securities and Exchange Commission. The same documents that create liability exposure and legal risks also introduce regulatory oversight risk for the new firm. Regulatory investigations can consume material resources for a growing company and, even if no formal issues are uncovered, tying up those resources can incur a significant opportunity cost. Public commentary by senior management will also be scrutinized, and can further create regulatory issues if information is not disseminated appropriately. If violations, misrepresentations or inadequate disclosures are uncovered, this can also lead to fines and penalties for the firm or management.
Evaluate Your Existing Insurance Program
Traditional insurance coverage can leave gaps for companies as they transition from private to public. It is essential to understand your current insurance to determine gaps in coverage. This is especially important regarding any public statements made or public filings as the company approaches its IPO and after the IPO in regard to company performance.
Unlike more established companies, many smaller firms and startups do not have appropriate D&O insurance in place. There are different legal requirements for a public corporation than there are for a private business. In turn, appropriate coverage is different for public corporations. Your broker can help you understand these critical distinctions and make an educated decision about coverage.
You should also evaluate the company’s indemnity contracts, which are typically part of the toolkit for directors and officers to address personal risk management. Some firms rely on the de facto language in their corporate bylaws, but many public and private firms take the additional step of providing custom contractual indemnities to each director to address ambiguity.
When going public, examine whether a standalone indemnity contract is warranted or whether an existing one should be updated. Also consider how the contract or bylaws fit with the board’s insurance protection. This will provide comfort in case of a liability claim, or can address issues when conflicting interests arise between directors or between a director and the company.
While management controls the firm, the firm’s interests are not always aligned with every individual director. A lack of understanding by all parties about the risk management process can lead to a public dispute and harm both individuals and the company.
Understand the Type of D&O Policy Needed
D&O coverage is not only a great tool to reduce risk and give directors and officers added protection, it can also help attract top leadership to your organization. In many cases, top-tier executives will not consider associating with organizations if their own personal assets could be at risk.
Specific D&O needs will vary by company, so it is important to work with a broker to design the right plan for your organization’s critical risk factors.
In designing such a plan, there are two key considerations. First, public and private policy contracts must be separate. Unlike in many private businesses, the founder and other shareholders at a public company may not be involved in direct management. This means changing your protection. A new D&O policy must cover the risk for the public company, while the old policy covers the historical liability pre-IPO.
Private D&O insurance offers broad entity coverage to protect the corporation. However, public D&O insurance can become much more restrictive and expensive due to the increase in stakeholders, from shareholders to regulators to customers. For example, public D&O coverage may be triggered to only protect individual directors and officers, or protect both the company and the individuals. You may want to negotiate or purchase broader coverage, especially when it comes to employment practices liability coverage, corporate protection or other excluded areas.
The second consideration is whether you will need to arrange for roadshow coverage. The IPO roadshow is an often-overlooked area of risk. These presentations are made when the company is still private, but the roadshow may be specifically excluded from your existing D&O policy, and any litigation stemming from misrepresentations made may not be covered. You will need to address this gap in coverage on your private insurance policy.
Transitioning from a private to a public company is a complicated process. By doing your due diligence about D&O insurance coverage needs before going public, you can best mitigate the risks to directors, officers and the business.