How to Prepare a Company for an Initial Public Offering
For many growing companies, "going public" is more than just selling stock. It's a signal to the world that the business has made it.
That's why undertaking an initial public offering (commonly known as an IPO) -- the first sale of stock to the public by a private company -- has long been the ultimate goal for many an entrepreneurial business. An IPO can not only provide a company with access to capital to fuel growth and liquidity for founders and investors, but it provides the public market's unofficial stamp of approval.
Yet recent regulatory changes, such as the 2002 Sarbanes-Oxley Act (SOX), have given new meaning to the term IPO. It's not just a public offering of stock, but it can also be an intensely arduous and increasingly expensive ordeal. In order to gain the benefits of raising capital and achieving greater liquidity that an IPO offers, companies must be more solidly established and better able to pass tougher regulatory requirements than in the past. Doing so comes with a bigger price-tag than ever before. These days, companies going public should expect to pay more than $2 million in out of pocket expenses to cover a host of fees – among them legal, accounting, printing, listing, filing -- in addition to the underwriter discount and commission of 7 percent of the offering proceeds and to shore up internal processes to meet the tougher reporting and governance standards for public companies.
The following pages will detail the pros and cons of going public, the qualifications a business needs to go public, and the steps involved in the IPO process.
Taking a Company Public: Why You Should Consider It
An IPO is one of the most sign ificant events in the life of a business. The capital raised through a successful public offering boosts a business' ability to expand into new market s or grow through acquisitions. It can help a company attract new talent with stock options and other equity awards and reward initial investors with liquidity. "There is also the prestige factor," says James S. Rowe, a securities partner with Kirkland & Ellis LLP, a 1,500-lawyer firm that has counseled countless companies through the IPO process. "The fact that you're a public company gets you in the door with vendors and suppliers and prospective business partners. Being a publicly traded company has additional cache and is something that can be helpful to a company in its commercial relationships."
Such benefits, however, don't come without costs. One important intangible cost to consider is the loss of control over the business when a formerly private company goes public. The following is a list of pros and cons to consider in determining whether to take a company public.
Taking a Company Public: The Benefits of Going Public
• Given the higher valuation of a public company and the greater liquidity in the public markets, there is greater access to capital, Rowe says. In fact, while the first public offering may be costly and time consuming, if there is market demand for the stock a company can always issue more stock -- which can be conducted more quickly and efficiently as a seasoned issuer.
• The increased liquidity can help a company attract top talent by enabling it to grant stock options or restricted stock awards.
• A public offering provides a business with the currency with which to acquire other businesses and a valuation if your business becomes an acquisition target, Evans says.
• An IPO serves "as a way for founders or em ployees or other share or option holders to get liquid on their investment, to see a financial reward for the hard work that has gone into building the business," Evans says.
• The act of going public can also serve as a marketing event for a company, to drum up interest in the business and its products or services.
Dig Deeper: What's Your Business Worth Now?
Taking a Company Public: The Downside of Going Public
• The biggest downside to going public is often the loss of control over the company for management and founders/investors. Once a company is public, managers will be under often intense pressure to meet quarterly earnings estimates of research analysts, which can make it much more difficult to manage the business for long-term growth and predictability.
• The SEC requires public companies to reveal sometimes sensitive information when they go public and on an ongoing basis in required filings. Such information may include data about products, customers, customer contracts, or management that a private company would not have to reveal.
• Public companies have additional reporting and procedural obligations since the passage of the Sarbanes-Oxley Act, many of which may be costly for a company to implement, such as the Section 404 requirements relating to internal controls over financial reporting, says Bruce Evans, managing director at Summit Partners, a Boston-based private equity and venture capital firm.
• In a worst-case scenario, a group of dissident investors could potentially obtain majority control and wrangle control of the company away from the board.
• If a stock performs poorly after a company goes public, an IPO can generate negative publicity or "an anti-marketing event" for the company, Evans says.
Taking a Company Public: Which Companies Should Consider an IPO
Not every company can -- or should -- go public.
There is an array of factors to consider before summoning the bankers. These factors include meeting certain financial qualifications set by the various exchanges, the appropriateness of an IPO strategy for your business and business goals, and the market receptivity to IPOs generally and within your particular sector.
Before you can even consider taking your company public, you must meet certain basic financial requirements, which are set by the exchange where you expect to list.
For instance, if you want to list your company's stock on the New York Stock Exchange (NYSE), you will generally need a total of $10 million in pre-tax earnings over the last three years, and a minimum of at least $2 million in each of the two most recent years.
The NASDAQ Global Select Market requires pre-tax earnings of more than $11 million in the aggregate in the prior three fiscal years and more than $2.2 million in each of the two most recent fiscal years.
