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Building A Board For The Pre-IPO Company

Companies are going
public again (or talking about it), and the initial public offering can again
be discussed, without embarrassment, in polite company.

A business
contemplating an IPO needs to address the composition of its board of directors
well in advance of that undertaking.

One recent regulatory thrust of the Securities and Exchange
Commission, acting together with the SROs (self-regulatory organizations such
as the Stock Exchanges and the NASDAQ), has been to make public boards of
directors more powerful.

That thrust has two prongs: First, to place upon directors
more mandatory functions (particularly but not exclusively in the audit and
financial control area), and second, to turn boards into independent watchdogs
by requiring that a majority of the public board (and all members of certain
key committees) be independent of management.

This article will explore how these dual prongs impact on
building a board in anticipation of an IPO.

Although there is no requirement that a newly public company
must list its shares for trading on any particular exchange or through the
auspices of any SRO, we will focus on the steps to be taken by an IPO
registrant intending to have its shares listed for trading on the NASDAQ
National List, a typical approach particularly for technology enterprises.

Other SROs may have different requirements, but those
differences are only in the details, and (given the push by the SEC) not
surprisingly there is a common denominator running through the various SRO

Timing Is Everything

The federal statutory scheme, primarily driven by the
Sarbanes-Oxley Act of 2002, together with the NASDAQ rules, would allow an IPO
company to first comply with certain board composition requirements 90 days
after its IPO.

Although some directors prefer to join boards only after the
completion of the IPO, so as to reduce the risk they may run for any material
misstatements or omissions contained in the IPO prospectus, there may be some
advantage in putting in place a quality board of directors prior to the IPO

Additionally, if board composition requirements are
applicable a mere three months after the IPO, prospective board members must be
identified in advance even if they formally begin to serve only after the
closing of the IPO. Given requirements of director independence, and the other
factors discussed below in building a board, adding more directors is no longer
the quick and casual exercise it might have been prior to Sarbanes-Oxley.

Building The New Public

The most important requirement is that a majority of
directors be “independent.” The concept of an “independent director” is highly
complex and fact-dependent. An independent director cannot have a relationship,
which, in the opinion of the company’s board, would interfere with the exercise
of independent judgment.

Each current and proposed member of the board of directors
must be evaluated with care and sensitivity. “Independence” is primarily driven
by SRO regulation, so our IPO company must keep its NASDAQ rulebook close at

There are certain express ground rules that direct us on the
path of “independence.” You cannot be independent if, among other matters:

  • You were employed
    by the company or any of its affiliates during the current year or the prior
    three years (affiliation generally means that one company controls another or
    that the two are under common control);

  • You accepted
    compensation from the company or its affiliates in excess of $60,000 during the
    prior year (except as compensation for service on the board or under certain
    other limited circumstances);

  • Someone in your
    “family” is, or in the past three years has been, employed by the company or
    its affiliates as an executive officer (“family” actually is described as
    “immediate family” and includes spouse, parents, children, siblings, in-laws
    and anyone who resides in your home; “executive officer” has the technical
    definition contained in an SEC rule under the Securities and Exchange Act of

  • You are, or a
    family member is, a partner, controlling stockholder or executive officer of
    another enterprise that has conducted $200,000 of business with the company in
    any of the past three years (or if the volume of such business has exceeded 5
    percent of the recipient company’s gross);

  • You are, or a
    family member is, or in the prior three years was, a partner or employee of the
    company’s audit firm; or

  • You are, or a
    family member is, employed as an executive of another enterprise, and a
    company’s executive serves on the compensation committee of that other enterprise
    within the prior three years.

    These specifics are only examples. The board must determine
    whether a proposed member is in fact independent. Recently decided cases have
    suggested that independence also can be compromised by a variety of social or
    charitable interlocks, which in the past might have been viewed benignly as a
    combination of friendship and support for the same good causes.

    It is important for a board to make inquiry of its own
    members and of executive employees, to ferret out all linkages, who knows whom,
    how did the candidate get recommended, by whom and based upon what
    relationship, and how close is that relationship to the business of the
    company, its other directors and its executives?

    Factors Other Than

    There are other factors, aside from determining
    independence, that may bear upon selection of board members. Expertise in the
    company’s business, or expertise in an area which is important to the company’s
    growth (such as corporate finance, government contracting, or the guidance of
    rapidly expanding enterprises) might be desirable.

