Preparing for an IPO
The ratio of myth and misinformation to reality around IPOs is enormous. Perhaps because the events are such significant milestones or perhaps because they attract more press and are more glamorous than more mundane business announcements, rumors, innuendo, and significant misunderstandings lead many a company down a rockier road than need be. In this chapter, we hope to offer just a few suggestions to get started down that yellow—or hopefully gold—brick road while minimizing flying monkey and wicked-witch visits.
Going public is a time consuming and tedious process of dotting a lot of “i’s” and crossing many “t’s.” Before rolling eyes at that, understand that the process should be hard. If a company’s management finds going public too trying, the team should contemplate that “going” public is nothing compared to being public. Operating as a public company is a whole new stair-step up in corporate responsibility.
An IPO is neither a payday nor an exit. It is a change in the ownership structure of the company in return for a change in the amount of cash in the bank. The upshot is that, after an IPO, management and the board have a responsibility not only to customers and employees but also to a large new group of owners/investors. In return for cold hard cash, a company is selling an ownership stake to these unaffiliated funds and individuals, all of whom have high expectations. Quite simply, IPO participants are buying ownership in the company today because management convinced them that as the company grows, these new investors will receive more money back for relinquishing that ownership “tomorrow.”
Why go public?
Thanks to the JOBS Act, companies can increasingly raise previously unimagined sums from the aggregation of a large number of private investors. Until that Act, companies had the obligation of sharing audited financial information with investors once there were 500 of them with money at stake. Many, including Google and Facebook, used that public information-sharing requirement to launch the transition from private to public. The thinking generally was “let’s use the unveiling of our financial information as the catalyst to kick off our IPO.” Unfortunately, the JOBS Act removed the 500 shareholder rule, swapping in a toothless placeholder, and thus removed a legal incentive for the best of the growth companies to share the investment opportunity with public investors during what is likely to be a period of rapid growth. Prior to the change, it was not at all common for a private, venture-backed company to be valued at over $1.0 billion pre-IPO; that valuation was only for the best of the best. After the JOBS Act, “unicorns,” companies valued at more than $1.0 billion in the private markets, are suddenly as common as golden retrievers, although not nearly as dependable.
Since private investment money can, for some companies, be seemingly unlimited, private company management can reasonably ask “Why go public at all?” There are four main, important reasons:
- to create a liquid market in the stock
- to enhance the profile of the company
- to provide liquidity to early investors and
- to discover the “real” valuation of the company as determined by third-party trading in the stock. Among other uses, this information is critical should a company want to use its stock as an acquisition
While there are a host of other attributes accompanying public market status, those four are for many the primary drivers.
Once a board has made the decision to go, the next question to consider is timing. First and foremost, companies should know that the process is time consuming and cannot be tightly controlled. Even the most organized teams find the timing of an offering will fluctuate depending on market conditions, auditor schedules, the SEC’s schedule, and sometimes competitors’ plans. While there are plenty of examples of both shorter and longer processes, it is not unreasonable to expect the process from pre- banker selection through IPO to run seven to nine months, if all runs smoothly. Yes, some move more quickly but for others, more than a year can elapse between banker selection and an IPO’s effective date. All who embark on the process should understand that like air travel through O’Hare in the wintertime, mapping out an expected, precise ETA is an exercise in futility.
Before the board says go:
The IPO process is long and involves intense scrutiny, just as is the case with the sale of any high-priced asset from a home to art to a business. Fortunately, potential issuers can reduce the intensity of the project by taking a few steps before any formal IPO process begins.
For example, the best time to gain a first-hand understanding of how public investors differ from private company investors is when the IPO is just an imaginary date on a distant calendar page. Investors in public companies make decisions differently and work on time frames completely foreign to venture investors. The sooner a management team understands the former’s lens, the greater the understanding and therefore the ease of the entire process. In recent cases, crossover investors have participated in later-stage private rounds and can be one source of information for private company management teams, but for others, attending a couple of investment bank public company conferences, even just as an unidentified audience member, is a terrific way to see what kind of questions these investors ask and how they view and evaluate investment opportunities.
Even better, while still far from an IPO, invite an institutional investor or two to come visit. Do not share projections or even historical financial results but do show the most recent company presentation and ask (and watch) for feedback about what works and what baffles. The more of these early meetings a team has, the more able it will be to incorporate some of the thinking into future presentations and ultimately, into the S-1 and the roadshow. Investor thinking matters at IPO time because generally, and too often overlooked, is the fact that these people are not interested in a company’s technology or patent collection. They are interested in the commercial application of those assets and how they will ultimately convert to growing revenue and profitability.