Fortunately, both exchanges have alternative markets that have less rigorous financial requirements for listing companies. The NASDAQ Global Market requires companies have income from continuing operations before income taxes in the latest fiscal year or in two of the last three fiscal years of $1 million or more. The NASDAQ Capital Market has a lower barrier to entry, requiring net income from continuing operations in the latest fiscal year or in two of the last three fiscal years of at least $750,000. Meanwhile, the NYSE's American Stock Exchange (AMEX) requires pre-tax income of $750,000 in the latest fiscal year or in two of the three most recent fiscal years.
The exchanges also offer alternative listing standards based on cash flow, market cap, and revenue for larger companies not meeting the pre-tax earnings' tests.
Under SEC rules, a company must also have three years of audited financial statements before it can register to go public. If a company lacks three years of audits, it can often create them 'after the fact,' Rowe says, assuming it has the records and systems in place to allow an auditor 'look-back.' Since that can be a costly and time-consuming undertaking, pre-planning is essential.
Taking a Company Public: Picking the Right IPO Strategy
Even if a company meets the minimum requirements for listing on one of the exchanges, it may not be in the company's best interest to go public.
"I think businesses should go public that have achieved a size that would allow them to have a predictable revenue and earnings stream," Evans says. "Smaller businesses tend to be more volatile and there is a premium paid for predictability in the public markets."
Another factor to consider is whether your business will have a market capitalization large enough to support enough trading in your stock that buyers consider that stock to be "liquid," Evans added. "To go public with too small a market cap means that buyers don't get a really liquid public security. The reality is that unless you have enough of a market cap, I think public offerings are probably best for growth companies."
Another factor that is increasingly determining whether companies go public is the economy and, in particular, the public's appetite for IPOs.
The IPO market hit a 30-year low in 2008, when only 31 companies went public on the major U.S. exchanges, according to Hoovers. Nine years earlier, in 1999, there were 477 IPOs, more than half of which were venture-backed, according to the National Venture Capital Association (NVCA). Market interest in IPOs definitely waxes and wanes – especially recently. The good news is that the IPO market picked up slightly in 2009, when 63 companies went public on the major U.S. exchanges, with virtually all of that activity occurring in the second half of the year.
"There is a pipeline, things are turning around," says Evans. But he says the market for IPOs would get better if some of the regulations in the Sarbanes-Oxley Act were pared back. The law, which sought to provide the public with more corporate accountability, requires compliance with so many costly rules that the overhead associated with compliance "adds millions to a company's operating expenses," Evans says. "Companies tend to have to wait longer now to overcome that expense before they can go public. It's a direct impediment to their ability to go public."
Another component of the law requires CEOs and CFOs to personally certify financial and other information in their securities filings. "Quite frankly, it makes it less attractive in some instances to want to take that on," Evans says.
Taking a Company Public: The Steps You'll Need to Take
If your company meets these financial requirements, you determine an IPO will help you meet business goals, and the market conditions appear right, then it's time to begin the IPO process. Typically, it takes four to eight months to complete this process, from the time you actively engage underwriters to the time you close the offering. Here are the key steps in the IPO process:
Put the right management team in place.
Fast growing companies generally have strong management teams already in place, but the demands of becoming a public company often require additional strengths and capabilities. The senior management team must have considerable financial and accounting experience in complying with increasingly complex financial and accounting requirements. In light of this, many pre-IPO companies seek to recruit CFOs or other executives from outside who have had experience going public with other companies. "I don't agree with that at all," Evans says. "An experienced CFO that knows his or her business well, and who has been successful in that role, doesn't need to have gone through a public offering before." But it is important that key managers possess strong communication skills to present the company's vision and its performance to the market, and to meet the often-intensive informational demands of research analysts and investors.
The composition of your board of directors may also need adjustment. The exchanges require that a majority of the company's board of directors be 'independent,' and that the audit, compensation, and nominating corporate governance committees -- to the extent they exist -- be composed of independent directors. In addition to creating even more stringent independence requirements for audit committee members, Sarbanes-Oxley requires an issuer to disclose whether it has an 'audit committee financial expert.' To meet these requirements, independent board members (who are not insiders or affiliates) may need to be recruited, particularly for the audit committee, Evans says.
Upgrade financial reporting systems.
Before proceeding, you need to ensure that you have the proper systems in place to ensure a flow of accurate, timely information. Identifying the right metrics and closely monitoring them can significantly enhance your business results, since it forces everyone in the company to focus on the factors that drive your business.
Sarbanes-Oxley imposes a number of additional requirements in this area, including 'disclosure controls and procedures,' which are necessary to ensure that information is properly captured and reported in the company's public filings. Another requirement relates to 'internal controls over financial reporting,' which are designed to help ensure that the company's financial statements are accurate and free of misstatements. Developing and assessing these controls can take time and be quite costly. This is especially true in the case of internal controls over financial reporting, which are governed by Section 404. Although IPO issuers are not required to comply with 404 until well after they go public, it is important to anticipate any potential material weaknesses in these controls and to address them as early as possible.
Select investment bankers.
