If you’ve considered taking your company public, you know there are a lot of risks, benefits, and details to sort through. You may have asked yourself what factors are involved in the initial public offering decision or wondered which alternatives are available. In this blog on initial public offerings (IPOs) explained, we’ll review the most important information to help you decide whether your business is ready to go public.
What is an Initial Public Offering?
We’ll start by providing a basic initial public offering definition. An IPO is when a private company makes shares of its business available to the public through the issuance of new stock. A form of equity financing (rather than debt financing), IPOs require a company’s founders to give up a percentage of ownership in exchange for capital.
In order to go public, companies must meet the rigorous requirements of the Securities & Exchange Commission (SEC) and major stock exchanges. They must also work with investment banks (known as underwriters) to initiate, facilitate, and execute the IPO process.
What Are Private Corporations?
Before digging too far into IPOs, it’s important to understand what constitutes a private company. While they may have shareholders and issue stocks, shares of private businesses aren’t traded on public exchanges. Private company stakeholders typically fall into two categories:
- Early investors (founders, family, and friends)
- Professional investors (venture capitalists and angel investors)
Because they don’t trade openly, it’s more difficult to value private companies than private ones. They also don’t have to satisfy SEC filing requirements, so their financial records are less accessible.
Advantages of Taking Your Company Public
There are many advantages of holding an initial public offering, which we’ll examine in more detail below.
Increased Access to Capital
Because it allows you to raise money by issuing new stock to a wider market, an IPO can help you grow your business, pay off debt, fund R&D, or execute new marketing campaigns. They may also lower your cost of equity and debt capital, allowing you to undertake new business endeavors. Plus, you can raise additional capital through secondary offerings via your new access to public exchanges.
Better Loan Terms
Going public subjects your company to extreme scrutiny and requires complete transparency. However, this process also increases your credibility and gives lenders more confidence in the accuracy of your financial statements. As a result, you may be able to obtain better borrowing terms than you did as a private entity.
Exit Strategy for Original Investors
Holding an IPO provides an exit strategy for your early investors, who may want to liquify their stock and cash in on their investment. After the six-month post-IPO lock-up period, anyone holding shares in your company can sell them on a secondary exchange, like the New York Stock Exchange (NYSE).
Heightened Exposure & Credibility
IPOs are star-marked in the stock market calendar, which can significantly boost your visibility as a newly public company. This increased exposure and credibility can benefit your public image and help you boost sales and profits.
Improved Ability to Attract Talent
One of the best ways to attract top-notch talent is by compensating your staff through employee stock ownership (ESOP). Liquid stock equity participation gives employees the ability to buy and sell your company’s stock at market value, which can set you apart from the competition.
Disadvantages of Taking Your Company Public
While there are many benefits of holding an IPO, there are also several disadvantages to keep in mind before signing on the dotted line.
The IPO process is extremely expensive due to legal, accounting, printing, and filing fees. In fact, companies that raise an average amount of proceeds (typically around $100 million) will spend $1.5-2 million in legal fees, $1 million in auditor fees, and $500,000 in registration and printing fees. And once you go public, you’ll also be subject to new costs related to compliance and maintenance.
Stringent SEC Regulations
As we mentioned above, going public requires adherence to ironclad SEC rules and regulations. All of your financial statements must be prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and audited by a CPA firm. You’ll also have to satisfy the conditions of the Sarbanes-Oxley (SOX) Act, issue regular disclosure statements, and release your financial results.
Loss of Control
In some cases, the addition of new stakeholders can lead to a loss of control, time, and capital for your original management. IPOs typically reduce your percentage equity and voting interests, which means more decisions will be made by your board of directors. You may also be more vulnerable to class action and shareholder lawsuits due to the influx of more shareholders.
How Do You Know If You’re Ready for an IPO?
Wondering what factors are involved in the initial public offering decision? As a general rule, companies are ready to hold an IPO once they reach unicorn status, or a private valuation of around $1 billion. You should also make sure you’re ready for the stringent requirements of the SEC and potential responsibilities to new public investors.
In some cases, smaller businesses may be ready for an IPO depending on their profitability potential, industry competition, and ability to meet SEC and exchange listing requirements.
What Does the IPO Process Look Like?
