How Not to Go Public

It's a narrative compliance executives hear all too often: audit finds a weakness in internal controls, putting the company at the center of a Securities and Exchange Commission probe. Next, the stock price tanks, shareholder lawsuits whirl, and senior management is left to pick up the pieces.

Yet no legal or regulatory hardship feels more acute than the growing pains of a company that is new to the public market.

“Going public is a massive undertaking; all of a sudden you are under a microscope and have a lot of different stakeholders to manage,” says Neil Dhar, a partner in PwC's transaction services. Without a robust plan in place for managing the initial public offering process, “you can run into trouble pretty quickly.”

Online coupon Website Groupon learned those lessons the hard way after the company announced in March that it was revising down its fourth-quarter financial results, its first as a public company, by $14.3 million, its fourth-quarter operating income by $30 million, and its net income by $22.6 million than originally expected.

After an audit of its 2011 financial statements by Ernst & Young, Groupon suffered the additional sting of having to attach a statement of a material weakness in its internal controls over its financial statement close process in its annual report.  

It didn't take long for news of the material weakness to spark a legal firestorm against Groupon. The latest complaint, filed last month in U.S. District Court for the Northern District of Illinois, comes in the form of a derivative lawsuit filed by shareholder Theresa Monturano.

“Defendants intentionally, recklessly, or negligently breached or disregarded their fiduciary duties to protect the rights and interests of Groupon,” the complaint stated.

A screw-up of Groupon's proportions can have other consequences, as well. Shareholders can use it as a justification to launch proxy fights.  In addition to unspecified damages, Monturano's lawsuit seeks the right to nominate at least three candidates for election to Groupon's board of directors.

Another shareholder Fan Zhang also brought a lawsuit against Groupon for misleading investors. That lawsuit could incur class-action status. Additionally, the SEC reportedly is examining Groupon financial statements following revisions, although an official investigation hasn't been launched.

Shareholder suits over a statement of a material weakness in internal controls are becoming more common. Just last month, shareholders of software company Quest filed a series of suits alleging that CEO Vinny Smith moved to sell the company to a private equity firm because it was facing a SEC probe over internal control failures.

What Went Wrong

So what exactly did Groupon do wrong? While litigation experts would not discuss Groupon, specifically, they were willing to share three critical mistakes to avoid in preparation of going public.

1. Ignoring weaknesses in internal controls: If a weakness in internal controls is discovered at the time of an initial public offering, then there is a good chance the registration and prospectus will be considered false and misleading. “Management cannot conclude that the company's internal controls are effective if just one un-remediated material weakness is found,” says James Hamilton, principal federal securities law analyst at Wolters Kluwer Law & Business.

“Management cannot conclude that the company's internal controls are effective if just one un-remediated material weakness is found.”

—James Hamilton,

Principal Federal Securities Law Analyst,

Wolters Kluwer Law & Business

In Groupon's particular case, the company admitted several internal weaknesses just weeks after its public offering. These include:

Failure to maintain a financial closing process and procedures that were adequately designed, documented, and executed to support the accurate and timely reporting of financial results;

Failure to maintain effective controls to provide reasonable assurance that accounts were complete and accurate and agreed to detailed support, and that account reconciliations were properly performed, reviewed, and approved;

Failure to have adequate policies and procedures in place to ensure the timely, effective review of estimates, assumptions, and related reconciliations and analyses, including those related to customer refund reserves.

“Finding a deficiency in internal controls is not uncommon, Hamilton says. “You find a material weakness and you fix it,” he says. “It's the unremediated material weaknesses that cause the problem.”

2. Not minding the GAAP: Non-standard financial metrics are not unusual, but regardless of how the figures are used, they need to be accurate. When Groupon filed for a $750 million IPO in June 2011, for example, the SEC took issued with its unusual “adjusted consolidated segment operating income” metric.

The problem was that such a metric inflated the value of the company by not taking into consideration such things as marketing costs, stock-based compensation, or interest expenses to repay debts. Sounding more like a Hallmark card than an IPO filing, Groupon CEO Andrew Mason reasoned: “We want the time people spend with Groupon to be memorable. Life is too short to be a boring company … While weighted toward the measurable, our decision-making process also considers what we feel in our gut to be great for our customers and merchants, even if it can't be quantified over a short time horizon.”

