Initial Public Offerings

The goal of this article is ambitious because a definitive decision-rule does not exist. Each company’s setting is different so an IPO’s pros and cons will produce a customized result. Nevertheless, a general recommendation will be presented (while the definition of “going public” has expanded with the advent of crowdfunding, Reg A+, etc., the focus […]

August 4, 2015

The goal of this article is ambitious because a definitive decision-rule does not exist. Each company’s setting is different so an IPO’s pros and cons will produce a customized result. Nevertheless, a general recommendation will be presented (while the definition of “going public” has expanded with the advent of crowdfunding, Reg A+, etc., the focus herein pertains to Securities Act of 1933 IPOs).

Present Conditions

IPO activity has steadily increased over the 2010-2014 period (17% CAGR) and is strong. This has been due to: (1) high equity valuations, which are above the mean but still considered reasonable, (2) a very low VIX index (measures anticipated volatility: aka the “fear index”), and (3) unprecedented buyside demand for yield exacerbated by the dearth of alternatives, and the moderation of actively managed fund interest.

An Accelerator

The JOBS Act related to “emerging growth companies,” defined as companies with less than $1B in revenue (90% of IPO companies are EGC’s), has been an IPO facilitator as issuers can: (1) defer compliance with the SOX provision related to internal controls, with which many companies are struggling given tightening standards, (2) file two (vs. three) years of audited financial statements, and (3) submit confidential filings to the SEC to “test” their candidacy without any public disclosure.

A Decelerator

A rapidly growing product-class of private placements directly between a company/issuer and a syndicated set of three to seven institutional investors, like Fidelity and T. Rowe, have been gaining IPO market share. The net result is the delaying of an IPO from 2-4 years to 8-10 years, and thus, these placements are displacing IPOs. Again, this product-class is driven by the quest for yield by the buy side.

Why Yes

The top 5 reasons for an IPO are:

1) Liquidity. For employees, sponsors (VC/PE), and only partially for managing owners. The counter is the ability to achieve liquidity within the vibrant private market, e.g., minority interest investments in companies with EBITDA as small as $1mm to $3mm are readily available, sponsors can liquefy to other sponsors, etc. The private market’s current limitations are immediacy, small trades and trade costs.

2) Capital Raising. For companies seeking initial and ongoing equity capital formation. The counter is the depth and sophistication of the private market, which possesses the ability to fund any requirement faster and less expensively, i.e., there is really no public market advantage.

3) Public Profile. For companies assigning value to creating additional marketplace exposure for brand enhancement, creditability and stature to their standing, etc. The counter is that brand enhancement is best achieved via directly (vs. indirectly) strengthening the affiliation relationship with customer.

4) Valuation. For companies believing a higher valuation might be achieved based on the efficiency of the entire public marketplace. The counter is whether efficient markets exist, the hostage-effect related to algorithmic nano-trading and the externality diversity, and if secondary market and research coverage support can be provided.

5) Currency Effect. For companies desiring a form of consideration to be used to make acquisitions, compensate management, recruit, etc., that possesses an immediately assignable value. The counter is using private company stock that would require third-party valuation intervention.

Why No

The top 5 reasons against an IPO are:

1) Management Practices. An IPO requires a new set of managerial skills, e.g., handling earnings calls, providing performance guidance, and embracing the pressure to perform over the short-term. Teams conduct mock calls and guidance, and find a quarter-to-quarter orientation to be different.

2) Capability Enhancement. An IPO requires a quality Board that reduces the management’s autonomy, building an investor relations capability since 70% of the shareholders change in two years, and trading activity is opaque (40% on the listing exchange & 60% in “black pools”), etc.

3) Compliance Responsibilities. An IPO requires the assumption of substantial compliance requirements related to SOX and otherwise, necessitating pristine financial reporting, acute internal controls (standards are increasing), comprehensive governance umbrellas, etc.

4) Confidentiality Compromise. An IPO requires full transparency related to financial reporting, strategic development matters, executive compensation, etc., and as such, such disclosures may provide “interesting” information to competitors, customers, and suppliers.

5) Initial & Ongoing Costs. IPO and post-IPO economic and man-hour costs are substantial. The one-time initial costs are related to registration, legal, accounting and underwriting fees, while the post-IPO costs are correlated to a company’s complexity.

Prevailing Sentiment

It seems an IPO might be best for a company that has: (1) at least $250mm of Equity Value (vs. EV) since securities of at least $75mm in value, equating to 15% to 30% of overall Equity Value, are sought for an IPO, (2) a customer value proposition that ideally, although not exclusively, would have an appeal to retail and institutional investors, (3) a robust strategic development agenda creating an expectation of quality earnings growth, (4) support from both, a top underwriter willing to actively participate in the secondary market, and a diversified and high-quality set of research analysts, and (5) the ability to evolve toward accommodating the necessities of a public company. However, if a company is offering a (truly) disruptive, understandable and consequential offering, or has a niche leadership position, then the size factor is less relevant.

Overall Conclusion

The size, vitality, and ease of the private market in regard to private equity and the noted private placements, anesthetize, if not obviate, some of the traditional IPO benefits, while the outlined militating factors are consequential. As a result, lower middle-market, and most middle-market companies possessing Equity Values of less than $250mm should not consider an IPO, save the disruption and niche considerations (most micro-caps should consider going-private). So, an IPO might make sense under special circumstances.

Jeffrey R. Knakal

Jeffrey R. Knakal

Managing Partner & Founder | Growth Partners

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