Frequently, private companies overshare their financial results and forecasts far too early, in hopes of impressing future public investors. There is no benefit and definitely a potential cost in doing so. Threading the needle between promoting financial success and forecasting financial prospects is complex. Companies that keep their numbers confidential until the time comes to unveil them thoughtfully and with appropriate talking points often end up better able to control the narrative on an ongoing basis. If the financial results are solid, companies will benefit at the time of publication of the public prospectus and IPO. If the investment proposition is more about future hopes and dreams, there is no advantage to launching that often distracting conversation too soon.
In addition to potential investors, companies that believe an IPO is on the horizon should spend some time with investment bankers. The operative word is “some.” Bankers can offer solid insight into what is on investors’ minds, competitive dynamics, and overall market trends. They can also chew up a significant amount of management’s time. Companies need to find the optimal mix of meeting bankers, both to hear their commentary and to assess their strengths relative to one another, as well as to know that “No thank you” is a perfectly fine response to the umpteenth request for a meeting. Otherwise, the process can quickly become unproductive. When the time comes, the bankers will (of course) take management’s call, regardless of how often they were turned down in the past.
However, of greater importance than meeting with bankers is meeting with investment banks’ research analysts well before the process begins. As long as they hail from reputable (which is not the same as large) firms, for analyst introductions more is better. Again, the caveat applies: keep financial results confidential or at very least vague, “we generated more than $85 million top line last year and can see profitability in our future,” with no further clarification. With that caution, teams will benefit from meeting with and reading the research of analysts from a wide variety of firms. Once public, the analyst community will act as a megaphone for all new issuers’ messages, complemented by their own thoughts. Time spent helping these analysts understand the nuances and differentiation of a business is almost always time well spent.
While still in the early days, ask a CEO or CFO who has recently been through the process to lunch, or perhaps preferably, a drink. Ask them what they know now that they wish then knew “then” or about their experiences with various service providers including bankers and lawyers. Ask them what they would do differently. Every transaction is different but everyone can learn from the wheel- building that has already transpired.
How does a company know if it is ready? How big is big enough?
Perhaps the most frequently asked question in the period before the board has hit the IPO launch button is “How big do we have to be?” Unfortunately, the answer really is “it depends.” Investors understand the 0–90 mph trajectory of companies in the biosciences fields, and therefore often invest when revenue is nonexistent or microscopic. On the other hand, for companies selling more tangible products that don’t require FDA approval, investors generally require evidence of an enthusiastic reception from the target customer market. Service companies often fall somewhere in between. While some of their preferences are variable, stalwart, fundamental investors always favor companies with solid financial results and a promising forward-looking profit and loss (P&L). “Solid” does not mean “currently profitable” but the stronger the financial health and realistic outlook, the less risky an IPO candidate appears and the more generously that firm is likely to be compensated with a higher relative valuation.
While the exact size of the top line, growth rate, or time to cash-flow profitability can vary widely for IPOs, before embarking on the IPO adventure, a potential issuer must have the financial wherewithal to cover the costs of both the process and of being a public company. These costs include, among others, legal and audit fees, compliance fees, advisor fees, the costs of a fully capable finance team, and ongoing investor relations expenses. When the Sarbanes-Oxley rules went into effect, some howled that the incremental expenses were too big a burden for an issuing company. Actually, those costs serve as an important, necessary hurdle. Very simply, if a company cannot afford the cost of having its financial statements audited, it most definitely cannot afford to operate as a public company and should not begin the process.
What else matters?
Assuming the company is established enough to tell an accurate and compelling story to potential public investors, what else matters? Well, plenty, but two things above all. The easy one is management. The more the team has been together and is fully filled out, the easier the sale to investors. While it is not terribly uncommon to see management changes as a potential IPO approaches—after all, different team members prefer companies at different stages— switching out financial or sales or senior members of management in the months just before a process begins is a suboptimal route. Importantly, the CEO and CFO have to sign personal attestations about the information in the S-1, statements for which they incur personal (that is, no directors and officers coverage) liability. Investors are right to wonder about the finance expert willing to swear all the numbers are accurate after just a month or two on the job. More importantly, an IPO often puts the team under incremental stress. A team that operates cohesively before adding the extra challenges is likely to have an easier go of the process. Furthermore, on this point, mutual fund managers and others repeatedly say that the heart of the “invest-or-don’t-invest” decision is the assessment of the team that will run the company. The shorter the team’s tenure with the company, the greater the risk to investors and the greater the potential negative impact on valuation.
