Alibaba. Visa. Facebook. Beyond being household names, what do all of these companies have in common? If you’re thinking about how they all have valuations greater than the GDP of countries like Greece, you’d be right. However, these companies also share the title for some of the largest IPOs… ever. In the venture capital business, we invest in companies with the ultimate goal of seeing them flourish. From a financial standpoint, the measuring stick for a flourishing company is an exit. Exits can take the form of a merger and acquisition or the sought after initial public offering (IPO). As an investor and limited partner, you are likely already well versed in these exit strategies and their basic principles. Even so, this article aims to take a deep dive into the process of an IPO and, hopefully, provide even deeper insight into the important considerations our portfolio companies must make before tackling such an undertaking.
The IPO process begins with the “bake-off”, an interview process whereby the company searches for investment banks that will act as the underwriters. Once the underwriting group has been selected, organizational meetings and due diligence is performed by the underwriting team. Just like in VC, the due diligence step is incredibly important so that underwriters can ensure that there’s nothing wrong with the company in question and is ready to be publicly listed. Due diligence also provides the underwriters time to consolidate all of the necessary information to draft a prospectus: a document that contains key information about the company, which is later shared with potential investors.
It is also during this time that bankers begin to file for SEC Registration by drafting an S-1 document. The S-1 is a thorough report of the company’s plans, business, governance, compensation structure, etc. and is required by the U.S. Securities and Exchange Commission (SEC) for approval. Upon meeting all of the requirements of the SEC, the company can then file a “public S-1” for the world and their competition to see. Upon receiving SEC approval, the company and its underwriters begin a mass marketing campaign known as a “road show”, circulating materials and information to potential investors while travelling around the country for meetings and presentations. Over the course of a company’s “road show”, the underwriters keep track of investors who have sent “indications of interest”, compiling what is referred to as an “order book”. Using the “order book”, bankers and management will meet and decide on the final offering price.
Once the price is set, interested investors are allocated shares, which are then sold. To do this, the company first sells all of the allocated shares to the underwriters, who then immediately sell shares to the institutional investors according to their allocation. While anyone can technically participate in an IPO, large institutional investors are usually the first to get a piece of the pie since their long-term holding behavior is favorable. Typically, the IPO price is discounted at approximately 15% so as to mitigate any risks, and investors will typically expect the stock to trade at a premium to the IPO price. Following the IPO sale, the first trading day soon follows. By the time of the first initial trade, a company will have already selected and applied for which exchange they would like their shares to be traded on. Of course, IPOs do not always yield returns for investors. Snap Inc.’s stock, which IPOed for $17 and was then traded at a price of $24, was going for as low as $5 in 2018 and is still trading at only $21. Snap Inc. is a perfect example of how big name shares can quickly drop in value after the hype subsides. However, IPOs can be a source of enormous returns for all stakeholders involved, especially early investors such as VCs.
At this point, it goes without saying that an IPO is an incredibly time consuming and costly process. Not to mention the large amount of responsibility companies must be prepared to take on when accepting money from institutional investors and the general public. So why undergo an IPO in the first place? For starters, an IPO provides a company with a large influx of capital, opening the doors to the entire investing public and making future raises a lot more accessible. Additionally, the increased transparency and stability that is required of a public company can help with negotiations for better credit borrowing terms down the line. An IPO also provides greater exposure to the general public, which can help attract more skilled employees and management personnel. On the other hand, IPOs can bring with it some drawbacks. Loss of control, too much transparency, high cost, rejection of IPO price, and risk of legal/regulatory action are all challenges that a company may face before, during, and/or after an IPO.
At DRADS Capital, we will help to ensure that our portfolio companies are ready for an exit when the time comes.