“The IPO is no exit for the entrepreneur; it’s the start of purgatory.” — Vivek Wadhwa
In last week’s installment we talked about various forms of startup financing. You can build your company with money from your own pocket; you can borrow from a few rich angel investors; you can take out a loan from a bank; or you can get VC money. The biggest, hairiest, and most audacious option, though, is to take the company public.
When you “go public” you’re simply offering to sell tiny little shares of your company to the general public, opening up the doors to small individual investors. As democratic and egalitarian as that sounds, in practice it’s a lawyer-infested bureaucratic process that can bring a grown CFO to tears. Public life is very different than private life (in the corporate sense), and it’s nearly irreversible, so you want to be sure you know what you’re doing.
Just as with those other types of financing, the goal is for you to get money to spend on your company. Maybe you need it to expand into a larger building. Maybe you’re funding an expensive R&D project. Maybe you intend to blow it all on TV and Facebook advertising. Whatever the reasons, it’s more money than you have right now, so you’re willing to sell off a portion of the company in exchange for the cash.
Conceptually, selling shares to the public isn’t much different than selling them to a venture capital firm. You get the cash; they get a piece of your company. The difference is, professional VCs, banks, and angels (collectively called “institutional investors”) are pros. They know what they’re doing, and they don’t need (or want) anyone holding their hands. If they wind up getting burned in the deal, well, that’s just one more war story to tell on the yacht. But when you sell to the public, you must be very careful that you don’t mislead or cheat anyone.
The public, as you may have noticed, is pretty stupid. Half of them are below average, after all. Over the years, the U.S. government (as well as every other sovereign nation that maintains a public stock exchange) has developed a dizzying array of laws, rules, regulations, and colorful customs designed to protect the Average Joe from sneaky businesspeople like you. In short, you’re going to be on your best behavior – and you won’t like it. Many of the securities regulations will seem very arbitrary and, honestly, counterproductive. But you don’t mess with the SEC (the United States Securities and Exchange Commission) or its international counterparts. It’s their world; we’re just playing in it.
The Kickoff
The process for taking your company public is very structured and takes several months, from the day you decide to do it until the day you go public and get to ring the bell on the floor of the stock exchange. First, you need to set a valuation. What’s your company worth? You can’t very well sell shares of something that doesn’t have a price tag on it. So, just as with the VCs, you need to meet with professionals who will pore over your financial records, stick a finger in the breeze, and decide on a valuation. Pick a bank with experience running public offerings (your “underwriter”) and they’ll work with you on a valuation. They will also, incidentally, be buying a large portion of your stock on opening day. More on that later.
As part of their financial deep-diving (called “due diligence”), your bank’s underwriters may uncover some, uh, irregularities. Maybe you’ve been a bit sloppy in your accounting. (“Hey, I’m just a startup!”) Maybe you’re overly optimistic about your profit margins. Maybe you’re still doing bookkeeping with an Excel spreadsheet. Regardless of how squeaky clean you’ve been, you probably haven’t been scrupulous enough to make your underwriters happy. (They’re bankers, remember. They chose this as a career.) Depending on what your underwriters find or don’t find, they may advise you to postpone the IPO for a few months while you and they clean up the anomalies. Don’t worry. This will be just the first of many disappointments that you’ll face.
The New Math
Your bankers will probably have lots of “constructive criticism” regarding your accounting practices, and this will annoy your own financial staff. Maybe you’ll have to change accounting software. Maybe you’ll have to alter the way you recognize new business, project future sales, or calculate taxes. There can – and likely will – be dozens of small- to medium-sized changes to the way your company handles its books. Have fun.
The Quiet Period
Like any product launch, you want to build up public enthusiasm before your IPO and wind up expectations before the “product” (your company) goes on sale. You want a lot of buzz and an opening-day rush. You want to sell out. And that means talking to more bankers.
Time to plan the IPO roadshow.
The purpose of the roadshow is to make sure your stock sells out on opening day. Why? Because nobody wants their first-day sales to be a flop. Whether it’s the opening day of a new movie or the release date of a new game, everyone will judge you on that first 24 hours. You want a sell-out. You want lines out the door. You want investors chanting your company name. You want them foaming at the mouth. You want to whip up so much excitement for your IPO that investors will pay almost any price to get a piece of you.