    Diversity in gender, race or geography may be important,
    from a strictly business standpoint or to present the company in a particular

    Serving as a director, and particularly serving on certain
    committees of public companies, has become very time consuming. Care should be
    taken not to add individuals who, because of a combination of other work and/or
    directorship responsibilities, will not be able to discharge the directorship
    and committee responsibilities you anticipate.

    Persons who serve as CEOs, or on audit committees of other
    public companies, particularly should consider limiting their involvement in
    other public companies to not more than two. Total directorships likely should
    not exceed four, although certain professional directors only hold a greater
    number of appointments.

    In the IPO, or soon thereafter depending on the sequence of
    facts, a public company must make substantial disclosures concerning its
    directors. These disclosures include business transactions between the company
    and a director (or companies affiliated with the director) involving more than
    $60,000 annually, and specific information concerning the director’s
    employment, past financial problems (personal and with affiliated companies),
    criminal or securities law violations and the like. Building a board involves
    asking the embarrassing questions so as to pre-qualify potential directors.

    “Independent” directors are needed to staff the audit
    committee, and any compensation committee or nominating committee that may be
    established. How hard are your potential directors willing to work? Naming
    three independent directors who might staff all of these committees may not be
    very smart. Many companies have at least four independent directors so as to
    provide a large enough “working group” (and since independent directors must be
    a majority, that means a board of seven).

    NASDAQ exempts a company owned 50 percent or more by one
    person or entity from most of the foregoing requirements. Thus, a public
    holding company with a partially publicly held subsidiary need not fill that
    subsidiary’s board with a majority of independent directors. However, certain
    requirements remain in place, such as the independence requirement for the audit
    committee, and all disclosure requirements that are mandated by SEC (as opposed
    to NASDAQ) rules.

    Staffing Committees

    The board must elect an audit committee, and Sarbanes-Oxley
    places a great deal of responsibility on that committee. The committee must be
    entirely made up of independent directors who have certain minimal qualitative
    capacity to read and understand financial statements.

    Audit committee members also are subject to even stricter
    technical independence criteria, as described in SEC Rule 10A-3(b). (A
    three-member audit committee can in fact include one non-independent director
    who is not a current officer or employee, or family member of a current officer
    or employee, under certain limited circumstances for a period of up to two
    years, provided the company’s next annual meeting proxy statement discloses the
    reasons that the board believes such membership is in the best interest of the
    company and its shareholders.)

    The audit committee also should have at least one member who
    is a “financial expert,” a person with past employment experience in finance or
    accounting, a professional certification in accounting, or any other comparable
    experience or background that creates financial sophistication.

    If an audit committee does not contain such an expert, under
    Sarbanes-Oxley Section 407 the company must make an undesirable and perhaps
    embarrassing disclosure in its SEC filings as to the reason that it has not
    complied with this requirement.

    Although not mandated by NASDAQ, many companies have both a compensation
    committee and a nominating committee. The compensation committee sets
    compensation for executive officers and administers stock option plans. The
    nominating committee selects nominees for board positions. If a NASDAQ company
    does choose to have either of these committees (which are indeed mandatory for
    NYSE listing), the entire membership of these committees similarly must be

    The existence of a compensation committee implicates two
    other statutes.

    The Internal Revenue Code denies a compensation deduction to
    public companies paying more than $1,000,000 per year to their CEO and next
    four highly compensated executives unless approved by shareholders and payable
    solely upon obtaining one or more performance goals determined by a compensation
    committee that consists only of two or more “independent” directors.

    And the SEC requires public disclosure if any members of a
    compensation committee have at any time been an officer or employee of the
    company. Similarly, if a company’s executive officer serves on the board or
    compensation committee of an enterprise whose executive officers themselves
    serve on the company’s board or compensation committee, a disclosure is
    required of such “such compensation committee interlock.”


    None of these considerations address the important issue of

    Not only must directors actually become active participants
    in the management of a company; since the regulatory scheme establishes the
    independent directors in somewhat of an arms-length relationship to management,
    it is also important for management to cause its present board to select
    “independent” directors who are committed to civility and to communication.

    After going public, when that complaint of irregularity is
    lodged with the audit committee against practices of management, company
    management will be well-served if it has selected independent directors who
    will work with management in a constructive way, so as to resolve tense matters
    without impairing shareholder value or destabilizing the company, or its
    management team.

    Stephen M. Honig is a member of Duane Morris’
    corporate department, and is a resident in its Boston office. His practice
    includes counseling public companies in matters of SEC compliance and corporate

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