What does "going public" mean? IPO By Rami Alame
Going public refers to a private company's initial public offering (IPO), thus becoming a publicly traded and owned entity. Businesses usually go public to raise capital in hopes of expanding. Venture capitalists may use IPOs as an exit strategy (a way of getting out of their investment in a company).
The IPO process begins with contacting an investment bank and making certain decisions, such as the number and price of the shares that will be issued. Investment banks take on the task of underwriting, or becoming owners of the shares and assuming legal responsibility for them. The goal of the underwriter is to sell the shares to the public for more than what was paid to the original owners of the company. Deals between investment banks and issuing companies can be valued at hundreds of millions of dollars, some even hitting $1 billion.
Going public does have positive and negative effects, which companies must consider. Here are a few of them:
- Advantages - Strengthens capital base, makes acquisitions easier, diversifies ownership, increases prestige.
- Disadvantages - Puts pressure on short-term growth, increases costs, imposes more restrictions on management and on trading, forces disclosure to the public, makes former business owners lose control of decision making.
The Pros And Cons Of A Company Going Public
For some entrepreneurs, taking a company public is the ultimate dream and mark of success (usually because there is a large payout). However, before an IPO can even be discussed, a company must meet requirements laid out by the underwriters. Here are some factors that may qualify a company for an IPO:
- The company has predicable and consistent revenue. Public markets do not like it when a company misses earnings or has trouble predicting what they will be. The business needs to be mature enough that it can reliably predict the next quarter and the next year's expected earnings.
- There is extra cash to fund the IPO process. It is not cheap to go public, and funds from going public can't necessarily be used to pay for those costs as there are many expenses that start occurring long before it actually becomes public.
- There is still plenty of growth potential in the business sector. The market does not want to invest in a company with no growth prospects; it wants a company with reliable earnings today but one that also has lots of proven room to grow in the future.
- The company should be one of the top players in the industry. When investors are looking at buying in, they will compare it to the other companies in the space. If it's just average compared to competitors, investors won't pay as much.
- There should be a strong management team in place. The quality of leadership is one of the biggest factors investors look at outside of the financials. Additionally, many of C- Level executives will have to talk on earnings calls, so they should be prepared and able to manage that aspect too.
- Audited Financials are a requirement for public companies.
- There should be strong business processes in place. This one is valuable even if a company stays private, but going public means each aspect of how the company is run will be critiqued.
- The debt/equity ratio should be low. This ratio can be one of the biggest factors in derailing a successful IPO. With a highly leveraged company, it is hard to get a good initial price for the stock and the company may encounter stock sales problems.
- The company has a long-term business plan with financials spelled out for the next three to five years to help the market see that the company knows where it's going.
Some underwriters require revenues of $x-$x million per year with profits around $x. Not only that, but management teams should show future growth rates of about X% per year in a five- to seven-year span. While there are exceptions to the requirements, there is no doubt how much hard work entrepreneurs must put in before they collect the big rewards of an IPO.
How an IPO is Valued
To a certain type of investor, few scenarios sound more satisfying than the idea of getting in on the ground floor of an investment opportunity and then watching said investment rise in price while the latecomers vie for the dwindling and ever more precious table scraps. People want to stake the gold claim on the previously overlooked part of the Klondike, drill the productive wildcat well in the Permian Basin or be Steve Jobs’s and Steve Wozniak’s third partner. Doing this involves slightly more work and more risk than finding a winning lottery ticket on the street, but without an appreciably better chance of success.
Among a few other reasons, this innate covetous desire to move to the front of the line is why the underwriting industry attracts the kind of people that it does – and why initial public offerings (IPOs) attract such attention.
An initial public offering (IPO) is the process by which a private company becomes publicly traded on a stock exchange. Once a company is public, it is owned by the shareholders who purchase the company's stock. Every public corporation in existence had to start trading at some point, which is to say, initiate an IPO.
The only real exposure many retail investors have to the IPO process occurs a few weeks prior, when media sources inform the public of the offering. How a company gets valued at a particular share price is relatively unknown, except to the investment bankers involved and those serious investors who are willing to pour over registration documents for a glimpse at the company's financials.
