Thursday, November 5, 2015

Leslie's thoughts on preparing for an IPO in what may be a tough market....

What does the current IPO market look like to public investors?   

As of today the answer is high risk and not so high reward.

Put yourself in the shoes of the institutional investor. Most of my investor friends love the thrill of a new company in their portfolio, but the unfortunate truth is that while the IPO is very important to the company going public, it contributes very little to the average institutional investor’s performance. To understand why you simply have to do the math. The T Rowe Price New Horizons Fund has $ 14 billion under management. Even a generous top 10 IPO allocation on a $ 100 mln IPO would hardly move the needle at less than 1/20 of 1% of that portfolio of stocks. Since Institutional investors are marked to market publicly every day, when markets are uncertain and stocks volatile, they logically focus on the bigger existing stocks in their portfolio that move the needle on a daily basis. Time leftover for IPOs becomes very small.

Another cloud hovering over the IPO investors’ heads today is the poor performance of those brave few IPOs that have ventured out in recent month.  Investors have felt the pain as 55% of IPOs since August are trading below issue with the average return of just 2.9% from IPO.  The good news is that those returns are slightly better than the return on the S&P over the same time period, but large institutional investors buy a majority of their shares in the aftermarket where returns have been a negative 5%. Even bell weather IPOs such as Ferrari and Pure Storage have broken issue. When a deal heads south, the liquidity for that newly listed company dries up quickly.  Many a fund manager has been caught with IPO positions trading below issue, a situation that may attract the scorn of investors and the consultants that recommend their funds.

While there are a few promising signs including the major indices moving back into positive territory for the year and the VIX (Wall Street’s proxy for fear and uncertainty) coming back to earth after skyrocketing in late August, the IPO market may be schizophrenic for some time to come.

Challenging market not withstanding, as the calendar year changes, we may see more companies heeding the advice offered by salesforce CEO Mark Benioff at a recent Fortune Global Conference:

 "Public markets are great for CEOs. You have to answer to the public market. You have to listen. You have to pay attention….. Entrepreneurs are making a huge mistake in waiting too long to go public"

What lies ahead?

Some smart companies will forge ahead although they may face a discriminating and more crowded market given the number of potential IPOs delaying in Q4. Those that want to maximize odds of potential success should take a few key steps.

1) Have a compelling reason.
When markets are tough investors will want to know why a company is moving ahead rather than waiting for calmer seas.  Is it hubris, desperation or something more rational?

 “Why do you want to be a public company and why now?” will very likely be the first questions in your roadshow meetings.  Be very sure you are clear on the answers to both and be equally sure that you can clearly articulate the answers.  Just a suggestion but “Our burn rate is really high and our early investors want out” is not likely to resonate well with public investors.

 Conversely, if you can explain how an investment today should accelerate the growth of your business, give you a marketplace advantage and presumably lead to stronger returns tomorrow, you will likely keep investors’ attention, at least long enough to hear the rest of your story.

2) Demonstrate a credible roadmap to profitability.

Surprise! Profitability matters after all.  Expect public investors to be focused on your path to profitability. When markets are sailing along smoothly and funds are attracting new investment dollars (inflows), investors’ minds drift out the risk curve. In good times, they are willing to pay high multiples on revenue for growth, daring to dream that the rest will work itself out over time. In uncertain times when volatility is up, inflows are stagnant or negative and IPO returns down, investor focus turns to self-preservation and limiting downside risk. The dare to dream valuation scenario goes poof when markets are falling. Newly issued, track-record free stocks with valuations built on a dissolvable, sugary rock candy mountain of imaginary profit and cash flow will be punished the most.

In these times, while current profitability may be optimal, it may not be possible without throwing the growth plan into a tailspin. Having a credible roadmap to profitability over the next 4 to 6 quarters, an appropriate public investor time horizon, is the next best thing.  Combine a path to profits with a compelling, sustainable growth trajectory and you have meaningfully increased your odds of a successful IPO. The IPO will look even more appealing if the numbers presented to investors are on the upswing, meaning past any trough in Ebitda, with bankers’ profit margin estimates showing consistent and tangible progress towards black ink. Investors feel more confident when companies talking about levers to profitability and can actually demonstrate that those levers work.

