An initial public offering is often hailed as a company’s “coming out party.” However, 2019 was rife with disappointing stock market debuts. From WeWork’s withdrawn IPO to Lyft’s dramatic stock decline, the path to public is littered with unicorn funerals and surprising flops.
These high-profile failures fueled apprehension across industries, driving some 44 companies to withdraw their 2019 IPO registrations by the beginning of December. That withdrawal level is up almost 50% over 2018 and the highest since 2016, according to IPO research firm Renaissance Capital.
Yet, a tumultuous 2019 does not render entering the public markets inadvisable. There is simply too much capital in search of an outlet and too many industries undergoing transformation for the IPO adventure to be considered imprudent.
Instead, CFOs need to draw lessons from these misfires to make their companies’ IPO leaps successful.
The past few years have been marked by companies and their private investors substituting vision and promises for revenue and profit margins.
This trend was perhaps most prominently — and dramatically — illustrated by the rapid rise and very public fall of WeWork. On the surface, it may be hard to understand how WeWork ever attained its high valuation. The business model was highly questionable. It asserted that it was a tech company rather than a real estate company, with the word “technology” appearing over a hundred times in its prospectus, thus justifying its high valuation.
Why? Some claim it was the company’s charismatic, and now ousted, CEO, Adam Neumann. Neumann pitched himself as the “gatekeeper to the rising generation.” He wasn’t selling a place to work. He was selling a movement and a new way of living. WeWork’s mission statement: “to elevate the world’s consciousness,” epitomized that mentality.
Prior to joining WeWork’s board, Benchmark Capital general partner Bruce Dunlevie characterized the appeal of the company, stating, “You’re not selling co-working, you’re selling an energy I’ve never felt.”
In hindsight, it’s easy to shake your head. But the bigger picture points to an institutionalized pattern.
Make no mistake: WeWork isn’t an aberration. It’s the poster child of companies bringing magic instead of math to the table — and private investors dishing out money. Angel investors, venture capitalists, corporations and private equity firms have used their seemingly endless capital to incubate companies for unprecedented amounts of time. A predatory pricing model has become common: Equip a company with exorbitant funds to foster aggressive growth with a goal of ultimately overwhelming competitors and achieving primacy in their markets.
By the time many of these companies look to IPO, their value has been artificially pumped up to absurd, arbitrary levels. Many never showed a path to profitability.
The lesson CFOs must draw from Uber, Lyft and WeWork is that private market hype doesn’t count for much in the public markets. In fact, it’s shifted sentiment on Wall Street, forcing a reckoning for private investors. We expect 2020 to mark a decline in the current cycle of unsophisticated financial models, inflated valuation and lax due diligence on the part of the private markets.
This will have repercussions for all companies looking to IPOs.
“There's always a pendulum swing in private markets,” said Patricia Nakache, general partner at Trinity Ventures, in a panel at Fortune’s recent Most Powerful Women Summit. “We have swung way out towards growth at most costs. But now public markets have weighed in and resoundingly said, ‘This has gone too far. We need to clear a path for profitability, and we need to recalibrate.’”
Silicon Valley is on track to (re)adopt a mantra held in high esteem by the public markets: Make a profit.
Discerning public investors won’t be seduced by fast-talking founders and clever storytelling. They, alongside a likely more restrained private market, will be looking past “grow-at-all-costs” companies and focusing on the bottom-line-oriented fine print. You’ll need a solid business model, positive unit economics and healthy gross margins to survive the scrutiny of cautious investors.
A compelling story will still aid a company greatly. But it is imperative to merge, not replace, the qualitative with the quantitative to create a mature business case that will convince investors of your viability. Here’s how.
First, as it could render all other steps null, it is integral for CFOs to thoroughly assess their companies’ readiness to go public. It may be that an IPO is wrong for your business — either at that moment or entirely. Not all businesses are suited for life in the public eye. CFOs must thoroughly assess the cost, time and requirements of an IPO and then ensure their executive management teams and boards fully understand the implications.
This checklist can help.
The assessment process will vary based on company and is dependent on factors like size, market, competitive landscape, growth stage and current financials of the business.
However, there is one consistent commonality that CFOs will appreciate: cost. IPOs are a bit of a juxtaposition in that the motivation for them is primarily financial, yet they are incredibly expensive.
In a PWC survey, 83% of CFOs estimated spending more than $1 million on one-time costs associated with the IPO. This excludes underwriter fees. According to PwC analysis of 315 public registration statements, these average out to 4-7% of gross proceeds. Additionally, the companies studied cited IPO costs from printer fees, roadshow expenses and legal/accounting fees, which added up to an average of $4.2 million. Unfortunately, these costs don’t end once public. Two-thirds of CFOs estimated spending between $1 million and $1.9 million annually on the costs of being public.
After a rigorous assessment, you’ll be better able to determine whether the benefits outweigh the drawbacks and the specific functional areas to focus on should you pursue an IPO.
