Part one of a three-part series on going public, covering the pros and cons of an IPO, the IPO process, and IPO valuation.
Executive summary
An IPO can have many benefits for the right company, but it is not the right decision for most. IPOs require complex decisions and difficult trade-offs, and many companies enter discussions about an IPO only to abandon the effort part way. Before proceeding, management and the board should carefully evaluate the pros and cons of all capital alternatives. In many cases other options fit the company's needs better. In general, an IPO is more often the right answer for a bank than for a mortgage company, more often for a large cap than a small cap, and more often for a tightly controlled company than a flexible one.
The case for
- Enhanced market visibility
- A diversified investor base
- Broader access to equity markets for growth capital, and potentially to more sophisticated debt markets
- Enhanced external and internal reporting requirements, which may improve financial reporting discipline
- Active market feedback on company performance
- Acquisition currency for stock-based M&A
- Stock and options as compensation, which may attract and retain key talent
- Greater transparency for employees, customers, and vendors
- An opportunity for founders and investors to monetize investments and execute exit strategies
- A vehicle for holding and transferring inter-generational wealth
The case against
- A considerable amount of work to execute, making it expensive and distracting
- Cost. The gross spread payable to the investment bank is typically 7 percent of proceeds
- New layers of ongoing compliance, including SEC and Sarbanes-Oxley requirements
- Additional compliance, investor relations, and other personnel, a minimum $2 million incremental annual cost once public
- Exchange requirements covering shares available for trading, share price, shareholder count, and market makers, which make an IPO impractical for companies raising less than $50 million
- A need for investor attention, difficult to obtain unless market cap and float allow active trading and adequate liquidity, with practical minimums around $200 million market cap and $100 million float
- Stringent audit standards that significantly increase the cost of annual audits
- Public disclosure of financial and operational data, including compensation for top officers, which competitors can use in targeted sales or recruiting
- Volatility, since most non-bank financial services companies have short valuation windows offering little earnings visibility
- Short-term focus, as investors watch earnings trajectory and pressure management to hit current period goals
- New fiduciary obligations that may limit operating flexibility
- Restrictions on personal stock sales, pledging, and trading for management and control shareholders
- Reduced control and increased accountability to outsiders
- Exposure to activist investors and short sellers
- Potential for poor stock performance, particularly where the company is excluded from major indices, the sector falls out of favor regardless of fundamentals, there are few publicly traded comparables, or industry practices are not widely understood by investors
- Potential to lose control of the company
Enhanced market visibility
The public part of being a public company is a double-edged sword. The annual report and investor presentations provide an opportunity to go beyond financial reporting and tell the company's story, how the business works and what sets it apart. A good strategy and story make for better visibility and prestige.
The downside is multifaceted. Disclosure is the opposite of confidentiality. It makes it impossible to hide strategic decisions from competitors and harder to stay a step ahead. Once pertinent operating data is disclosed, investors expect it to continue. And management can lose control of the narrative, because it is impossible to ignore publicly disclosed statistics even when they are no longer particularly relevant. Disclosure makes it harder to shift strategic direction.
This issue is muted for banks. Banks already file quarterly call reports, putting most information in the public domain for competitors, vendors, and investors to see, so an IPO has relatively little incremental impact on visibility or confidentiality.
Diversifying the investor base and access to capital
Access to growth capital is often the primary reason for an IPO. Especially in financial services, companies can only grow revenue and assets as fast as they grow equity. Any company with opportunities that exceed its return on equity will need to raise equity.
An IPO unquestionably diversifies the investor base while meeting that need. Public companies have public investors, both individuals and institutions who cannot or will not invest in a private company. That said, private companies also have equity and the ability to sell it to private investors. The real question is whether to embrace outside equity investors at all.
There are many similarities between an IPO and a private equity offering. In both cases the company needs to get its house in order, put together offering materials, and go on a roadshow. In the IPO scenario all of that work becomes public and available to customers, vendors, and competitors. One key difference is that in a private offering you only get one bite at the apple, because if the investor is not convinced there is no ongoing market providing second chances.
There are ancillary benefits to the discipline required to bring in outside investors, whether public or private. Such companies tend to have better control regimes and better governance, and public reporting provides a mechanism to tell the story. That transparency extends access to debt capital, particularly with more sophisticated lenders.
Active market feedback
Stock prices are a remarkable feedback loop, grading management on every public statement. They are also subject to wide fluctuations driven by broader markets without any news from the company. As with all criticism, consider the source.