Where to Begin
Even if one of the richest private corporations were to go public, say Cargill or Koch Industries, it wouldn’t be enough to just buy shares as soon as they became available and then assume the rocket ride will continue. As the old-but-true saw goes, you make your money going in. A lucrative but overpriced moneymaker might not be as good a deal as its mildly profitable but much less expensive counterpart.
The problem, of course, is that incipient IPOs, by virtue of being currently private companies, don’t have long histories of disclosing financial statements publicly. But disclose they do, in much the same manner of established public companies. Every one produces balance sheets, income statements and cash flow statements – all the usual culprits.
Quantitative Components of IPO Valuation
Like any sales effort, a successful IPO hinges on the demand for the product you are selling – a strong demand for the company will lead to a higher stock price. Strong demand does not mean the company is more valuable; rather, the company will have a higher valuation. In practice, this distinction is important. Two identical companies may have very different IPO valuations, merely because of the timing of the IPO as compared to market demand.
An extreme example is the massive valuations of IPOs at the 2000 peak of the tech bubble compared to similar (and even superior) tech IPOs since that time. The companies that went public at the peak received much higher valuations – and consequently much more investment capital – merely because they launched when demand was high.
Another aspect of IPO valuation is industry comparables. If the IPO candidate is in a field that already has comparable publicly traded companies, the IPO valuation may be linked to the valuation multiples being assigned to competitors. The rationale is that investors will be willing to pay a similar amount for a new company in the industry as they are currently paying for existing companies.
In addition to viewing comparables, an IPO valuation depends heavily on the company's future growth projections. Growth is a significant part of value creation, and the primary motive behind an IPO is to raise more capital to fund further growth. The successful sale of an IPO often depends on the company's plans and projections for aggressive expansion.
Spend less than a minute looking up the company’s financial disclosures, contrast that with the company’s expected theoretical initial book value (IPO price times number of shares issued), then determine for yourself whether company management and the underwriting banks have overshot, undershot, or assessed accurately.
Qualitative Components of IPO Valuation
Some of the factors that play a large role in an IPO valuation are not based on numbers or financial projections. Qualitative elements that make up a company's story can be as powerful – or even more powerful – as the revenue projections and financials. A company may have a new product or service that will change the way we do things, or it may be on the cutting edge of a whole new business model. Again, it is worth recalling the hype over internet stocks back in the 1990s. Companies that promoted new and exciting technologies were given multi-billion-dollar valuations, despite have little or no revenues. Similarly, companies undergoing an IPO can bulk up their story by adding industry veterans and consultants to their payroll, giving the appearance of a growing business with experienced management.
Herein rests a harsh truth about IPOs; sometimes, the actual fundamentals of the business take a back seat to the marketability of the business. It is important for IPO investors to have a firm understanding of the facts and risks involved in the process, and not be distracted by a flashy back story.
Facts and Risks of IPOs
The first goal of an IPO is to sell the pre-determined number of shares being issued to the public at the best possible price. This means that very few IPOs come to market when the appetite for stocks is low – that is, when they're cheap. When equities are undervalued, the likelihood of an IPO getting priced at the high end of the range is very slim.
The IPO market basically died during the 2009-2010 recession because stock valuations were low across the market. IPO stocks couldn't justify a high offering valuation when existing stocks were trading in value territory, so most chose not to test the market.
The Bottom Line
Valuing an IPO is no different than valuing an existing public company. Consider the cash flows, balance sheet and profitability of the business in relation to the price paid for the company. Sure, future growth is an important component of value creation, but overpaying for that growth is an easy way to lose money.
Most IPOs render their investors disappointed. But again, that’s reflective of the market as a whole, which is comprised of nothing but IPOs of varying vintages. The intelligent investor (with apologies to Benjamin Graham) understands that the fundamentals of the game transcend the particular investment. Buy underpriced assets. Sell, or eschew, overpriced ones. Then be patient, then profit.
Lebanon is looking forward to the electronic trading platform to which the Capital Markets Authority is already requesting RFPs for, and the Beirut Stock Exchange. 2019 can be exciting for a lot of investors so make sure to remain informed and keep reading.