There are generally four steps to the process of going public, which we’ll take a closer look at below.
1. Investment Bank Selection & Underwriting
The first thing you’ll need to do is hire an investment bank (underwriter) to guide you through the IPO process. Your underwriter is responsible for setting an initial price for your offering, with a goal of selling shares to the public for more than what you paid, thus turning a profit.
Underwriters perform thorough due diligence when pricing your shares, which involves a deep dive into your financial records. Once they’ve completed this examination, they’ll advise you on a price band (range) and recommend specific costs for each investor category.
Your underwriter is also responsible for the following tasks:
- Establishing how much you hope to raise and the type of securities you’ll offer
- Support as you prepare for Public Company Accounting Oversight Board (PCAOB) audits
- Valuations (409A analyses, cheap stock, and deferred compensation expenses)
- Creation of key investor documents
- Technical accounting documents (earnings-per-share and segment-/entity-wide disclosures)
- Scheduling meetings with potential investors (roadshows)
- Stock issuance
- Any required organization or process adjustments
2. S-1 Registration Statement Filing
Once your underwriter has completed their preliminary evaluations, you’ll need to file an S-1 Registration Statement with the SEC. This document has two parts:
- Red herring prospectus, which discloses information about your business strategy, historical financial statements, recent results, underwriters, and management
- Privately-held filing information, which includes data about your expected IPO filing date and recent sales of unregistered securities, along with Regulation S-X-compliant financial statements and footnotes.
Once you’ve satisfied SEC and stock exchange listing requirements, you can begin marketing your IPO and initiate final underwriting.
3. Marketing & Final Underwriting
As you move into the marketing phase, your underwriter will create investor preparation decks to promote your upcoming stock issuance. This process allows you to estimate demand for your new shares and determine a final offering price.
Your underwriter will then assemble a syndicate of investment banks and broker-dealers who are tasked with selling your new shares to investors. Keep in mind that you’ll also need to respond to any SEC comment letters you receive after filing your S-1 Registration Statement.
4. Initial Public Offering & Stock Exchange Listing
On the day of your IPO, your new shares are issued on the major public exchanges, including the NYSE and Nasdaq Composite. Any capital from your primary issuance goes to stakeholders as cash and should be recorded as stockholder entity. Additionally, previously-held private shares convert to public ones, and the value of existing shareholder stocks is equal to the public price.
Which Factors Can Impact the Performance of Your IPO?
There are four main factors that can improve or hinder the performance of your business in the weeks and months following your IPO. We’ll review each of these elements below.
Some investors may choose to resell their IPO stock within the first few days to earn a quick profit. This often happens if your stock is discounted, which can lead to inflated prices on your IPO date.
Typically lasting 3-24 months, lock-up periods prevent investors from selling their new shares right after your IPO. This lessens the likelihood of decreased stock prices that can result from excess supply.
3. Tracking Stocks
If you find that an individual segment of your company is worth more than your business as a whole, you may pursue tracking stocks. Also known as spinoffs, this divestiture involves breaking off part of your company into a standalone entity.
4. Waiting Periods
In some cases, a set amount of shares may be earmarked for purchase after a defined waiting period. When this allocation is implemented by your underwriter, it may cause your stock prices to increase.
Initial Public Offering Alternatives
Rather than pursuing an IPO, some companies opt for a buyout from a public company. Buyout terms vary greatly, and you may or may not retain your status as a stakeholder or manager.
If you choose a direct listing, your IPO is conducted without the input and guidance of underwriters. While this significantly reduces your costs, it increases the likelihood of something going wrong. Direct listings typically work best for more well-known brands with attractive business models.
With a Dutch auction, there’s no set price for your IPO shares. Potential investors bid for the stocks they want and the price they’re willing to pay. Then, the highest bidders are allocated the available shares.
Special Purpose Acquisition Company (SPAC)
Many private businesses are choosing to go public through special purpose acquisition companies (SPACs). These publicly traded businesses are formed solely to raise capital through an IPO to acquire an often-unspecified company.
SPACs don’t offer any products or services, and their sole profits are the results of their IPO. SPAC acquisition can significantly expedite the process of going public because there are no extended financial histories to disclose to the SEC.