3) Set conservative expectations.

Investors will want to see that you are conservative in the public expectations you discuss for the business. One third of companies miss analysts’ numbers by the second public quarterly report.  Be clear about your expectations for the business and what might be potential drivers of outperformance but be even clearer about the challenges ahead. Don’t fail to acknowledge future head winds and under play possible future tail winds. Savvy investors want management to relay a conservative view of the world and then outperform against it. Bottom line: set achievable expectations and communicate them clearly.

4) Raise money when you are comfortable, not desperate

If cash on your balance sheet is $13 million and you are burning $ 15 million this quarter, you can bet investors will go for the jugular. Institutional investors are master negotiators and if they see weakness, they will show all the mercy of a great white circling a slow, blubbery sea lion. To minimize their opportunity to extract more than a fair discount, time an IPO so that your balance sheet shows comfort not necessity. You would be well served to compliment that cushion with a credible path to profitability that can be achieved with this round of equity financing. Public investors do not want the guarantee of future dilution or even worse, a subsequent inability to fund in uncertain markets. 

What about those hush-hush ratchets and triggers? Let's start with the fact that those potentially costly and dilutive preferences are detailed in The S-1. Make no mistake, institutional investors read that fine print. Not surprisingly, they are never excited about paying direct deposits into the pockets of earlier investors; there is a zero ROI for them on those dollars.  Understand that they get the joke and will factor those dilutive clauses into the price they are willing to pay for the IPO.  Savvy public investors will value your IPO as if triggered. If it’s a tough market, work with your private investors to make the problem clauses go away – or at least try. Hey, nothing ventured….. Those companies that have horse-traded preferences in exchange for high private company valuations, and those investors that have asked for them, may need to compromise to get to the mutually beneficial goal of access to the public capital markets.

Understanding both the big picture and the nuances of the IPO process can make an enormous difference in the outcome.  Need more examples and suggestions? Get in touch.  Class V Group is laser focused on helping great companies, and the inspiring entrepreneurs who build them, sail smoothly and successfully into the public markets.

Thursday, January 1, 2015

Are you REALLY ready to go public? A hopefully helpful guide to some key questions

2014 is in the books. It’s been a pretty terrific year in the IPO market. According to Renaissance Capital, through December 15, there have been 271 IPOs in the US this year, as compared to 221 IPOs a year ago at this time, a volume increase of 23%.  Thanks to Alibaba’s thunderlizard of a deal, the dollars raised by IPOs this year $ 84.2 billion exceeds last year’s total of $ 54.6 billion, by 54%%.  Not bad

Ah, but look deeper and you will see that actually, roses weren’t coming up everywhere. While 271 IPOs have been completed so far this year, conservative estimates suggest that more than 350 companies filed S-1s, a difference of nearly 30%.  For every 3 deals that filed and went public this year, at least one did the training, filed an S-1 and didn’t make it to the starting line.

Of course, we need to back out those companies that filed late in the year, targeting a 2015 transaction.  If we aggressively estimate that 20 fit that pattern, we still have more than 50 that didn’t get the job done as planned. When you consider the time and expense required for an initial filing, that is a big number.

What’s the difference and what price “Optionality”?

Bankers and others can be convincing when suggesting companies take advantage of the relatively new option to file confidentially: “Get on file now, then choose your timing later, but you’ll be ready.”  Factually correct? Yes. Good for your business, your P&L, your employees or your IPO?  Not so fast.  Preparing for an IPO too soon is neither a cost nor risk free option.

The on-going and elevated expense, distraction, loss of momentum and sometimes embarrassment (Box anyone?) that accompany a premature “go” decision can easily outweigh any timing flexibility benefits.  Picture the horses as they are led into the starting gate on Derby Day.  There is a reason they don’t load them until seconds before the bell.

OK, but IPOs do take a long time. How do we know when to start?

At January board meetings, following the “year in review” appraisals, many private company boards will have the “Is this the year to go?” conversation.  By “go”, we don’t mean begin internal preparations.  “Go” means schedule a bakeoff and hire bankers.  In advance of those meetings, we offer 5 questions every board should ponder before dropping the green flag.

