Legal Definitions - testing-the-waters

Testing-the-waters refers to a practice that allows companies planning to sell their shares or other securities to the public to informally assess potential investor interest *before* they commit to the lengthy and costly process of a formal public offering. Essentially, it's like dipping a toe in the water to see if it's warm enough before jumping in.

Companies, known as "issuers," can communicate with certain large, sophisticated investors—such as major investment funds or pension funds—to gauge their appetite for the potential offering. This happens during the "pre-filing period," meaning before the company has submitted its official registration statement to the U.S. Securities and Exchange Commission (SEC).

The purpose of testing-the-waters is to gather feedback on the proposed offering's structure, valuation, and market reception. This valuable insight helps the company decide whether to proceed with the offering, adjust its terms, or even postpone it entirely, thereby reducing the risk and expense associated with a full public offering that might not find sufficient demand. This practice was expanded in 2019 by SEC Rule 163B, making it available to all companies, not just smaller, newer ones.

Here are some examples of how "testing-the-waters" might apply:

• Example 1: A Tech Startup's Initial Public Offering (IPO)

  A rapidly growing software company, "InnovateTech Inc.," is considering an Initial Public Offering (IPO) to raise capital for expansion. Before spending millions on legal and banking fees for a formal IPO, InnovateTech's executives and their investment bankers meet with several large hedge funds and mutual funds. They present InnovateTech's business model, growth projections, and a preliminary valuation range to these sophisticated institutional investors. The goal is to gauge whether there's sufficient interest in their stock at the proposed valuation. Based on the feedback received, Innovateatech decides whether to proceed with the IPO, adjust their target valuation, or wait for a more favorable market.

  This illustrates testing-the-waters because InnovateTech is informally assessing demand from key institutional investors *before* officially filing their IPO registration statement with the SEC, helping them make an informed decision about proceeding with the public offering.

• Example 2: An Established Manufacturer Issuing New Corporate Bonds

  A well-known automotive parts manufacturer, "Global Motors Components," wants to raise $500 million by issuing new corporate bonds to fund a major factory upgrade. Prior to formally registering the bond offering with the SEC, Global Motors Components' financial advisors hold discussions with major institutional bond investors, such as large insurance companies and pension funds. They present the proposed terms of the bonds, including potential interest rates, maturity dates, and credit ratings, to gauge demand and ensure the terms are attractive enough to secure the necessary funding from these large buyers.

  This demonstrates testing-the-waters as Global Motors Components is sounding out the market for its new debt securities among sophisticated investors *before* committing to the full registration process, ensuring there's a market for their bonds at acceptable terms.

• Example 3: A Biotechnology Company's Secondary Stock Offering

  "BioCure Pharmaceuticals," a publicly traded biotechnology company, needs to raise additional capital to fund advanced clinical trials for a promising new drug. Even though their stock is already listed on an exchange, they still need to register any new shares they wish to sell. Before filing the registration for this "secondary offering," BioCure's management and their underwriters engage with institutional investors who specialize in healthcare stocks. They discuss the potential size of the offering, the company's drug pipeline, and the expected use of proceeds to assess if there's sufficient institutional appetite for more shares at a favorable price, and to determine the optimal timing for the offering.

  This is an example of testing-the-waters because BioCure is proactively seeking feedback from large, knowledgeable investors about their willingness to purchase additional shares *before* formally launching the secondary offering, thereby minimizing the risk of an unsuccessful sale.