What It Is: An initial public offering (IPO) is the sale of equity in a company, generally in the form of shares of common stock, through an investment banking firm. These shares subsequently trade on a recognized stock market. For smaller, emerging companies, the stock market will probably be the Nasdaq SmallCap market or the Nasdaq National Market System.
Appropriate for: Startup to established companies. Startup companies must demonstrate the potential to develop into profitable enterprises that will deliver significant annual increases in sales and earnings. Established companies must also demonstrate significant future growth potential. In either case, minimum earnings growth potential is 20 percent per year, and the company should be able to achieve a valuation (total shares outstanding times their price) of at least $100 million to be truly successful as a publicly held corporation.
Best Use: Financing the expansion of manufacturing or service capacity or marketing activities that have immediate impact on earnings; also, providing a company with increasing sales, as a layer of working capital to fund growing inventory (if there is any) or accounts receivable. IPO funds can be used to finance research and development, but stock prices tend to decline during prolonged periods of product development, which in turn generates a new set of challenges for founders or senior management.
Cost: IPOs are perhaps the most expensive way to finance a company. Not only will an IPO cost a significant chunk of the company's equity--no less than 25 percent and perhaps a great deal more--but fees and expenses can climb to as much as 25 percent of the deal. For a $5 million offering, that's $1.25 million.
Ease of Acquisition: Unreasonably difficult. Going public is one of the most challenging transactions. During robust economic periods, about 750 to 1,000 companies go public each year in offerings underwritten by investment-banking firms. Many more try but fail during the process.
Range of Funds Typically Available: $5 million or greater
What are the strategic reasons a company should consider an initial public offering?
- If a company cannot reasonably expect to raise venture capital from institutional funds.
- If a company needs to raise more than $5 million. At this point, stalking angel investors can be too time consuming.
- If a company needs a significant amount of permanent capital it won't have to pay back to a bank or other lender.
- If a company seeks growth through acquisitions, and needs a "currency" other than cash to attract and consummate deals.
In addition to strategic considerations, being a public corporation often confers the following benefits:
- A public company has direct access to the capital markets and can raise more capital by issuing additional stock in a secondary offering. Public companies can also more easily raise funds privately.
- Public companies can use their common stock to attract and retain good employees.
- Being a public company is more prestigious than being a private company.
- Going public provides owners and founders an exit for selling their ownership holdings in the business.
- Public companies are worth more than private companies. The public companies that compose the Standard & Poor's 500 are valued at about 17 times their earnings (i.e., a company earning $1 million would be worth $17 million), while private companies are typically bought and sold at one to five times cash flow.
Going public makes you rich--at least on paper. And make no mistake, none of the lawyers, accountants or investment bankers involved in the process gets the least bit squeamish about your desire for riches. After all, your success means their success. For entrepreneurs who want to go public, their first, most important, task is to find an investment banking firm that will underwrite the offering. Once that task has been done, with a little luck, a strong market and a lot of determination, everything else will fall into place.
Finding Your Investment Banker
To find the right investment banker, you must conduct some research. Specifically, you must discern which firms in the past two years have consistently done initial public offerings similar in size and scope to the one that fit your needs.
There are three good sources of historical information on initial public offerings:
- Thomson Financial's Investment Dealer's Digest, which recently merged with leading industry resource Going Public: The IPO Reporter
- The SEC New Registrations Report, published by CCH Washington Service Bureau in Washington, DC
Investment Dealer's Digest is expensive but can be reviewed at any corporate or public library that subscribes. The SEC New Registrations Report, also expensive, can be found in libraries as well. The website www.ipocentral.com is free.
Whichever source you use, your research should identify 50 to 75 investment-banking firms that appear to underwrite IPOs similar in size to the deal you want--namely, $5 million $15 million. Of these firms, the following algorithm will indicate which are the best candidates to pursue and which might be better left alone.
- Investment bankers with one IPO to their credit during the past two years are probably not good candidates. Often, such an investment-banking firm makes an IPO not because it wants to but because it must. Or the low IPO count may be attributable to the fact that the one IPO that turned up in your research was a disaster, and the firm isn't interested in underwriting another one. Or, and unfortunately this happens all too often, the underwriter may have gone out of business after the IPO due to events that may be related to going public. Whichever of the above set of circumstances applies, underwriters with an IPO count this low are probably not worth your effort to pursue, unless the firm happens to be in your own backyard.
- Investment bankers that have done one IPO per year over the past two years may be viable candidates. Granted, one deal per year is low, but it also says a number of good things. First, it means the firm can put all its resources behind the offering to get the deal done. Second, it means that once the offering is trading, the firm won't be stretched so thin that it can't support the deal.
However, the investment banking firm that does just one IPO a year is probably pretty picky about its deals. Look at the thumbnail financials of the companies the firm underwrote. If the following characteristics are true:
2. all their underwritings are for companies in one industry;
3. all their underwritings are for companies with substantial revenue, and you possess none of these characteristics, this probably isn't a match.
