Initial Public Offerings

An initial public offering (IPO) is the process through which a privately held company issues shares of stock to the public for the first time. Also known as "going public," an IPO transforms a business from a privately owned and operated entity into one that is owned by public stockholders. An IPO is a significant stage in the growth of many businesses, as it provides them with access to the public capital market and also increases their credibility and exposure. Becoming a public entity, however, also involves significant changes for a business including a loss of flexibility and control for management. In some cases an IPO may be the only means left of financing rapid growth and expansion. The decision to go public is sometimes influenced by venture capitalists or founders who wish to cash in on their early investment.

Staging an IPO is a very time-consuming and expensive process. A business interested in going public must apply to the Securities and Exchange Commission (SEC) for permission to sell stock to the public. The SEC registration process is quite complex and requires the company to disclose a great deal of detailed information to potential investors. The IPO process can take as little as six months or as long as two years, during which time management's attention is distracted away from day-today operations. It can also cost a company between $50,000 and $250,000 in underwriting fees, legal and accounting expenses, and printing costs.

Overall, going public is an enormous undertaking and the decision to go public requires careful consideration and planning. Experts recommend that business owners consider all the alternatives first (such as securing venture capital, forming a limited partnership or joint venture, or selling shares through private placement), examine their current and future capital needs, and be aware of how an IPO will affect the availability of future financing.

According to Jennifer Lindsey in her book The Entrepreneur's Guide to Capital, the ideal candidate for an IPO is a small- to medium-sized company in an emerging industry, with annual revenues of at least $10 million and a profit margin of over 10 percent of revenues. It is also important that the company have a stable management group, growth of at least 10 percent annually, and capitalization featuring no more than 25 percent debt. Companies that meet these basic criteria still need to time their IPO carefully in order to gain the maximum benefits. Lindsey suggested going public when the stock markets are receptive to new offerings, the industry is growing rapidly, and the company needs access to more capital and public recognition to support its strategies for expansion and growth.

ADVANTAGES OF GOING PUBLIC

The primary advantage a business stands to gain through an initial public stock offering is access to capital. In addition, the capital does not have to be repaid and does not involve an interest charge. The only reward that IPO investors seek is an appreciation of their investment and possibly dividends. Besides the immediate infusion of capital provided by an IPO, a business that goes public may also find it easier to obtain capital for future needs through new stock offerings or public debt offerings. A related advantage of an IPO is that it provides the business's founders and venture capitalists with an opportunity to cash out on their early investment. Those shares of equity can be sold as part of the IPO, in a special offering, or on the open market some time after the IPO. However, it is important to avoid the perception that the owners are seeking to bail out of a sinking ship, or the IPO is unlikely to be a success.

Another advantage of an IPO is increased public awareness of the company. This sort of attention and publicity may lead to new opportunities and new customers. As part of the IPO process, information about the company is printed in newspapers across the country. The excitement surrounding an IPO may also generate increased attention in the business press. There are a number of laws covering the disclosure of information during the IPO process, however, so business owners must be careful not to get carried away with the publicity. A related advantage is that the public company may have enhanced credibility with its suppliers, customers, and lenders, which may lead to improved credit terms.

Yet another advantage of going public involves the ability to use stock in creative incentive packages for management and employees. Offering shares of stock and stock options as part of compensation may enable a business to attract better management talent, and to provide them with an incentive to perform well. Employees who become part-owners through a stock plan may be motivated by sharing in the company's success. Finally, an initial public offering provides a public valuation of a business. This means that it will be easier for the company to enter into mergers and acquisitions, because it can offer stock rather than cash.

DISADVANTAGES OF GOING PUBLIC

The biggest disadvantages involved in going public are the costs and time involved. Experts note that a company's management is likely to be occupied with little else during the entire IPO process, which may last as long as two years. The business owner and other top managers must prepare registration statements for the SEC, consult with investment bankers, attorneys, and accountants, and take part in the personal marketing of the stock. Many people find this to be an exhaustive process and would prefer to simply run their company.

An IPO is extremely expensive. In fact, it is not unusual for a business to pay between $50,000 and $250,000 to prepare and publicize an offering. In his article for The Portable MBA in Finance and Accounting, Paul G. Joubert noted that a business owner should not be surprised if the cost of an IPO claims between 15 and 20 percent of the proceeds of the sale of stock. Some of the major costs include the lead underwriter's commission; out-of-pocket expenses for legal services, accounting services, printing costs, and the personal marketing "road show" by managers; .02 percent filing costs with the SEC; fees for public relations to bolster the company's image; plus ongoing legal, accounting, filing, and mailing expenses. Despite such expense, it is always possible that an unforeseen problem will derail the IPO before the sale of stock takes place. Even when the sale does take place, most underwriters offer IPO shares at a discounted price in order to ensure an upward movement in the stock during the period immediately following the offering. The effect of this discount is to transfer wealth from the initial investors to new shareholders.