Secondly, nothing is more important than being able to accurately forecast financial results. Yet this is a swamp of quicksand into which IPO companies fall with stunning and disheartening regularity. Providing a fail-safe forecast for the year ahead is tremendously challenging for a number of reasons including:
- For most rapidly growing businesses, forecasting out several quarters is very challenging because too many pieces of the P&L are in flux and undoubtedly somewhat
- The pricing of the IPO correlates closely to the projected financial results for the next fiscal year, and therefore there is always pressure on the finance department to be
- Investors’ response to earnings announcements during those first public quarters are highly A company that outperforms expectations generally receives a hearty round of applause from the market, reflected by the positive reaction of the share price the following day. On the other hand, a company that misses its targets for an early quarter will likely be crushed in the markets by investors who often feel they were somehow misled. To be clear, “crushed” can mean a share price haircut of 20 to 50 percent. The morale impact of that swan-diving share price can have severe and long lasting ramifications for both investors who bought into the deal and the employee base.
Combine genuine uncertainty with strong pressure to be concurrently optimistic (boards) and pessimistic (bankers), and teams have a challenging balance beam for even the most sophisticated finance organizations. The successful navigation of this ledge is a mandatory part of the process and the issuer’s future.
Regardless of potential issuer’s size and even if management has been together for 10 years, if the company’s finance department cannot accurately forecast the P&L several quarters out within a very small margin of error, rethink the timing of the IPO.
What about timing?
As already explained, much of the timing will be out of the issuer’s control, and planning to “hit the window” is a waste of time. The size of that window varies directly with the strength of a company’s financial prospects. The stronger the numbers, the closer to profitability, the less important a window is. It is true that during periods of economic meltdown such as the 2008–2009 period, investors may have no interest in new issues. This is because new issues involve greater investment risk than established or “seasoned” public companies. During times of greater overall market volatility, the largest of the public investors tend to minimize risk in their portfolios by moving into more proven, less volatile stocks. Consumer staples and utilities tend to outperform faster growing, unprofitable technology stocks when markets are risky. Furthermore, sometimes the bluest of the blue chips are “on sale” in these periods, and many a portfolio manager prefers shifting money into proven performers at a discounted price rather than into an unproven “trust me it will be great” new issue.
Market volatility is measured by an index, the VIX. The VIX, also called the “fear index” is calculated by the Chicago Board of Trade as an estimate of the market’s near-term (30-day) volatility. When the VIX is up, the IPO count goes down. Who wants added risk on top of the market’s already heightened level of indigestion- inducing daily swings? When markets are relatively more stable, the IPO count climbs.
The challenge for issuers is that the VIX readjusts daily. It simply isn’t possible today to predict how volatile markets will be in six months. The only time companies trying to time the market can have any impact is when they make the “go” or “no go” decision for the roadshow kickoff. Even then, timing the market is almost impossible; swings happen daily. That said, there are times during the year that are suboptimal for an IPO. Companies should assume there will be fewer institutional buyers in the market during the last two weeks of August, traditionally a vacation time for many investors and similarly, the last two weeks of December. Beyond that, all timing conversations are guesses that could be prescient or completely misguided, with the answer clear only in hindsight.
The best strategy for management is to begin preparations when the company’s fundamentals are solid, forecasting competent, and the team is in place. Potential issuers can always choose to slow the process down if internal or external factors dictate that to be the prudent choice, but accelerating the process can be done only on the margin because the SEC review process generally takes not less than 90 days from the initial filing and often takes significantly longer. Solid advance preparation of parts of the S-1 and an early start on audits can meaningfully reduce the time spent leading up to the initial document filing. However, even then, the IPO registration and execution process takes the better part of a year.
This chapter covers just the visible portion of the IPO prep iceberg but offers some elements to consider. Summarizing those:
- Exactly what a company aims to accomplish with an IPO should influence the
- Companies should:
° meet with investment bankers judiciously, when and if they want. When the time comes, bankers will be fully attentive and ready.
° choose IPO timing based on internal pre- paredness, not an externally influenced target or an imaginary “window.”
° not share too many financial details too early. There will be plenty of time for more effective leveraging of those numbers later in the process.
° befriend a few institutional investors early. There is much to be learned from them that will serve an issuer well when the time comes.
° should not publicly complain about the cost of Sarbanes-Oxley. If it is too big a hurdle, the company isn’t ready.
An IPO is the brass ring (or a college graduation) for entrepreneurial ventures with a bright, independent future. A strategic approach to the process of becoming public can deliver enormous benefits down the road.
Lise Buyer, Partner, Class V Group
Leslie Pfrang, Partner, Class V Group