The only trouble is, it’s illegal to whip up excitement for your IPO. In fact, you’re entering the “quiet period.”
Because you’ll be selling an intangible product to a gullible public, you have to be extraordinarily cautious about what you say about your company, its finances, and your future plans. You can’t oversell your prospects or over-hype its profit potential. What might pass for normal lunchtime conversation on any other day becomes a punishable offense if you say it right before an IPO.
The securities laws are designed to protect Joe Average investor from you, not the other way around. You know more about your business than anyone, and certainly more than the man on the street, so it would be awfully easy for you to mislead the public by painting an overly rosy picture of your company and its future.
You can’t lie, obviously. You can’t say you’ve secured a multibillion-dollar contract to supply lemonade to the government of Namibia if it’s not true. You also can’t exaggerate. If sales have increased recently, you can’t say they’re “through the roof” or even that it’s “the best quarter we’ve ever had” unless that’s demonstrably true. On the other hand, you have to be very forthcoming about bad news. If you just lost a big customer, you have to publicize that fact immediately. Basically, any statements about your company that aren’t provable are off-limits.
What you can talk about in the buildup to your big IPO is the same thing, over and over. That is, it’s important to give everyone the exact same information, without embellishment or elaboration, so that everyone can arrive at the same financial conclusion. You can’t tell one group of investors that your lemonade costs $0.15 per cup to make but tell another group that you think the cost might fall to $0.14 next year. Information is power, and power is money… or something like that. At any rate, you’re legally required to provide the same data to everyone, without any special winks or smiles for your friends.
In the run-up to the IPO, a lot of people who’ve never heard of your company will take a sudden interest in your business, your finances, and your competition. They’ll be trying to judge whether you’re a good investment or not, and many (perhaps most) of them are utterly unqualified to make that determination. Teaching them sound investment strategies is not your problem. Providing them rock-solid data without hyperbole or salesmanship is. Look up “circumspect” and you’ll see a CEO the day before an IPO. The bankers, lawyers, and Federal agents will be standing right behind him.
During the quiet period, you’re still allowed to conduct business as normal, but the “normal” part will be under scrutiny. If you’re running big advertisements in EE Journal, please continue to do so. If you’ve got a new product in development, carry on, by all means. Just don’t make any sudden moves that might startle a potential investor doing his research. Don’t fire any senior executives. Don’t have any big layoffs. Don’t cancel an important project or change product strategies midstream. Steady as she goes.
The Roadshow
To make sure you have a sell-out crowd on your IPO day, it’s important to drum up enthusiasm for the stock – within the rules, of course. The best way to make sure your stock sells out is to pre-sell as much of it as you can. You could either (a) talk to a million different investors each buying a $1 share, or (b) talk to a dozen banks, each buying $1 million worth of shares. Guess which option makes better use of your time.
Banks buy stocks, just like people do. In fact, they’re probably going to be your biggest “customer” for the new shares, especially at first. So, it makes sense to pitch them personally. It’s also a good way to see the world in a sleep-deprived blur.
Your underwriters will organize an around-the-world trip for you and a handful of your executives (often the CEO, CFO, and a marketing person who can speak in complete sentences). You’ll visit banks in New York, Paris, Frankfurt, Rome, Tokyo, and San Francisco. And that’s just on Wednesday. Seriously, the roadshow will be the most grueling trip you’ve ever taken, but also the one with the most on the line.
You and your colleagues will present the same PowerPoint slides, in exactly the same way, to each group of bankers. They’ll ask a few polite (but mostly uninformed) questions, and you’ll give the same answers as always. With luck, they’ll be excited about your company’s prospects and offer to buy a few million shares when IPO day comes around. It’s a nonbinding offer; just a promise, really. But it gives you some idea of how much traction your story is getting within the financial community.
There’s a bit of gamesmanship involved, too. One bank doesn’t want to miss out on a potentially lucrative IPO that a rival bank is investing in. As word of your fantastic roadshow performance gets around, a few nonbelievers may quietly join the choir. On the other hand, a few apostates may drop out, too.
