- August 1, 2020
- Posted by: XB4
- Category: Assurance
Starting a company involves investing a chunk of your money in the hopes of eventually growing the business. But when a small venture starts to gain traction, many realize that they need outside financing to get the company off the ground. This is where initial public offering (IPO) comes in.
What is an Initial Public Offering?
An IPO, or initial public offering, is a process through which a private corporation offers shares to the public in an attempt to raise capital from investors. Through an IPO plan, also famously known as ‘going public’, a business transitions from a private organization to a public operated entity, with public stockholders being the owners.
For decades, the term initial public offering (IPO) has been a buzzword among investors in Wall Street. The Dutch financial innovators should be credited for streamlining the IPO process and laying the first modern IPO foundation in 1602 when shares of Dutch East India Company were offered to the public.
Why ‘go public?
An initial public offering proves to be a transformational event for a company seeking to fuel expansion either by establishing its existing business or acquiring others. The IPO process provides access to the public capital market and enhances the organization’s credibility and exposure. Best of all, the obtained capital does not involve an interest neither has to be repaid. The only reward IPO investors expect in return is the increase in their investment and dividends.
An initial public offering offers an immediate infusion of capital and provides easier means of financing future needs after the business goes public.
In addition to this, increased transparency of the company’s financial position that comes with the issuance of quarterly reporting makes it easier to seek favorable credit borrowing.
Furthermore, as a younger private entity, companies often have to pay higher interest rates in exchange for a loan from banks. Once the company goes public, banks would be willing to offer additional capital in lower interest rates, as the business provides an increased assurance and is perceived as less risky.
For the business founders, it is finally time to cash out on their early investment. They can award themselves a significant percentage of initial shares of equity, which can be sold as part of the IPO or on the open market later when the company goes public.
Is IPO all about injecting funds into the business? No! That’s not all! An IPO also attracts increased public attention, which could lead to new business opportunities and customers. As part of the IPO process, the company’s information is printed in newspapers. A series of roadshows are held across the country, generating overwhelming enthusiasm about the organization and its IPO. Furthermore, this could enhance credibility with suppliers, customers, and lenders, leading to improved business terms.
Another advantage of an IPO involves offering stock options as part of creative incentive packages to management and employees. Such compensations attract top talent to the company and further motivate them to perform better.
Moreover, an IPO provides a company’s public valuation, which helps during mergers and acquisitions as the business can offer stock instead of cash.
Every company has stakeholders who invest a considerable amount of time and fund into the business in the hope of making substantial profits. These founders often spent years to see significant financial gains in return for their contributions. In such a situation, an IPO serves as an excellent exit opportunity for investors to liquidate the capital tied up in the company.
The funds raised from an IPO are seen as financial compensation for years of ‘sweat equity’ by investors and founders. That said, there are many examples of Middle Eastern family businesses where the members seek to receive their potential amount of share from the company, which eventually boils down to disputes. In such circumstances, an IPO offers an incredible exit opportunity.
However, it is essential to note that after IPO has been executed founders will have to sell their shares on a secondary exchange to receive liquidity.
Is ‘going public’ right for your company?
An organization begins to think about going public when their business requirements exceed its ability to raise capital through other channels. But simply raising funds through an initial public offer process may not always be the right approach. You should consider asking a number of questions before making the decision.
Staging an IPO requires extensive work, careful consideration, and planning. This time-consuming process requires an entity to seek approval from the Securities and Exchange Commission (SEC) to sell stocks publicly.
As part of the SEC registration process, the company faces intense scrutiny and has to disclose a great deal of detailed information to potential investors. The entire IPO process can take 1 to 2 years to complete, which can significantly distract the company leaders away from the day to day operations.
Companies should objectively assess their readiness to go public. An IPO is an enormous undertaking that requires management to be well prepared from day one. Examining the ongoing compliance and regulatory requirements, risk management, stable stakeholder relationships, and regular reporting is a crucial first step of the procedure.
Jennifer Lindsey writes in her book, The Entrepreneur’s Guide to Capital, that IPO is well suited to small to medium-sized enterprises in an emerging industry. Companies with a strong management group, consistent growth of at least 10% annually, and debt of no less than 25% fit an IPO’s basic criteria. However, having met the requirements still require excessive time and planning to execute the program carefully.
An initial public offering can be extremely expensive. Experts say that the cost of this initiative can be 15 to 20 per cent of the proceeds from the sale of stock. Underwriter’s commission, printing costs, roadshows, handling shareholder relationships, filing costs with the SEC, legal, accounting, and filing are some of the process’s major expenditures.
Since public companies are entrusted with additional reporting requirements, a business will likely need to upgrade their accounting systems and employ more staff to meet quarterly reporting deadlines.
Despite such expenses, there is always a probability that unforeseen problems will derail the IPO before going public.
Another disadvantage associated with an IPO is the loss of confidentiality and flexibility. The Securities and Exchange Commission requires public companies to disclose sensitive information about the organization’s profitability, market, and future plans. This triggers untold problems when your competitors and employees are aware of the inner workings of the company.
Equity dilution takes away much of the management’s control over the day to day operations. When shareholders seek representation on the board to exercise influence, they have enough powers to stage a takeover or oust management if the company does not perform well.
