Initial Public Offerings
A company’s Initial public offering (IPO), is when it sells its stock to the public for the first time. The shares can then be traded on exchanges such as the Nasdaq Stock Exchange, New York Stock Exchange, London Stock Exchange, or Stock Exchange of Hong Kong.
These primary exchanges make up what we call “the stock market“. Every publicly traded company has a “ticker symbol”, which is a one to four-letter abbreviation that acts as an identifier. When a company is “made public”, its shares can trade daily on an open market, where buyers and sellers will determine the current equity value.
A company’s IPO is a transformative event that benefits its owners and employees. The company’s operations and business model will change in many ways. The public will have access to financial and business information. This information can be used for analysis. Management will host quarterly earnings calls and answer questions from analysts on the sell-side.
They will also be available to speak with potential investors and existing investors. To meet public company requirements, new accounting, legal, regulatory, and investor relations infrastructure will be required.
Although IPO candidates may be from different sectors, sizes, and financial profiles, they must have performance and growth attributes that would appeal to public investors. Are the company’s markets large enough to grab the attention of investors? Are they market leaders? Is the growth opportunity exciting? Is the entry point to the cycle attractive? What is the ability of the management team to manage this?
Market conditions should also be favorable. The performance of the stock market is directly related to the number of IPO offerings in a given period. The more IPO offerings there are, the better the market. In a down market, the IPO spigot may slow to a trickle, or even shut off completely. Even the most compelling candidates would prefer to wait than launch in an unfavorable marketplace and risk a failed deal.
The company and its shareholders can take the help of investment banks for a review of a company’s IPO prospectus, market conditions, and valuation recommendations. The banks can also make recommendations about valuation, the size of the offering, and how to proceed.
Characteristics for a Strong IPO Candidate
What is the company’s role and in what industry? What is the company’s revenue? This is the most important thing to do when doing investor due diligence. Sometimes industry or sector can outweigh all others, for better or worse.
Think about the IPOs of tech companies in the 1990s or the rapid-growing unicorn start-ups that went public last year. Rising tides tend to lift all boats. If the sector is not in favor, even a highly-quality company may have difficulty going public.
There are limitations to being the best house in a poor neighborhood. Investors will doubt the sustainability of your property and therefore its resale worth.
What do IPO investors look at in a sector? Structure, size, and growth are all linked to earnings prospects and sales. In practice, large sectors are relevant. Their size suggests growth opportunities. Investors pay attention to a company’s total addressable market (or TAM).
The growth sectors are often “early stages” during major secular or cyclical waves. The former can be categorized as technological, regulatory, or consumer preference-driven. Look at oil & gas, real estate, industrials, metals & mining for cyclical.
Strong Competitive Position
Market leaders are more attractive to investors than those who are less well-established. Market leadership is an effective marketing tool and statement in itself. It is even more important what it represents: a track record of success and sustainable competitive advantages. These could include superior products or services, brand strength, and established customer relationships.
Although being the #1 player in a sector is desirable, it’s possible to be a meaningful #2 or #3 player. Investors may also be interested in a second-tier player, which is growing faster, that is expanding its market share. The current state of play is not enough. Trends and the competitive outlook are even more important. Equity investors always look ahead.
Investors also consider the number of competitors when assessing competitive positioning. The theory goes that the fewer competitors the better the chances of outperforming. Fierce competition may cause lower growth, profitability, or diminishing returns. This is particularly true when market participants engage in irrational behavior in order to win market share.
In the hopes of making large returns, investors take a chance on a new company. These returns can only be achieved if there is growth. Organic growth is the priority.
These opportunities are generated within the company – new customers and products, geographical expansion, and greenfields. It is important to have a strong and viable platform for M&A. Multiple growth drivers are what make the best IPO candidates.
Investors in IPOs want growth but also understand its volatility. It is important to weigh the possibility of rapid growth against the risk of failure. This is especially important for pre-profit, early-stage companies. Any growth that relies on geographic expansion, M&A, or cyclical growth will be closely scrutinized. A low-risk story with high growth is desirable, just like any other company.