At the end of the roadshow, you will (a) sleep for days, and (b) tally up your bankers’ promised purchases. With luck, they’ve promised to buy more shares than you’re offering. Congratulations, you are officially “oversubscribed.” Perfect.
Pre-IPO Jitters
As some point during the roadshow, you and your underwriter will have to set a price for your new shares. To reuse our old example, if your lemonade stand is valued at $35,000 and you want the shares to be priced at $1 apiece, then each share is worth 1/35,000th of the company. Conversely, if you want to offer 1000 shares (a nice round number), then each one will be priced at $35.00. The arithmetic is pretty simple and doesn’t really affect anything, but it’s customary to price new shares somewhere between $10 and $40.
Note that you’re not selling the entire company. You’ll generally hold back some shares within the company and sell the rest at the IPO. The shares you keep can be doled out later as employee stock options, or for subsequent (not initial) public offerings, or because you think your own company is a good investment. The relative proportion is up to you. You might sell 20% of the company at IPO and keep the other 80% in-house, or vice versa.
The Blessed Event
Your roadshow was quick because financial markets can change on a dime. You don’t want to spill your corporate details to a bunch of bankers in March if the IPO isn’t until November. The information will be stale by then, the bankers’ ardor will have cooled, and your IPO will be a dud. Instead, you price the stock, do the roadshow, and go public all within a few days while everyone’s still on the same page.
Your underwriters will have decided which stock “market,” that is, which exchange, will carry your stock. In the U.S., that’s typically either the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations, better known as the Nasdaq. (There are others, too.) Other countries have their own exchanges. For the rest of time, this will be the exchange that “lists” your company stock.
In the old days, a stock exchange was a physical marketplace where people bought and sold shares of companies by exchanging slips of paper. Now, it’s a combination of modern computer networks with automated trading algorithms, combined with oddly anachronistic brokers. The NYSE, for example, still employs human traders in blue jackets yelling and making mysterious hand signals at one another and swapping pieces of paper. (The NYSE reportedly removes 4,000 pounds of litter at the end of each trading day.)
At 9:30 in the morning, your stock will begin trading for the first time. It is the initial offering of shares to the public: an initial public offering, an IPO. You’ve hit the big time.
And “trading” is the operative word here. The share price is now entirely out of your hands. It is now a fungible commodity, like rice or petroleum or pork bellies, rising and falling on the waves of enthusiasm or the troughs of despair, floating on the open market. (Indeed, British companies call an IPO a “flotation.”)
If your cunning scheme has gone according to plan, there will be more than enough buyers – mostly the banks you spoke to last week – to buy your shares at the opening price. That’s the first good sign. (However, if things go badly and your share price starts dipping early on, your underwriter will step in and buy up shares to create an artificial shortage, driving up the price. They’re taking one for the team, but that’s part of what you pay them for.)
The next good sign is if the price rises throughout the day. This indicates that bankers and/or individual investors who couldn’t get their shares at the opening price at 9:30 AM are willing to pay a little extra at 10:00, or noon, or when the market closes at 4:30 PM. Ideally, you want your shares to close out the day higher than they started. More of that, please.
And so it goes, day after day. It’s easy to get fascinated by your own share price, watching the stock ticker change second by second, agonizing over each $0.01 rise and fall. Don’t be. For starters, the signal/noise ratio of the stock market is remarkably low. It’s almost all noise, and people have gone crazy trying to make sense of it. (They’ve made fortunes, too, but mostly by selling their “secrets” to other gullible investors.)
But most of all, you shouldn’t worry, because it’s not your money. Your company got its money at 9:30 AM on opening day. That was your one-time cash-out. You sold the 1,000 shares and you got the $35.00 apiece for them (minus your underwriter’s considerable expenses, of course). From that point on, your company neither benefits from share price increases nor suffers from declines. Those shares are now someone else’s property, and those shareholders are buying and selling them to each other based on… who knows what?
It’s certainly nice to see your company’s share price rising. It’s a public declaration of support. It means that someone (×1000), somewhere (×1000) believes enough in your company’s future to pay a little above the going rate for a piece of the action.
We’ll talk about the other kind of shareholders next time.