Other disadvantages involve the public company's loss of confidentiality, flexibility, and control. SEC regulations require public companies to release all operating details to the public, including sensitive information about their markets, profit margins, and future plans. An untold number of problems and conflicts may arise when everyone from competitors to employees know all about the inner workings of the company. By diluting the holdings of the company's original owners, going public also gives management less control over day-to-day operations. Large shareholders may seek representation on the board and a say in how the company is run. If enough shareholders become disgruntled with the company's stock value or future plans, they can stage a takeover and oust management. The dilution of ownership also reduces management's flexibility. It is not possible to make decisions as quickly and efficiently when the board must approve all decisions. In addition, SEC regulations restrict the ability of a public company's management to trade their stock and to discuss company business with outsiders.

Public entities also face added pressure to show strong short-term performance. Earnings are reported quarterly, and shareholders and financial markets always want to see good results. Unfortunately, long-term strategic investment decisions may tend to have a lower priority than making current numbers look good. The additional reporting requirements for public companies also add expense, as the business will likely need to improve accounting systems and add staff. Public entities also encounter added costs associated with handling shareholder relations.

THE PROCESS OF GOING PUBLIC

Once a business has decided to go public, the first step in the IPO process is to select an underwriter to act as an intermediary between the company and the capital markets. Joubert recommended that business owners solicit proposals from a number of investment banks, then evaluate the bidders on the basis of their reputation, experience with similar offerings, experience in the industry, distribution network, record of post-offering support, and type of underwriting arrangement. Other considerations include the bidders' valuation of the company and recommended share price.

There are three basic types of underwriting arrangements: best efforts, which means that the investment bank does not commit to buying any shares but agrees to put forth its best effort to sell as many as possible; all or none, which is similar to best efforts except that the offering is canceled if all the shares are not sold; and firm commitment, which means that the investment bank purchases all the shares itself. The firm commitment arrangement is probably best for the small business, since the underwriter holds the risk of not selling the shares. Once a lead underwriter has been selected, that firm will form a team of other underwriters and brokers to assist it in achieving a broad distribution of the stock.

The next step in the IPO process is to assemble an underwriting team consisting of attorneys, independent accountants, and a financial printer. The attorneys for the underwriter draft all the agreements, while the attorneys for the company advise management about meeting all SEC regulations. The accountants issue opinions about the company's financial statements in order to reassure potential investors. The financial printer handles preparation of the prospectus and other written tools involved in marketing the offering.

After putting together a team to handle the IPO, the business must then prepare an initial registration statement according to SEC regulations. The main body of the registration statement is a prospectus containing detailed information about the company, including its financial statements and a management analysis. The management analysis is perhaps the most important and time-consuming part of the IPO process. In it, the business owners must simultaneously disclose all of the potential risks faced by the business and convince investors that it is a good investment. This section is typically worded very carefully and reviewed by the company's attorneys to ensure compliance with SEC rules about truthful disclosure.

The SEC rules regarding public stock offerings are contained in two main acts: the Securities Act of 1933 and the Securities Act of 1934. The former concerns the registration of IPOs with the SEC in order to protect the public against fraud, while the latter regulates companies after they have gone public, outlines registration and reporting procedures, and sets forth insider trading laws. Upon completion of the initial registration statement, it is sent to the SEC for review. During the review process, which can take up to two months, the company's attorneys remain in contact with the SEC in order to learn of any necessary changes. Also during this time, the company's financial statements must be audited by independent accountants in accordance with SEC rules. This audit is more formal than the usual accounting review and provides investors with a much higher degree of assurance about the company's financial position.

Throughout the SEC review period—which is sometimes called the "cooling off" or "quiet" period—the company also begins making controlled efforts to market the offering. The company distributes a preliminary prospectus to potential investors, and the business owners and top managers travel around to make personal presentations of the material in what are known as "road shows." It is important to note, however, that management cannot disclose any further information beyond that contained in the prospectus during the SEC review period. Other activities taking place during this time include filing various forms with different states in which the stock will be sold (the differing state requirements are known as "blue sky laws") and holding a due diligence meeting to review financial statements one last time.

At the end of the cooling off period, the SEC provides comments on the initial registration statement. The company then must address the comments, agree to a final offering price for the shares, and file a final amendment to the registration statement. Technically, the actual sale of stock is supposed to become effective 20 days after the final amendment is filed, but the SEC usually grants companies an acceleration so that it becomes effective immediately. This acceleration grows out of the SEC's recognition that the stock market can change dramatically over a 20-day period. The actual selling of shares then takes place, beginning on the official offering date and continuing for seven days. The lead investment banker supervises the public sale of the security. During the offering period, the investment bankers are permitted to "stabilize" the price of the security by purchasing shares in the secondary market. This process is called pegging, and it is permitted to continue for up to ten days after the official offering date. The investment bankers may also support the offering through over allotment, or selling up to 15 percent more stock when demand is high.