Barriers to Entry
Investors are looking for quality businesses with sustainable competitive advantages over peers and low barriers to entry. This is often referred to as a “moat”.
Differentiated products and intellectual property, scale, brand loyalty, low upfront capital investment, sticky customers, low-cost structure, and high upfront capital all contribute to a business’ resilience. Investors are more comfortable with the business’s resilience and track record if it is the market leader.
High barriers to entry and fewer competitors mean that there are greater chances of outperformance in certain industries. However, industries that are generating high returns may be attractive to new entrants. Even the most successful companies cannot afford to be complacent.
Healthy Financial Profile
Candidates for IPO should have a solid financial record of growth and profitability. A plus is visibility into future earnings, sales, and cash flows. Operational upside companies should be distinguished from fixer-uppers.
High-capital intensive businesses must also be considered in an IPO context. Investors will look for assurance about the company’s cash burn rate as well as its ability to generate Free Cash Flow (FCF). As it grows in scale and profitability, investors will also be looking at how the company can generate FCF. This is especially important when evaluating loss-making businesses with promising growth prospects.
Disruptive & Differentiated Solutions
Investors in IPOs want stories that promise the kind of electric growth tech companies promise. Disruptive powers are available to any business that grabs share from established players. Some fads last for years and others can be ended quickly. Don’t confuse fads with sustainable disruption.
Favorable Risk Profile
IPO investors are focused on the risk and not just the reward. Companies looking to go public should work together with their leading investment banks to identify any potential weaknesses and address them immediately. Sometimes, the risks can prove too overwhelming and the company may choose to skip the rigorous IPO process.
Proven Management Team
An experienced, skilled C-suite (e.g. CEO, COO, and CFO) with key division heads who have a strong collective track record helps to de-risk the investment and increase the confidence in the upside. The company’s culture can also be a distinguishing factor.
This is especially true for family-owned IPO candidates that are founder-led or family-owned. These cases show that company ethos can be a powerful performance driver. It motivates employees and other stakeholders to achieve outstanding results.
It can also be a marketing tool that creates buzz and a halo effect with investors. No matter what company it is, the integrity of leadership is scrutinized for obvious reasons.
Why do Companies go Public?
The circumstances will determine the motivations for an IPO. A desire to create liquidity and monetize the company, secure growth capital, or leave a legacy may drive the decision to go public.
Many IPO candidates are held by private equity (PE), and venture capital (VC) companies looking to exit investments. Others could be founder-owned or family-owned businesses that have reached an inflection stage. These may be non-core companies or divisions that the parent has decided to end the cord.
There are different ways IPO is used. This is also known as a secondary offer, which occurs when existing shareholders sell shares to receive cash in a liquidity event.
A primary offering is when the company sells shares for growth, repayment of the debt, or other corporate purposes. An IPO can be entirely composed of primary shares, secondary shares, or a combination. The type of offering will depend on the circumstances.
Regardless of the type of offering, an IPO gives both original and new shareholders a market and a valuation benchmark for their shares. Pre-IPO shareholders typically have a 180-day lockup. They can then freely purchase and sell their shares, except if they are affiliates or insiders of the company, and thus subject to certain legal restrictions.
The most common reason to take a company public is to offer liquidity or monetization for the owners. An IPO can be a more attractive option than a cash sale to another company, PE firm, or other entity. First, the valuation of IPOs is usually higher. Sometimes, the company may not have a cash buyer, making an IPO the only option.
Second, some owners might want to retain control over the company. An IPO typically offers 25% of a company’s shares to the general public, which gives legacy shareholders a substantial majority of ownership.
The original owners can still participate in the potential upside of the company by holding a large stake. They can also sell their shares at a later time. Potential future share price appreciation opportunities could be significant.
The company may use the IPO proceeds for any number of growth initiatives, including new products and locations, geographic expansion, and human capital. You can also use the cash to fund M&A.