Market feedback is only relevant if investors understand the business. Where market participants have good comparables and industry experience, it works. Where fundamentals are not well known, it is problematic. Banking is widely analyzed and well understood relative to other segments of financial services. Mortgage banking is far more esoteric.
Considering investor experience, banks make better IPO candidates than mortgage banks. Valuations of servicing operations and origination operations often move in opposite directions, yet servicing-weighted mortgage banks are compared directly to origination machines that also service. Even within originations there is a large margin difference between correspondent and retail, and operations differ materially, yet multiples on all of these companies are compared endlessly. Market feedback is only an advantage if it is relevant.
Historically, the volatility of the mortgage business has produced poor stock price performance. During boom times companies trade at very low price-earnings multiples, which is reasonable because investors are looking past this year's earnings to the prospect of a sharp decline when the party ends. A low multiple is a red flag.
Acquisition currency
Public stock broadens M&A options. Companies pursuing growth through acquisition find it valuable to offer stock rather than only cash. Cash is king, but when stock is needed, for example where there are tax reasons for a seller to prefer it, a fair market valuation matters. Any seller taking stock needs to know what it is worth, and after an IPO the market price on any given day is that value.
Public stock also plays into recruiting. It is not only a corporate acquisition currency but a way to acquire employees. Private companies can offer equity or phantom stock linked to performance, but recruits consistently ascribe more value to equity-linked compensation from a public company than to comparable value in a private program.
Transparency and reporting discipline
Financial reporting discipline tends to improve performance, because it increases the universe of what is monitored. Any company bringing in outside investors needs to provide enough information about operating and financial performance to satisfy them, and that reporting improves management's ability to decide. Private company managers analyze the important data too, so while there is a lift from establishing public-company discipline, the lift is not dramatic.
Nothing is free, including disclosure. At a minimum a public company must staff compliance and investor relations functions. Together with higher external audit fees, most companies experience cost increases of at least $2 million. Beyond cash cost, the company must also account for distracting key executives for four to six months.
Personal wealth and exit strategy
Personal financial planning is often cited as the key rationale for an IPO. An IPO is first and foremost an equity offering, and once sold, the risk of that equity's performance shifts to the new investor. This is frequently the real reason: the owner needs to diversify or reduce the concentration of personal net worth in the company. For companies without a clear succession plan for equity owners, an IPO provides an exit that monetizes stock without swapping out the management team.
It is critical to evaluate both personal tax and short and long-term financial goals. Pre-IPO is the time to grant low-basis stock to a family limited partnership, irrevocable trusts, or grantor retained annuity trusts for estate planning and tax management.
Losing control is often an unintended consequence when the IPO route is chosen to raise capital rather than to exit, and it can affect both management and owners. An IPO sets a fair market price for the equity, and the board, with its fiduciary obligation to shareholders, is then obligated to consider offers, including from unwanted suitors. Public companies are also subject to pressure from shareholder activists and short sellers.
Final caveats. Beyond the 7 percent underwriting spread there is the cost of legal counsel and accounting support, the soft cost of restricted sales windows for management and key insiders, and the intangible cost of meeting public expectations even when that is not what is right for the company. Control shareholders must file a 10b5-1 selling plan, which can limit gains, and large positions are generally exited through a secondary offering or block trades at additional expense of up to 5 percent of proceeds. Lockup periods prohibit large investors and insiders from selling for 90 to 180 days following an IPO, and 180 days to a year following a SPAC. The end of a lockup can depress the stock price even if no insider sells.
Summary
An IPO is one of the most complicated decisions a company faces. In some cases the bigger stage afforded a public company complements the rest of the business strategy, and an IPO is the only answer. For most companies there are viable alternatives: public versus private equity, equity versus preferred or debt, and so on.
For the right company an IPO is the public culmination of years of hard work, the advantages far outweigh the disadvantages, and the choice is clear. For a surprising number of companies, pursuing an IPO is a mistake. It is also a mistake that few advisors are able to counsel against.
Endurance Advisory works as an independent advisor alongside companies evaluating this decision: providing a gap assessment identifying the changes needed to facilitate a successful IPO, assisting with corporate strategy, risk management planning and investor messaging, supporting dual-track strategies including private equity and M&A, assisting with regulatory dialogue, helping assemble the IPO team including underwriters and accountants, and identifying prospective independent directors.