After a successful offering, the underwriter meets with all parties to distribute the funds and settle all expenses. At that time the transfer agent is given authorization to forward the securities to the new owners. An IPO closes with the transfer of the stock, but the terms of the offering are not yet completed. The SEC requires the filing of a number of reports pertaining to the appropriate use of the funds as described in the prospectus. If the offering is terminated for any reason, the underwriter returns the funds to the investors.

IMPROVING THE PROSPECTS FOR A SUCCESSFUL IPO

For most businesses, the decision to go public is made gradually over time as changes in the company's performance and capital needs make an IPO seem more desirable and necessary. But many companies still fail to bring their plans to sell stock to completion due to a lack of planning. In an article for Entrepreneur, David R. Evanson outlined a number of steps business owners can take to improve the prospects of an IPO long before their company formally considers going public. One step involves assessing and taking action to improve the company's image, which will be scrutinized by investors when the time comes for an IPO. It is also necessary to reorganize as a corporation and begin keeping detailed financial records.

Another step business owners can take in advance to prepare their companies to go public is to supplement management with experienced professionals. Investors like to see a management team that generates confidence and respect within the industry, and that can be a source of innovative ideas for future growth. Forming this sort of management team may require a business owner to hire outside of his or her own local network of business associates. It may also involve setting up lucrative benefit plans to help attract and retain top talent. Similarly, the business owner should set about building a solid board of directors that will be able to help the company maximize shareholder value once it has become a public entity. It is also helpful for the business owner to begin making contacts with investment banks, attorneys, and accountants in advance of planning an IPO. In 1997, Evanson recommended using one of the "Big Six" accounting firms based on their trustworthy reputations nationally. Unfortunately, the reputations of these firms took a hit in 2001 and 2002 with a string of high-profile bankruptcy filing. Serious allegations of accounting fraud followed and extended beyond the bankrupt firms to their "Big Six" accounting firms. In 2005, the ranks of the "Big Six" accounting firms had been reduced. The remaining "Big Four" accounting firms are: Deloitte & Touche, Ernst & Young, KPMG Peat Marwick, and PricewaterhouseCoopers.

Businesses interested in eventually going public are advised to begin acting like a large corporation well in advance of an IPO. Although many deals involving small businesses are sealed with an informal handshake, investors like to see a pattern of formal, professional contracts with customers, suppliers, and independent contractors. They also favor formal human resource programs, including hiring procedures, performance reviews, and benefit plans. It is also important for businesses to protect their unique products and ideas by applying for patents and trademarks as needed. All of these steps, when taken in advance, can help to smooth a business's passage to becoming a public entity.

The pace of IPOs reached a peak in 1999, when a record 509 companies went public, raising an unprecedented $66 billion. IPO fever was fueled by "dotcoms," or new Internet-based companies, which accounted for 290 of the initial public stock offerings that year. These fledgling companies went public to take advantage of a unique climate in the stock market, as giddy investors trying to catch the next Internet fad did not demand much in terms of profitability. New Internet-based companies with limited track records were able to use the public markets as a form of venture capital. In fact, new issues of stock in dotcoms jumped an average of 70 percent on their first day of trading in 1999. By the middle of 2000, however, drops in the tech-heavy National Association of Securities Dealers Automated Quotation (NASDAQ) made investors more cautious and dramatically changed the situation for Internet IPOs. Studies showed that 40 percent of high-tech IPOs were trading below their original offering price by that time. As a result, 52 companies decided to cancel or postpone their IPOs in the first six months of 2000. During the first 10 months of 2005, 147 IPOs took place, fewer than took place in 2004 (331) but almost twice as many as there had been in 2003 (75). Business owners must keep a close eye on market conditions and make sure their companies are well positioned and show a strong chance of long-term viability before engaging in an IPO.

see also Direct Public Offering; Private Placement

BIBLIOGRAPHY

"2005 Annual IPO Review" IPOHome, Renaissance Capital. Available from http://www.ipohome.com/marketwatch/review/2005main.asp Retrieved on 15 March 2006.

Draho, Jason. IPO Decision, Why and How Companies Go Public. Edward Elgar Publishing, 2004.

Evanson, David R. "Public School: Learning How to Prepare for an IPO." Entrepreneur. October 1997.

Joubert, Paul G. "Going Public." The Portable MBA in Finance and Accounting. Wiley, 1992.

Lardner, James, and Paul Sloan. "The Anatomy of Sickly IPOs." U.S. News & World Report. 29 May 2000.

Lindsey, Jennifer. The Entrepreneur's Guide to Capital: The Techniques for Capitalizing and Refinancing New and Growing Businesses. Probus, 1986.

MacAdam, Donald H. Startup to IPO. Xlibris Corporation, 2004. O'Brien, Sarah. "Red Tape Said to Strangle Small-Business IPOs." Investment News. 9 July 2001.

Tucker, Andy. "IPO Ahead? Try These Steps to Avoid Hitting Roadblocks." Business First-Columbus. 17 March 2000.

                                Hillstrom, Northern Lights

                                  updated by Magee, ECDI