Capital Markets Access
Companies can access capital through public equity markets. This is possible by selling additional shares, also known as follow-on offers. Because of their depth and breadth, major stock exchanges can raise capital more efficiently than private markets. Public companies have access to liquid markets that allow them to issue registered debt, convertible notes, and hybrid securities.
The proceeds of an IPO offer are often used to pay off existing debt. This strengthens the balance sheet and allows for more growth potential. This is especially common for companies that are heavily leveraged, such as former LBOs. The public markets are often the best option for raising equity capital to deleverage in these situations.
Access to the deep and liquid public equity markets can increase M&A firepower. An M&A target shareholder can offer a liquid public currency directly. It can also be used for raising cash proceeds to finance an acquisition. This gives you more flexibility than private companies, where equity is often sourced from the existing owners.
Legacy and Image
Publication creates a sense that a company is permanent. This is especially true for founders or family-owned companies where the legacy of the company is a top priority for their owners, employees, and all stakeholders. An IPO can also be a highly publicized event that increases the company’s visibility and solidifies its image. A public ticker can be thought of as free advertising.
Talent Attraction and Retention
Employers can receive stock-based compensation packages from public companies, most often in the form of restricted stock or options. These packages are transparent and liquid, which makes them different from private companies. This allows for talent attraction and retention and aligns incentives for shareholders and management.
Steps to an IPO
The valuations and proposals of underwriters discuss their services, including the best security type to issue, price, number of shares, and the estimated timeframe for the market offering.
Find an IPO Underwriter
First, the company must select an investment bank. These banks are registered with SEC (Securities and Exchange Commission) and act as underwriters. IPO underwriters work with the company issuing the IPO. They determine the initial price of the IPO, purchase shares from the issuing company, and then sell shares to investors. They usually have a network to help them reach potential investors in order to sell shares.
File the Company Prospectus for Official Review
After all, paperwork is completed, the SEC files the company prospectus. This report outlines the financial history of the company and its projected growth. The SEC conducts an investigation to verify that the prospectus is not invalid.
Investors and the economy would be in trouble if unsound or questionable companies were allowed to trade on the stock exchange. To maintain stability in the market, standards exist and are enforced.
The next step is the promotion of the IPO. The investment bankers and underwriters are responsible for this. They would make a splash by promoting the IPO and travel to financial hot spots.
In an effort to attract investors, the team promotes the IPO. They meet fund managers and business analysts. They host sessions such as Q&A, small-group meetings, and virtual presentations.
The company and the underwriter can agree on the effective date, number, and price of the initial offer. The company’s value is usually the determinant of the price. This process is called the valuation and takes place before the IPO process begins.
An IPO is often underpriced. Investors will expect the price of an IPO to go up if it is too low. This increases demand. Investing in an IPO reduces the risk that investors take, as it could fail.
The final prospectus and application forms will be made available online and offline for a period of usually five working days. During this time, investors can apply for an IPO.
After the price has been finalized, the company and the underwriters work together to determine the allocation of shares to each investor. This takes place within 10 days from the end of bidding.
The shares that are not sold are returned to the shareholders who were oversubscribed. This step ensures that no shares are given to any internal or related parties.
There may be some provisions after the initial public offering (IPO). The time period that underwriters have to purchase additional shares may be specified after the initial public offerings (IPO). During this time, some investors might be subject to quiet periods.
Types of IPO
There are two types of IPOs that are common: fixed-price or book building. Either one can be used by a company separately or together. Participating in an IPO allows investors to purchase shares before the public on the stock exchange.
Fixed Price Offering
Fixed Price IPO is the price at which companies issue their initial shares. Investors are informed about the stock price that the company makes public.
Once the issue has closed, the demand for stocks on the market can be seen. Investors who participate in the IPO must make sure they are able to pay the full amount for the shares.
Book Building Offering
Book building is the second type of IPO. This process does not involve a fixed price, but bids. Investors are provided with a price range by the company. This price range includes both the floor and maximum bids. The ceiling is the minimum, while the cap is the maximum. This is a price guideline.
Bidding involves investors deciding how many shares they want, and what price they are willing to pay. The company determines the final price after the bidding is closed.