Once your business decides to go public, embrace preparation. Successful IPOs are usually launched 18 to 36 months in advance, with the average time being 24 months, according to Deloitte. This gives your team time to build out needed capabilities and execute a smooth transition into the public domain.
Viewing IPO preparation through a long-term lens allows sufficient time to:
By being ready early, you can fully realize the value an IPO creates and be poised to catch the right transaction wave when it comes by.
Later we’ll suggest a detailed timeline. But for now, follow these prep steps.
Transitioning from private to public is an arduous task for any company. As with any complex undertaking, having enough people with the right skills is crucial. When going public, that list falls into several internal and external brackets.
According to PwC’s survey, “37% of respondents spent more to address internal staffing needs since going public than they anticipated prior to the IPO. There is also a growing trend of companies increasing their headcount across the board.” While hiring is expensive and does lower profit margins, many companies do not have a choice. They simply don’t have enough personnel with the right skills to ensure compliance with SEC legal and reporting requirements, manage investor relations and mitigate the risks associated with being public.
And it’s not just about bulking up lines of business.
Both the executive team and board will be subject to regulation and scrutiny by potential investors and financial media. These parties will want assurances that members of the executive team have the talent and aptitude to lead the company through the IPO. Every public company must have a board of directors composed of members who are both internal and external to the organization. Additionally, independence requirements could require the board composition to change.
Don’t just assume that you have the right people in place — the perception of investors might be very different from what you expect. When PwC asked what’s important, institutional investors stressed management’s confidence and conviction (96%), experience and credibility (93%) and their facility with financial numbers (91%). Most institutional IPO investors also look for at least 11 years of executive experience in board members.
Is your team set to impress?
Going public requires a company to operate in line with strict governance standards. Greater transparency and disclosure requirements, particularly when it comes to financial disclosure and other regulatory reporting, will require significant effort from the CFO.
The SOX Act, passed to protect investors from fraudulent financial reporting by corporations, applies to all public companies and is now factored into a company’s pre-IPO path. Generally speaking, the law requires that:
It’s also worthwhile to check whether your company qualifies as an “Emerging Growth Company” (total gross annual revenue of less than $1.07 billion and other factors) or a “Foreign Private Issuer” (50% or less of outstanding voting securities are held by U.S. residents plus other determining factors).
Hopefully you’re getting a sense of how complex an IPO is.
Moreover, early on, finance leaders should assess key systems and processes and address any gaps between their current state and the level of performance that will be required by stakeholders and the SEC. These parties will expect annual reports (Form 10-K), quarterly reports (Form 10-Q), current reports to disclose any major events (Form 8-K), proxy statements that describe matters to be voted on and information on the company’s executive compensation, and any additional disclosures. These might include proposed mergers, acquisitions and tender offers.
This is the time to upgrade finance systems, implement an effective internal controls structure and practice meeting the stringent disclosure obligations for public companies. In other words, a private company should begin operating like a public one in terms of compliance long before its IPO.
As PwC discusses, your “equity story” is the foundation of a successful IPO. An effective equity story will summarize both the business’ current state and its vision. Perhaps more importantly, it serves as the reason investors should buy the stock. CFOs are tasked with translating the company’s performance into a compelling rationale.
As finance professionals, CFOs may be inclined to focus on the numbers — debt to equity ratios, EPS growth, sales growth, ROE, profitability, EBITDA growth. While these KPIs are surely important, investors base an average of 40% of their IPO investment decisions on non-financial factors, says EY in its guide to going public. Key factors include quality of management, corporate strategy and execution, brand strength, intellectual property rights, operational effectiveness and corporate governance.
During the IPO process, CFOs and CEOs become the public faces of their firms. They spend most of their time outside of the office, and investor relations becomes a top priority. The IPO roadshow is a golden opportunity to attract the right investors in your target capital pools. A smooth investor roadshow and a smooth IPO are inextricably linked.
Some tips for CFOs to consider:
Perhaps most importantly, think like an investor. How is our company unique? How is it viable in the long term? What merit is there in investing?
Institutional investors rarely visit the companies they finance. Instead, they rely on information presented at the roadshow. It will likely be your only opportunity to maximize selling price by communicating directly with potential investors.
Timing is everything in the context of a strategic IPO launch, especially as we enter a new year. Yet recent events re-emphasize that predicting the IPO market is near impossible due to the influence of external shocks. Instead, CFOs must focus on what they can control, like preserving the company’s value, IPO readiness preparation and being flexible in IPO timing and pricing.
Then, when the opportune window presents itself, your company will be ready.
And remember, ringing the bell is just the beginning. An IPO launch is not an end in itself. Rather, it is a monumental milestone in the complex transformation from a private to a public company. CFOs must be prepared to continue the journey in the public spotlight by meeting expectations, fulfilling promises and continuing to build effective relationships.
One to Two Years Out: Assess your company’s suitability for an IPO and public life.
Six to 9 Months Out: Preparations
Three Months Out: Execution
Post-IPO: Stabilization & New Reality
Megan O’Brien is Brainyard’s finance & business editor, covering the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Reach Megan here.