To Be IPO Ready, You Need to Prepare for These 5 Potential Pitfalls
The IPO market has seen significant activity, largely due to an uptick in public offerings among private companies with a valuation of more than $1 billion. In fact, as of October 2018, Crunchbase data shows 23 unicorn IPOs globally, well outpacing full-year totals for 2016 and 2017.
Unicorn status is hard to come by and not all pre-IPO companies need to achieve such high valuations. However, emerging growth companies do need to make critical decisions regarding how to effectively scale for growth. Investors look for exponential revenue growth along with a strong operational foundation to sustain the company through an IPO.
This means that scale can be equally as important as growth. According to Fundable, "Scaling is about adding revenue at an exponential rate while only adding resources at an incremental rate." This positions a company to achieve higher profits without adding expenses. Growth adds size and revenue but also adds expenses like staff, technology or other resources required to meet growth demands.
Growth is the building block to an IPO, whereas scale is the path forward. To balance both, consider the following:
1. Sales tax compliance
A recent Supreme Court decision determined that states in the United States may impose sales taxes on transactions that exceed certain dollar or transaction count thresholds, regardless of where the company conducting the business is located. A physical presence in the state -- be it inventory, an employee or an office -- is no longer required.
The upshot? Before this court ruling, many pre-IPO companies may not have owed tax for their online sales across state lines. Now they may in states that require it -- and many are likely to pass such legislation in the coming years -- even if operating at a loss.
For companies with an internet presence, this means gearing up for increased tax compliance. Billing systems should be capable of tracking and recording the appropriate tax for each transaction. Financial processes will have to accommodate the collection and remittance of sales tax in potentially hundreds or thousands of state and local jurisdictions. In short, companies with plans to scale need to adjust their operational strategies in ways that may not have been necessary before.
2. Revenue recognition and leasing
New accounting rules for revenue recognition and leases have been issued. The revised guidelines for revenue recognition, known as Accounting Standard Codification (ASC) 606 and International Financial Reporting Standard (IFRS) 15, greatly enhance the requirements for disclosure. They also introduce new concepts, many of which involve significant judgment, such as estimating transaction price. In a similar vein, another new accounting standard, ASC 842, requires changes to how companies categorize and record leases on their balance sheet.
Publicly traded companies, required to adopt these rules sooner, have discovered that implementation can take significant time and have an unexpectedly broad impact on their operations, valuation and profitability. ASC 606, for example, can change the timing of revenue recognition. Meanwhile, ASC 842 brings off-balance-sheet leases that were previously disclosed in a footnote (if at all) onto the books as liabilities.
Pre-IPO companies can learn from the experiences of public companies and adopt these new accounting standards before they approach potential investors. That way, they can be accurate and transparent in sharing information related to revenue, including explaining any discrepancies that may arise between cash revenue and revenue as reported from a GAAP perspective.
3. Systems, processes and controls
Publicly traded companies face high standards for financial disclosure and other regulatory reporting. Consistent with this, Section 302 of the Sarbanes-Oxley Act of 2002 requires the CEO and CFO to certify to the accuracy and fair presentation of their organization's quarterly and annual financial statements and that they have established and maintained adequate internal controls.
This means pre-IPO companies may need more formal internal controls. Beyond that, it may also be worth rethinking existing processes around sales, ordering, fulfillment and logistics. Streamlined processes can enhance the effectiveness and efficiency of the company's financial reporting.
An upside? By increasing the rigor of their internal systems at the outset -- rather than as an afterthought -- companies can reduce many time-consuming, error-prone manual processes that otherwise would burden the resources they need to scale.
A cybersecurity breach can hurt the company in terms of reputation, customers and employee attention. It also can invite litigation and regulatory action. Post-IPO, a breach can also drive away investors.
Recently, the potential cost of cyber attacks became clearer thanks to a pair of important new laws. The European Union's General Data Protection Regulation (GDPR) requires companies operating in its jurisdiction to obtain unequivocal permission from specific people before using their personal information. Upon discovering a data breach, companies must notify customers within 72 hours. Fines can reach 4 percent of the previous year's global revenue.
In contrast, the California Consumer Privacy Act (CCPA) does not require companies to secure people's permission to collect their personal information. But, it does give California consumers the right to know what personal information the company is collecting, why it is doing so and how it will be used. It also empowers them to block the sale of their information.
And at $750 per consumer, the CCPA's penalties can be even greater than under the GDPR. Suppose a company's technology platform has just $30 million in annual sales, but 50,000 registered users. A security breach might cost the company $1.2 million under the GDPR. However, it could cost a devastating $37.5 million under the CCPA. Public or private, all companies expecting to scale must protect the personal information residing on their systems -- for their own sake as well as that of their customers.
5. Governance and risk management
When it comes to public offerings, things do not always go according to plan. Maybe the company would like to see more stability in the equity markets, or a higher valuation than current projections indicate. Maybe investors are simply urging more time to allow the company's business model to mature. Whatever the reasons, the outcome can be the same: a delayed IPO.
Risks like these are what corporate governance aims to manage. Effective corporate governance anticipates the principal risks confronting the company and sets up contingency plans to address them. Corporate governance also seeks to strike the appropriate balance between risk and reward. It supports the rest of the organization in achieving this balance by overseeing management of the policies, procedures and controls that underlie the company's day-to-day operations.
Although this level of corporate governance is more commonly found in publicly traded companies, it can make private companies stand out. For instance, a robust corporate governance structure may help accumulate information for reporting to the board and external stakeholders. It may also lend credibility to executives as they explain to investors how they have assessed the company's prospects.
For companies scaling up for a public offering, preparation for twists and turns along the way is crucial. Today, scalability for pre-IPO businesses involves upfront investment in the appropriate plans, systems and processes. Building this foundation effectively can help take a business from entrepreneurial dream to post-IPO reality.