1.     Can your sales and financial teams accurately forecast results for the next few quarters? Did you nail your forecasts last quarter?  If answering either of these is anything other than a rock solid “yes”, then take your time. Public investors show no mercy to companies that miss an early quarter.  Once you are in that doghouse, it’s a long slow climb out. Worse still, the brickbats that will come your way courtesy of angry investors are mere annoyances relative to the grenades your employees, customers and partners may lob through your door if you miss an early public quarter.  A swan-diving stock disappoints, creates instability and begs questions about  management’s reliability. It just takes one miss.

2.     Do you have the right team in place?  No really, are you sure you have the right team in place, not just for the IPO but also for the long term?  Step back and take a cold clear look.  The team that helped you get this far may be gifted, battle-tested and may be composed of friends. That doesn’t mean it’s the team for a fast-growing public company.   Public investors want to know that the C-suite in place for the IPO can scale the organization.  Newly public companies juggle enough knives when adjusting to the market’s spotlight.  There’s little bandwidth for concurrently integrating new senior leaders.  Save, time money and aggravation; line up the ducks before, not during, the process.

3.     Is your business model stable and ready for public scrutiny?  Admittedly, there companies (ex. Twitter) where even 12 months post-IPO the model remains an enigma. We grant that if your business has north of 200m active users, investors may cut you some slack.  However, for most, a more stable model correlates to a larger crowd of investors rallying around your IPO’s order book.   Are you hoping to migrate to a subscription model? Do you see significant price changes or regulatory updates on the near term horizon? Launch that new model or absorb the changes before you step on the IPO court.  In the eyes of investors, a foot-fault of your own making or because someone else moved the lines in a way you could have predicted, will cripple your stock’s performance and likely your personal reputation for a very long time.

4.     Are you ready for an intense audit?  There isn’t even a close second. The reason most companies on the IPO trail get thrown off course is because their audits aren’t ready on schedule. Audits won’t be rushed. The drill down scrutiny on every last decimal point is much more intense when your auditors know you’re preparing for an IPO.  We recently ran into IPO/ technical-accounting expert Barrett Daniels, Managing Partner of Nextstep Advisory.  He put it this way:

The reason an IPO audit takes longer than a typical private company audit is the dramatic increase in the risk profile. I assure you the audit partners want the audit to go quickly but they are, and rightfully so, going to take extra precautions to ensure the work is performed to endure the utmost scrutiny from the company, bankers, and ultimately the SEC.  The size of your audit team and number of questions will often triple during this process making for a robust and challenging process. 

5.     Is your company really strong enough to support the valuation you expect?  For this point, we will excuse readers at health-science companies, but for those selling products and services, not hopes and cures, size matters.   

a.     IPOs are expensive.  Bankers, lawyers, accountants, infrastructure and other service fees add up.  While most costs tied directly to the process are “one time”, other expenses including filings, higher legal and accounting bills and investor relations costs will be an on-going reality.  If the business isn’t able to comfortably absorb those charges, it isn’t ready to be public.

b.     Management teams tend to be optimistic. Bankers, reflecting experience, tend to be conservative.  Your finance team may produce a model projecting revenues over the next two years of $X and $Y. By the time bankers have helped you “refine” them, your forecasts (for the sell side analysts) will likely be closer $.7X and $.8Y. Expect similar treatment (opposite direction) for your expense projections.   It is those banker-adjusted numbers from which your initial valuation range will be determined.  Do the exercise in-house to be sure the projected valuation, based off a hacked-up model, will be acceptable before hiring banks and kicking off a process.  The more directly you face the conservative forecast reality, the better prepared you will be for the go/no go decision.

Companies need not score a perfect 5 to launch, but assessing answers to the hard questions upfront can profoundly improve the timing and reduce the costs of the IPO process.   Done right, an IPO can be a smooth, dare we say fun, stepping-stone to success.  A solid public launch not only enhances the corporate treasury but also an entity’s reputation, brand awareness, flexibility, competitive position and quite possibly, the rate of growth. 
The key, to paraphrase Kenny Rogers’ hit from yesteryear, “The Gambler”, is this:

“If your going to play the game folks, you gotta learn to play it right.”