Twitter will soon go public, but more than 100 companies have completed IPOs in the past six months or so. Many of those newly-public companies have struggled as stocks. They are up an average only 2%, while NASDAQ is up 13% over the same period. Nearly half of those IPO companies are actually trading below their offering price.
We have directly participated in 17 IPOs and supported many more. In our opinion there are three main stumbling blocks for companies going public in today’s market:
Stumbling Block 1: Public and private investors have very different expectations
Most companies that IPO started with venture capital backing. These and other private investors in high-growth companies tolerate of a lot of uncertainty. They value a company’s “story” and have long time horizons. By contrast, public market investors have quarterly, monthly, or even daily time horizons. They hate surprises and value consistency. This is not to say that venture investors have infinite patience, nor that public investors are short-sighted, but that there is a very real difference in the pressures on each of them.
Stumbling Block 2: The IPO process does not help management bridge this gap
The IPO process itself can become all-consuming for management. Preparing forecasts and offering documents and going on roadshows can consume a major portion of management’s time. And, there is tremendous pressure to get the deal done. There may only be a limited time in which the IPO window is open. The board, which typically represents the company’s venture investors, wants a liquidity event. The bankers’ incentives are largely aligned with completing a listing. In this environment there is little time for management to learn about the needs of its new investors. In fact, at the very time the company is shifting from investors who value the long-term outlook to those who value quarterly consistency, management is pulled far away from actually operating the business.
Stumbling Block 3: The IPO is only a first impression
Public investors have grown skeptical of IPOs to a degree and are looking to see whether management can meet expectations for several quarters after being public before really committing to a stock.
We advise our clients considering IPOs about five major solutions to these stumbling blocks:
Solution 1: Start investor relations at the beginning—not the end—of the IPO process
Companies should be thinking about how they are going to relate to their investors from the very beginning of the IPO process. “Investor Relations” is not just a routine function to be outsourced near the end of the IPO process. It is also a strategic initiative that should begin at the start of the process.
Of course, someone needs to manage the web site, stream webcasts, and provide links to SEC documents, but that’s not what we are talking about. We mean actually meeting with potential investors to understand what they have trouble comprehending about the company or the industry. We mean developing language, metrics, and materials that explain—in the clearest possible way—how the company creates value.
This strategic approach to investor relations involves thinking about which investors the company wants. What is the right mix of institutions, hedge funds, high net worth individuals, and retail investors? Which constituencies would be ideal shareholders? The company should be learning what would make its stock understandable and appealing directly from these investors. The company should also know where these investors are physically located. Are they all in New York? There may be regional investment banks with better access to certain types of investors; it may be wise to include them as underwriters.
Another aspect of this strategic IR that should happen before the IPO is analyzing which sell-side analysts are the most thoughtful about the industry. Since analysts from the IPO’s underwriters usually cover the company’s stock, companies should partially base their choice of underwriters on which analysts are best able to explain what the company does to its target investors.
Finally, the company’s strategic IR initiatives should include role playing and game planning for the roadshow investor Q&A. The insight that comes from actually relating to potential investors helps with this. One irony of the IPO process is the bankers who the CFO and CEO spend so much time working with rarely actually meet with investors themselves.
Solution 2: Build a story that draws investors back time and again
As much as investors focus on numbers and hard metrics, companies need to offer a story that is easy for investors to understand and gives them a reason to come back even if they do not invest at the IPO. We call this a story, but it should not be a work of fiction. What is the narrative arc of the company? How was it founded? Where does leadership want to take it in the future? This should come with tangible proof points so an investor who hears the story at the time of the IPO can come back a year or two later and see that the company has built on the foundations laid down during the IPO. Ideally, this should be a story about more than money—shipping 1 billion units, growing from a regional to a national player, and so forth. The IPO is as much about marketing as accounting.
Solution 3: Combine planning for the IPO and a secondary offering
We already talked above about how the IPO process can become all-consuming. It’s understandable how management could come to understand the IPO as the goal. But, in fact, management needs to think of it as just the beginning. There are three reasons for this:
First, many investors are coming to view IPOs somewhat skeptically, preferring to take a wait-and-see attitude. Companies need prove to these investors over the course of several quarters that they are worthy of investment. Second, although a company’s private investors and employees may push for a liquidity event, they are often locked up for six months or more. A better way to maximize value for these shareholders is to aim for a high stock price six to twelve months after the IPO. Finally, combining planning for the IPO and a secondary offering takes the pressure off to maximize the valuation at the IPO. Aiming for the highest possible valuation at the IPO puts management under pressure to turn all the dials to 11 in its forecasts, increasing the risk a company fails to meet its forecasts after the IPO. Which brings us to…
Solution 4: Use a conservative financial model
The worst possible thing a company can do after its IPO is to surprise investors with a bad quarter. We take that back—two bad quarters are even worse. Companies should be conservative in their IPO forecasts. A company should have a strong point of view about where it expects to be for each of the four quarters after the IPO and work to guide analysts to those figures. It should identify up-front the levers it has available to get back on track if necessary.
Figure 1 shows the stock performance of a company that IPOed in 2012 and missed its second quarter expectations. It will take a long time for this company to win back its credibility with investors. Its valuation is so low most analysts have stopped covering it. Liquidity also remains low, ensuring that many potential owners stay away.
Figure 1: The Consequences of Unpredictability
By contrast, SolarCity (Figure 2) is a company that has done reasonably well at meeting or exceeding quarterly expectations:
Figure 1: SolarCity Hits Milestones, Prepares for Secondary
Solution 5: Choose bankers to get the right post-IPO set up
Choosing bankers for an IPO can be a challenge because few growth company managers have a lot of experience with evaluating investment banks. Moreover, the theme of most banks’ pitches is “we are great and no one else can match us.” There is not a lot of nuance.
As we alluded earlier, we think companies ought to be choosing their IPO bookrunners based not only on size and reputation, but also based on who has the most thoughtful analyst(s) covering the company’s industry, who has access to the types of investors the company wants, and who has the best equity sales teams. There may be other criteria as well, such as whether the bank can assist with raising debt or with other corporate banking functions.
In summary, we think many IPOs in recent years have stumbled on a common set of hurdles. This does not have to be the case. By recognizing how incentives and time horizons differ among the parties involved in the process—and planning accordingly—the IPO can be the start of a major new chapter in the life of a company.