- Underwriters have completed four to eight deals during the past two years are good candidates for your IPO. One or two deals per quarter is a brisk clip for a small investment-banking firm. In fact, it's a pace that, in most cases, will ultimately destabilize the firm--a factor you as the company must keep in mind if you progress to the negotiation stage. But business risks aside, a firm doing four to eight IPOs a year is clearly looking for deals and is probably worth pursuing.
Even though your research may have helped you identify the underwriters you believe are the best candidates to take you public, that doesn't mean they want to hear from you. According to John Lane, an investment banker in Westport, Connecticut, with more than 20 years of experience in investment banking, "Most people in our business will not even look at a business plan that has not been in some way personally referred to them."
Lane's comment underscores a tough reality for entrepreneurs. If you aren't plugged into the financial community, your row is a tougher one to hoe.
You can be plugged in to a referral by making a connection between yourself and the underwriter. You can do this by hiring the following professionals:
- Accounting firms. If you are considering an IPO, experts frequently advise hiring a national accounting firm (or any firm that's handled six or more IPOs in one year) because these firms historically have done the audit work for most IPOs. And because IPOs are driven by financial issues, it also means that the accountants at these firms know investment bankers and can make the kind of introductions that will get your business plan to the top of the pile.
- Attorneys. The only professionals who probably rival accountants in terms of the investment banker's mind share are lawyers. Every financing transaction, whether an IPO, a venture capital financing or a fair-sized term loan, has at least two attorneys--one for the capital seeker and one for the capital provider. Consequently, capital providers, such as investment banks, often view lawyers as valuable counselors. A referral from an attorney can make an investment banker pay attention to your business plan.
Selling the Underwriter
When you meet with an underwriter, it's likely that you will be expected to make a formal presentation. However, in addition to presenting your company, there are other important points to keep in mind to ensure that your first discussion with the investment banker is not your last.
- Demonstrate that you can drive the deal. Investment bankers know how difficult an IPO is. Consequently, they won't bet on a weak horse.
- Don't negotiate fees. If you are contemplating an IPO of $15 million or less, the investment-banking firm will take the maximum allowable compensation by law. No amount of negotiating will change this fact, and trying to do so may even strain the relationship.
- Show your warts. If there's something lurking in your background, such as a bankruptcy or legal problem, it's better to disclose it upfront. If it comes out during the course of the underwriter's due diligence and it seems as if you tried to conceal it, your deal is dead.
- Prove your salesmanship. Your would-be underwriter must have confidence that you can excite others about your company and its growth prospects. After all, the underwriter depends on other underwriters, brokers and traders to make the offering a success. If you look like the kind of person who will put everyone to sleep, that presents an insurmountable challenge to your investment banker.
- Don't be too noble. IPOs are a game of greed. And like everyone else in the deal, you want to get rich. Trying to hide this fact only raises doubts about your character.
- Show that you are committed to the company. Investment bankers are wary of promoters who only want to take a company public and then move on. Granted, few people are capable of such a feat, but even the appearance of being such a character undermines you during your initial meeting with the investment banker.
- Forget about selling your shares in the IPO. In all but the most established companies, a founder selling his or her shares is unheard of. The underwriter simply can't sell a deal if the founders aren't tied to the company.
Common Deal Breakers
Most IPOs die on the drawing board, which is the period of time between when an investment banker issues a letter of intent and the day the offering is filed with the SEC. Here are the top 10 reasons offerings die on the drawing board.
2. The company's founders hide legal or financial problems that the underwriter eventually finds out about.
3. The company's financial reporting is aggressive. If upon further analysis of the company's financial statements it turns out that if it had more conservative accounting policies, the company would actually report a loss, the underwriter will shut things down.
4. The company dickers too much on the fees the investment banker is charging.
5. The company's founders and the underwriter are too far apart on what they think the company is worth and what public investors will pay for it.
6. A lack of salesmanship o the part of the company's owners or founders proves they are unable to excite anyone about the deal. 7. The company is in an industry that "falls out of bed" with Wall Street. Remember conglomerates?
8. Some wrinkle about the company or the offering prevents it from getting clearance in a state that contains several or all of the investment banker's customers.
9. The company cannot afford the $250,000 it will cost to put a preliminary prospectus on the Street.
10. The deal structuring drags on for a long period of time and sales and earnings begin to fall. Unfortunately, the decline may be directly attributable to the amount of time senior management spent cooped up with accountants, lawyers and investment bankers.
Here is the typical timetable for an IPO from when an entrepreneur commits to the process to when he collects the big check at the end of the closing table.
Week 1: Conduct organizational meeting.
Week 5: Distribute SEC registration statement; hold additional drafting sessions.
Week 6: Distribute second draft of registration statement; hold additional drafting session.
Week 7: Distribute third draft of registration statement; hold additional drafting session.
Week 8: File registration statement with the SEC; begin preparations of road-show presentations; begin getting clearances in states where the offering is to be sold.
Week 12: Get comments from the SEC on registration statement.
Week 13: File first amendment to registration statement with the SEC; addressing comments.
Week 14: Prepare and distribute preliminary prospectus; commence road-show meetings.
Week 15: SEC declares offering effective; company and underwriter agree on final price. Prepare, file and distribute final prospectus.
Week 16: Close and deliver offering proceeds.
Excerpted from Financing Your Small Business.