In the business, this is called the "beauty contest." It's a process through which you typically choose your investment banking partners and assure that they concur that the business is ready to go public, that they have the sales and distribution capabilities you need for successful execution of the IPO, and can provide strong analyst coverage once you go public. "It's not uncommon to invite three to five bankers to each make presentations to the decision makers as to how they see the company, what valuation, what they expect to see in the current market, and why they are the firm that should lead the offering," Rowe says. You should use a variety of criteria for choosing your bankers: a proper "fit" personality-wise, good research and analyst coverage, knowledge and understanding of your business and your industry and whether that bank has brought other companies public in your sector, Rowe says.
After engaging underwriters and embarking on the IPO process, a company is considered to be 'in registration' and therefore subject to SEC 'quiet period' restrictions, which will significantly limit what the company and its managers can say and do outside of the formal registration process. In 2005, a safe harbor was created for statements made more than 30 days before the filing of an SEC registration statement, but issuers must still be vigilant in controlling information that could be viewed as 'conditioning the market' for their securities.
Craft your "story" and draft the prospectus.
This is where the lawyers get involved. The principal offering documents include the IPO prospectus, which is filed with the SEC as part of the IPO registration statement, and the 'road show' slides, which the underwriters and senior management will use, together with the prospectus, to market the offering. Crafting the right "story" in these documents is critical to the success of the IPO. "It's really about positioning your company -- highlighting its strengths, strategy is, the market opportunity, and why this is a good investment over the long term," Rowe says. Because the prospectus is subject to extensive disclosure requirements, it will typically take several weeks to prepare and lawyers will try to anticipate the questions and comments the SEC will have to the filing.
File the registration statement and begin the review process.
Once a draft of the prospectus is completed, the company will file the registration statement with the SEC. While immediately available to the public on the SEC's EDGAR system, the registration statement is subject to review and comment by the SEC through a review process. Almost invariably, the SEC reviews an issuer's initial filing and typically provides extensive comments within 30 days of the initial filing. Shortly after filing, the company will also file its initial listing application with the exchange on which it wishes to list, and the underwriters will make filings with the Financial Industry Regulatory Authority (FINRA) in regard to the underwriter compensation arrangements. "It can be an extensive and labor intensive process," Rowe says. "You can not price the IPO unless you have cleared all the SEC comments."
Organize the road show.
The road show is launched once the issuer has responded to and resolved the SEC staff's material comments, generally through multiple amendments to the registration statement. That's when the issuer will print the 'reds' -- the preliminary prospectus setting forth an anticipated offering size and anticipated price range. They call it the "road show" because it typically lasts for up to two weeks, during which time senior managers meet prospective investors, often in multiple cities in the same day. "It really is taking the show on the road," Rowe says. "It's not uncommon to be in two or three cities a day for five days a week. You have investor meetings every waking moment of the day, including investor breakfasts and lunches, all with the intention of building a book for the underwriters so the IPO can succeed."
Price the IPO.
When the review process is completed and the underwriters have 'built a book' of prospective IPO investors, the issuer's board of directors -- typically through a pricing committee -- and the underwriters will set a price at which the company and any selling stockholders will agree to sell shares to the underwriters at closing. The pricing usually occurs after the close of the markets on the final day of the road show; the stock will begin trading on the exchange on a 'when issued' basis the next morning.
Typically, Rowe says, companies will reconstitute their capital structure so that they can target a price of between $14 and $16 per share, a range that is attractive to most IPO investors. "At pricing, you want to maximize the price yet you don't want to overprice the offering just to get the last dollar out," Rowe says. "It's critical that the stock to perform well in the aftermarket." If the stock trades down, it can create bad publicity for your company and can make it exceedingly difficult to complete a follow-on offering in the future.
Complete the offering and begin life as a public company.
The IPO will typically close on the fourth business day after the pricing. At that time, the issuer and any selling stockholders will release the shares to the underwriters, and the underwriters will purchase the shares, frequently at a 7 percent discount to the price at which they have offered the shares to the public -- that's their fee. The issuer will continue to be in an SEC quiet period for 25 days following the pricing -- the period during which broker-dealers have an obligation to deliver prospectuses to investors. During that period, the company must continue to be circumspect in what, if anything, it says to the public outside of the IPO prospectus. Following the expiration of the quiet period, the company will be in frequent communication with the market, both through its periodic SEC filings and in its interaction with the analyst and investor communities.
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Nasdaq's Listing Requirements and Fees
Information for companies interested in having stock publically traded on the Nasdaq market.
New York Stock Exchange (NYSE)
NYSE's listing requirements for companies that want to have stock publically traded on the exchange.
Listing standards for the NYSE Amex exchange.
National Venture Capital Association (NVCA) -- Made up of 400 member firms, the trade association for the U.S. venture capital industry provides information for entrepreneurs and investors and current research on the venture capital industry.
Securities and Exchange Commission (SEC) -- The SEC provides information for companies considering an IPO, including this section on guidance for small companies considering an initial public offering of stock.
Going Public: A Guide for Owners