Small-cap floats warm up the IPO market

Would-be directors need to have due-diligence processes before accepting positions on newly listed entities.

Observers of the Initial Public Offering market tend to judge it by value (capital raised). What matters for directors are IPO volumes and new board formation – a metric that is improving as smaller companies list on ASX this year through floats.

Most IPOs this year have been capitalised below $100 million and many were formed for the purposes of listing on ASX through an IPO. Higher float activity creates more board demand as The Corporations Act (2001) requires a minimum of three directors for public companies.

HLB Mann Judd’s annual mid-year IPO report, released in late July, identified higher volumes of smaller company IPOs in the first half of calendar 2017. Fifty-seven companies listed on ASX, up from 34 for the same period in 2016.

“The first half of 2017 has seen a strong performance in what is historically a quieter period for new listings,” said HBL Partner of Corporate and Audit Services, Marcus Ohm. “The last time more than 50 companies listed in the first half of the year was in 2011.” IPOs are typically busiest in the fourth quarter as companies rush to list before Christmas.

Another good sign was IPOs this year achieving their target subscription. About 83 per cent of total subscription funds sought was achieved: 42 IPOs closed fully or oversubscribed, according to HLB. Many small IPOs have struggled to achieve their minimum subscription or secure enough shareholders to meet ASX Listing Rules in the past few years.

The return of resource IPOs was another highlight in the first half: 15 of 57 mining floats were for resource companies. Mining and energy IPOs are traditionally a mainstay of IPO volumes each year as dozens of junior explorers list on ASX.

After peaking at the top of the resource investment boom in 2011, mining floats dried up when commodity prices tumbled. There have been hardly any such floats in the past three years, despite improving commodity prices. Most corporate activity for junior explorers has been in reverse takeovers, where technology companies bought the corporate shell or assets of dormant miners.

HLB says the first half of 2017 marked a decline in reverse takeovers or so-called “backdoor listings”. Ten reverse takeovers in the first half compared to 69 such deals in 2016.

Changes to ASX Listing Rules that require at least two years of audited accounts potentially add to the time and cost of reverse takeovers, thus reducing their appeal to vendors.

Although small-cap listings are improving, overall IPO activity is lacklustre. Expectations at the start of 2017 were for a strong IPO market, possibly one of the best this decade (by capital raised) as several expected blockbuster floats came to market. Some billion-dollar IPOs, absent from this year’s market so far, were in the pipeline, pending market conditions.

Hopes of a bumper IPO market were dashed by a subdued sharemarket and signs of float “fatigue” among institutional investors. Market fears about the threat of Amazon ramping up operations in Australia contributed to the withdrawal of IPO candidates such as OfficeWorks.

The IPO market raised only $1.9 billion in the first half of 2017, HLB Mann Judd data shows. For context, about $7.5 billion in IPO capital was raised for all of 2016. Some good news is that small-cap IPOs look almost certain to overtake the value and volumes of similar listings in 2017.

Here are 10 considerations for directors who are invited to join the board of an IPO:

1. Understand the risk

IPOs have a significant extra layer of governance risk because most are unproven as listed companies. Reputation, legal and financial risks are potentially magnified with IPOs, especially in those formed to float on ASX.

2. Less information

Unlike established listed companies, there are typically few broker or media reports assessing the small IPO’s prospects. Directors should be prepared to do significant, hands-on due diligence that extends beyond reading the prospectus, and be able to test key IPO assumptions.

3. Lines of sight

As with any offered board position, it’s a good idea to talk to the IPO’s chief financial officer and auditor, in addition to its CEO and Chairman. Meeting key shareholders to understand their goals can also add value in small-cap IPOs.

4. Be prepared for extra work

Small-cap IPOs sometimes establish governance systems from scratch in the lead-up to their IPO. Prospectus sign-off also requires considerable work and, as with many small-cap companies, boards are often expected to be more hands on in operational matters.

5. Understand the capital structure

Key decisions, such as executive options issuance and CEO pay, are often made around the IPO and can affect company performance for years. Be satisfied that the future capital structure (assuming options issuance) is appropriate for the company at its stage of growth. And that the CEO is appropriately paid.

6. Who else is involved?

Arguably the best indicator of a small-cap IPO is the involvement of others. Who is the company’s lawyer and its auditor? Is there a lead broker to the float? Who are the other directors? Small companies often use smaller professional service firms that cost less, but alarm bells should ring if there are reputational issues around chosen providers, or potential conflicts of interest from related-party transactions.

7. Understand the thrust of ASX Listing Rules

Some directors transition from private-company governance to listed public-company governance through an IPO. ASX Listing Rules, principally around continuous disclosure obligations, add a layer of governance issues for directors. The AICD Company Director’s Course is important for all directors and particularly so for those governing a listed entity for the first time.

8. Be prepared to transition as the company transitions

The skill set required of small-cap boards can change rapidly as they grow. A junior explorer, for example, might need a board with a high weighting of geological skills. An emerging mining producer might need more directors with capital-raising and mining-plant construction experience.

9. Cash flow

It’s a truism that many small-cap companies, particularly those yet to earn revenue, live from one capital raising to the next. Directors must be on top of the IPO’s current and future cash needs and ensure management conducts detailed cash-flow modelling. A liquidator bringing claims against directors for insolvent trading is a significant risk.

10. Asset protection

Every director should consider asset-protection strategies before joining the board an ASX-listed company, such are the potential legal and financial risks of governance if things go wrong. Successful IPOs can reward directors and be a tremendous governance experience. But as unproven listed entities, they can be among the more demanding board roles.