The dilution of ownership also greatly impacts the management’s flexibility. The leadership team cannot make quick decisions without seeking adequate approval from the board.
Additionally, public companies encounter the pressure to deliver strong short-term financial performance. This is because shareholders and financial markets always anticipate seeing good results. Unfortunately, this puts the company’s long-term position at stake since the strategic decision for the company’s future is given lower priority.
How to navigate an IPO process?
According to studies, private companies that operate as a public entity well in advance of their actual public listing lead to a successful IPO launch. These companies experience a relatively smoother IPO process and quickly transition to working as public companies.
An IPO is a lengthy process and should be performed in steps to ensure successful execution. So, let’s take you through each step.
Step 1 – Select an Investment Bank
The first step in the IPO process is to hire an investment bank to advise the company and underwrite the IPO. It is recommended to solicit proposals from various investment banks and evaluate the bidders according to the following criteria:
- Experience with similar offerings
- Industry experience
- Distribution network
- Quality of research
- Relationship with the bank
- Recommended share price
The selected investment bank finances the IPO and makes one of the three types of underwriting arrangements.
Best Efforts: In this arrangement, the bank makes the best effort to put together the buyers and sell as many stocks as possible but is under no obligation to purchase the stocks themselves.
All or none: This one is similar to ‘Best Efforts’ except that the arrangement is cancelled if all shares are not sold.
Firm Commitment: An arrangement where the bank pledges to purchase all the shares itself.
Step 2 – Assembling an underwriting team
Once the lead underwriter has been selected, the next step is to assemble other underwriters consisting of lawyers, auditors, certified public accountants, and financial printer.
The attorney plays a critical function in the process of going public. The company should look for a specialist who can advise the management concerning all SEC regulations.
On the other hand, auditors act as technical and strategic advisors. Since they play a key role, their selection should be based on experience with public company financial reporting, knowledge in GAAP and auditing standards, and prior experience with IPOs.
The accountant’s role is to provide reporting and financial information that is accurate and detailed. They ensure the new financial reporting protocols necessary for a public corporation are fully implemented.
The financial printer is the one who handles the printing of prospectus that contains a management analysis and detailed financial and non-financial information about the company. Management analysis is one of the most critical and time-consuming parts of the entire process. The report discloses why the company is a good investment despite having faced potential risks in the past.
Step 3 – Due Diligence and Regulatory Filings
Due diligence is the third step which is performed by the IPO team. The team reviews the significant agreements and contracts, cash flows, financial statements, tax returns, important minutes of board meetings, and performs analysis of the company and its industry.
The investment bank files the S-1 registration statement, which is sent to the SEC for review. The statement contains information concerning financial statements, management background, and legal problems. The statement discusses the company’s business model, how the money will be spent from stocks, its competition, and any potential risk.
As part of the due diligence procedure, the IPO team reads and verifies the registration statement to ensure it contains no material misstatement. Basically, the primary purpose of performing due diligence is to make sure the information sent to SEC is true and fair as the Securities Act of 1933 (1933 Act) holds the parties participating in the IPO process responsible in the event of any material misstatement.
The SEC review period is known as the ‘cooling-off’ or ‘quiet’ period. During this time, the SEC investigates the company and ensures the submitted information is correct. Also, the organization makes controlled efforts to market its offering.
Step 4 – Pricing
Once the IPO has been approved by the SEC, a lead manager, also known as a bookrunner, is appointed to help set an appropriate price at which the issuing company will sell shares. Deciding the offer price is an essential step as it helps the organization determine the amount of capital they have to issue.
There are two ways through which the price of an IPO is fixed. In the first method, the bookrunner determines the price using a ‘fixed priced method,’ which is the second most preferred way of an initial public offering. While the other approach uses and analyses the confidential investor demand data in an attempt to reach the optimal price.
Step 5 – Stabilization
After actual shares float to the market, the underwriters are allowed to ‘stabilize’ the security price by purchasing it at the offer price or below it. During the stabilization activities, the underwriter can trade and influence the price for up to ten days after the official offering date.
Step 6 – Transition to Market Competition
After the ‘quiet period’ mandated by SEC has ended, the underwriters provide estimates about the company’s profitability and performance. This helps investors transition from relying on prospectus’ data to publicly available information about the company.
How can companies improve their prospects for a successful IPO?
An IPO seems more desirable when the company takes adequate time to analyze its performance and capital needs. However, despite taking the time, many companies still fail to execute a successful IPO. Do you know what held them back from succeeding? Lack of planning!
Supplementing management with experienced professionals also improves the prospects of a successful IPO. Investors appreciate a management team who are confident and have expertise in what they do, proving to be a source of innovative ideas for future growth.
Corporate governance is one of the areas that the company should address when planning to go public. The Securities and Exchange Commission has set up rigorous rules to protect the interests of shareholders. Establishing a governance structure and adopting mandatory policies earlier in the pre-IPO process will send a positive message to potential investors.
Understanding what is happening outside of your business is highly essential. Therefore, business owners should keep a close enough eye on their competitors, market trends, and future viability before engaging in an IPO.
An IPO offers a window of opportunities that unlocks financial doors. However, going public is a complex process and may not always produce the desired outcome. Choosing the right underwriter and company is critical to the successful execution of an organization’s IPO.