The SEC, of course, didn't buy it. After re-filing in August using standard accounting procedures, Groupon went from showing operating income of $60.6 million for all of 2010 and $81.6 million for the first quarter of 2011 to incurring a $420 million operating loss for 2010 and a $117.1 million loss in the first quarter.

The lesson: stick with Generally Accepted Accounting Principles.

3. Not planning enough in advance: For companies considering going public, it is useful to understand how quickly windows of opportunity can open and close. “The IPO windows open and shut pretty quickly in the market we are currently in,” says Dhar, making it important to be well-prepared to enter the market when that right moment arrives. “You want to make sure you don't miss market windows.”

GROUPON'S MATERIAL WEAKNESS

The following excerpt is from Groupon's 10-K Filing:

In connection with the audit of our financial statements as of and for the year ended December 31, 2011, we concluded there is a material weakness in internal control over financial reporting related to deficiencies in the financial statement close process. Under standards established by the Public Company Accounting Oversight Board, a material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected and corrected on a timely basis.

We are working to remediate the material weakness. We have begun taking steps and plan to take additional measures to remediate the underlying causes of the material weakness, primarily through the continued development and implementation of formal policies, improved processes and documented procedures, as well as the continued hiring of additional finance personnel. The actions that we are taking are subject to ongoing senior management review, as well as audit committee oversight. Although we plan to complete this remediation process as quickly as possible, we cannot at this time estimate how long it will take, and our initiatives may not prove to be successful in remediating this material weakness. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected and we may be unable to maintain compliance with applicable stock exchange listing requirements.

Source: Groupon.

With Groupon, in the rush to get the IPO off before year-end, “it appears that everyone involved ignored material weaknesses in Groupon's internal controls and made no assessment,” says Reed Kathrein, a partner with law firm Hagens Berman, one of the law firms looking into Groupon's weaknesses.

“Companies seem to be preparing for an IPO much earlier than in the past,” says Dhar. “Some of that has to do with the fear of missing a market opportunity, because they understand the runway needed to prepare adequately, so they have flexibility in their plan to jump into the market if an opportunity is there.”

Companies that are thinking of going public are starting to approach PwC to assess market opportunities as much as two years—sometimes longer—before impact date, as opposed to six months prior, as in previous years.

IPOs on the Upswing

With enactment of the JOBS Act, companies considering going public now have a lot more to consider. “The JOBS act has dramatically changed the landscape of going public,” says Hamilton.

The JOBS Act creates a so-called “IPO on-ramp” for “emerging growth companies,” defined as those with less than $1 billion in annual revenue and $700 million in market capitalization that have been public for fewer than five years.

Under the most significant provisions, the JOBS Act would allow such emerging growth companies to:

Submit an IPO registration statement for SEC staff review on a confidential basis;

Prepare an IPO registration statement with two years of audited financial statements in lieu of the usual requirement for three years of audited financials;

Omit selected financial data for any periods preceding the earliest audited financial statements included in its initial registration statement;

Adopt any new or revised accounting standards using the same timeframe as private companies if the standard applies to private companies;

Comply with the SEC's executive compensation disclosure requirements on the same basis as a smaller reporting company.

Emerging growth companies would also be temporarily exempted for up to five years from the internal control audit requirements of Section 404(b) of the Sarbanes-Oxley Act, and certain current and future executive compensation-related disclosures. When deciding whether to go public, such exemptions are “important factors to consider,” stresses Hamilton.

Even with the JOBS Act, however, a company still needs to get its equity story across and show trends in the business, which typically are found in historical financial data, says Dhar. “So you may have the ability to show less, but from a practical sense you need to show what the business's historical trends have been and what its growth prospect is going to be.”

Look for more companies to, like Groupon, stub their toe coming out of the public market starting blocks. The JOBS Act is likely to lure more companies and less mature companies into the public markets, and many of them will be as unprepared as Groupon was.