4.5 Changes in Capitalization and Other Common IPO Considerations

Entities often have other capitalization changes that occur before, or concurrently with, the effective date or closing of an IPO. Some changes, such as a stock split or discontinued operations, are reflected retrospectively in all periods presented in the financial statements. Other changes, which may include, but are not limited to, the automatic conversion of preferred stock to common stock or the conversion of debt to equity, are only recorded prospectively and may not be reflected in the financial statements presented in an IPO filing. Registrants should present such changes in capitalization as part of the pro forma information. The SEC staff often focuses on the presentation of such pro forma information.

4.5.1 Pro Forma Information

Example of an SEC Comment

[W]e note the disclosure . . . that your preferred shares will automatically convert upon completion of this offering. Please address the following:

Tell us whether you intend to provide a pro forma balance sheet and statement of operations (including EPS) to give effect to the automatic conversion; . . .
Provide us with the relevant authoritative guidance supporting your planned presentation.

The SEC staff asks registrants to present pro forma information when changes in capitalization will occur after the date of the latest balance sheet. We understand the SEC staff believes that when such changes will result in a material reduction in permanent equity or are the result of a redemption of a material amount of securities in conjunction with the offering, the filing should include a pro forma balance sheet that takes into account the change in capitalization but not the effects of the offering proceeds.

In addition, we understand the SEC staff believes that when a conversion of outstanding securities occurs after the latest balance sheet date and will result in a material reduction in EPS exclusive of the effects of the offering, registrants should present pro forma EPS (but should exclude the effects of the offering) for the latest fiscal year and interim period. A common example of this scenario is the mandatory conversion of preferred stock to common stock in conjunction with an IPO. In this case, pro forma basic EPS would include the preferred stock on an as-converted basis.

If an issuer is organized as a nontaxable entity (e.g., a partnership, limited liability company, or S corporation) and expects to be converted to a taxable entity (e.g., a C corporation) in conjunction with its IPO, pro forma income taxes and EPS should be presented to reflect the impact of the conversion. This presentation is required for the latest fiscal year and interim period; but if the pro forma adjustments are limited to income taxes, pro forma information for all periods presented is permitted.

4.5.2 Draft Audit Reports

Example of an SEC Comment

We note that you intend to affect a reverse split of your common stock prior to the effectiveness of the offering. We remind you that in accordance with SAB Topic 4:C you will need to revise your financial statements and your disclosures throughout the filing to give effect to the expected reverse split. If your auditors believe that only a “draft” report can be presented due to a pending future event such as the reverse stock split, they can include in the filing a signed and dated preface to their “draft” report stating the reason and that they expect to be in a position to issue the report in the form presented prior to effectiveness. A signed, dated, and unrestricted auditor’s report must be included in the filing prior to effectiveness. See Rule 2-02 of Regulation S-X.

In accordance with Regulation S-X, Rule 2-02, and interpretive guidance (e.g., Section 4710 of the FRM), the auditor’s report should be dated and signed by the auditor and should not contain restrictive language (e.g., “draft”). The SEC staff will generally not commence its review of a registrant’s filing if the registrant has filed a registration statement that does not meet these requirements. However, if a transaction (e.g., a stock split, a change in reportable segments, a legal reorganization, certain accounting changes resulting from the adoption of a new standard, or a discontinued operation) is expected to occur immediately before the registration statement is declared effective, the registrant may wish to give effect to the transaction before it occurs. When such an anticipated transaction has been included in the historical financial statements, the SEC staff has accepted the filing of a “draft report” in the form in which the report will be expressed at the time the registration statement becomes effective. The draft report is allowed since the anticipated transaction prevents the auditor from expressing an opinion regarding the financial statements at the time of filing because the filing took place before the transaction occurred and before the registration statement was declared effective. Such a report would include a preface indicating that the report will not be final until the transaction is completed. The SEC staff will remind registrants to remove the preface from a registration statement that was filed before being declared effective because no registration statement can be declared effective until the preface is removed and the auditor’s report is finalized.

An entity may enter into a transaction to dispose of a component or group of components that meets the criteria in ASC 205-20 to be classified as a discontinued operation. Although the disposal may occur after the date of the entity’s most recent balance sheet included in the registrant’s financial statements (in which case, presentation as a discontinued operation would typically be precluded), the registrant in certain circumstances may be able to present the transaction retrospectively in the financial statements and include a “to-be-issued” accountant’s report on those financial statements. The highlights of the June 2014 CAQ SEC Regulations Committee joint meeting with the SEC staff indicate that for the registrant to be qualified to do so, “the following must be completed prior to the initial filing: 1) the disposal of the discontinued operation has occurred; 2) the audit of the financial statements, including the retrospective revision; and 3) registrant consultation with the appropriate [review office].” In addition to these requirements, a pre-effective amendment to the registration statement must contain (1) updated financial statements for a period that includes the disposal date and (2) an unrestricted accountant’s report.

If the event that requires retrospective revision of the financial statements, such as a stock split, will not occur until after effectiveness, the SEC staff generally requires the registrant to disclose the pro forma impact on the profit or loss per share computations in a manner consistent with the discussion in Section 4.5.1.