Investors, IPOs, and Shark Repellent

After almost grinding to halt in recent years, IPO activity is once again on the rise. A growing IPO market should be a good deal for private equity investors, who often use initial public offerings as an exit strategy for their investments. Sometimes, however, a company's defensive provisions may

Private equity firms should be careful about prompting their portfolio companies to go public. Companies making public offerings often include a range of "shark repellents," provisions intended to guard against hostile takeover attempts. The upcoming Google IPO, for example, contains a two-tier voting structure that gives Class B shareholders (primarily company founders Larry Page and Sergey Brin) 10 votes for each share while each Class A share being offered only carries one vote. This provision is intended to make it difficult for outsiders to takeover Google or influence the company's operations.

While intended to ward off outside takeovers, shark repellent provisions can also limit the flexibility of a company's investors to grant a lockup to a buyer or obtain a control premium not shared with other stockholders. Shareholder rights plans, for example, could make it harder for an investor to sells shares. Shareholder rights plans, also known as poison pills, are provisions that make it more expensive to acquire company shares after a certain threshold of ownership has been reached. Such a provision would make it more difficult for an investor to sell shares beyond that threshold.

Section 203 is a good example of a takeover defense that can work against investors. section 203 is a statute that applies to companies incorporated in Delaware. The statute imposes a three-year moratorium on business combinations between a public company and any 15 percent or greater shareholder unless the target's board approves the combination or the shareholder acquires at least 85 percent of the company's stock in the same transaction as it acquired the 15 percent. Companies can opt out of section 203 protection by so providing in their charter.

The statute makes an exception for investors who hold 15 percent or more of a section 203 protected company prior to its becoming public so private equity investors can purchase the company when it makes its IPO. But the exemption does not apply to anyone else who would purchase the investor's shares. This means that the investor's decision to sell more than a 15 percent stake to an outside entity would require board approval, with the board looking out for the interests of all shareholders, not just its investors. If the investor wants to sell to one acquiring company, but the board has received what it considers a superior bid from another, for example, the conflict is obvious.

Fortunately, poison pills and other defensive provisions appear to be on the decline. At least a dozen companies have already dismantled shareholder rights plans in 2004, including Circuit City Stores, FirstEnergy Corporation, BB&T Corporation, and the Goodyear Tire & Rubber Company. By contrast, only 29 companies did so in all of 2003, 18 did so in 2002, and only ten in 2001. According to data provider SharkRepellent.net, "Boards are becoming more concerned with the appearance of good corporate governance than with managing the risk of hostile takeovers." Antitakeover defenses can make it difficult for shareholders to challenge the board, a fact that has made them increasingly less popular.

Initial public offerings of venture-backed companies appear to be on the rise, particularly in the tech sector. seeing larger companies buy up startups convinces public investors of the value of venture-backed tech firms. This creates interest in stocks offered by startup companies through IPOs. With IPO activity rising and defensive provisions on the decline, perhaps it will be a good year for private equity investors.

Sources: CFO Magazine, The Deal, Information Week