A (Detailed) IPO walkthrough

What is an Initial Public Offering (IPO)?

It’s the first time that a previously private company can sell its shares to “the general public” (mostly institutional investors at first).

Usually the company issues around 20–30% of its shares (free float), though this varies by industry, company stage, and so on.

Most investors consider it riskier if the company only makes available a low number of shares — but if the company is “hot” enough. (e.g. Snapchat with its 15% offering).

Why Go Public?

You probably associate IPOs with tech, healthcare, or biotech start-ups, but they apply to a much wider range of companies than that.

You see everything from mature business service companies to energy firms to transportation firms going public, but they get far less attention than hot tech start-ups (see Renaissance Capital for updated lists).

Most companies go public to:

Raise capital for expansion efforts or to pay back debt.

Provide an exit for existing investors — whether the company is PE-owned, VC-backed, or owned by a small group of individuals or a single person.

Get an acquisition currency — most private companies’ stock is not highly valued, so it is much easier to acquire other companies using stock once they’re public. And raising debt to do deals can be easier once you’re public as well.

Reward employees — Making employees work crazy hours for 5–10 years is tough to pull off, but the lure of an IPO that will make them all wealthy is a great incentive for them to stick around.

Market themselves — Especially for lesser-known companies in “boring” industries, an IPO is a great way to increase prestige and attract new investors, partners, and customers.

And sometimes there are technical reasons as well: in the US, for example, the “500 shareholder rule” used to require any private companies with more than 500 shareholders to publicly disclose their financial statements…

…So they might as well just go public and get the other benefits — this was one of the key reasons why Google decided to go public in 2004.

The Downsides of Going Public:

Some companies don’t want to go public (or can’t go public) because:

· They have to give up control and answer to shareholders with quarterly earnings reports.

· They aren’t VC or PE-backed and therefore don’t need an exit.

· They’re already highly profitable and have no need for cash.

· Compliance costs are much higher as a public company due to legislation like Sarbanes-Oxley.

· They’re too small — it’s tough to go public if you have under $50 million in revenue.

However that is not the case recently, with the likes of Facebook, Snapchat going public with the founders still maintaining control over the company.

In Facebook:

Mark Zuckerberg maintained far more control than typical founders by splitting the stock into voting and non-voting shares, by controlling the Board, and by selling almost nothing along the way.

In Snap:

The company issues voting shares with less powers to its pre-IPO investors and nonvoting shares to IPO investors. With the founders retaining classes of shares with 10 voting rights to 1 share. This allow founders to retain control of the company with little to no dilution as new shares are issued to investors.

Who Decides if the Company Should Go Public?

In most cases, it’s up to the Board and major shareholders.

So if a private equity firm owns a company and they need to achieve an exit in year 4 or 5 to get acceptable returns, they might push for the company to go public (or get acquired) around then.

And it has traditionally worked the same way with venture capital firms that often end up controlling tech start-ups.

The IPO Process, Part 1 — The Pitch

In most cases, bankers from many firms have been speaking with the company in question and developing relationships for years — so they’re likely to know the company’s intentions well in advance.

If not, the company itself will reach out to bankers and invite them in to pitch for the business.

This is when you, the banking analyst or associate, get to stay up all night crafting 100-page pitch books and hoping you’ve remembered to dot all your i’s and cross all your t’s.

Afterwards, the company selects banks for book runner roles and picks other banks to be co-managers, based on its relationships with them, their pitches, and what the banks have done for them in the past.

Other factors might include banks’ IPO track records and their reputation and relationships with institutional investors.

Most IPOs have at least 1–2 banks as book runners and then a few more as co-managers;

Part 2 — The Kick-Off Meeting

Everyone involved in the IPO — company management, auditors, accountants, the underwriting banks, and lawyers from all sides — attends this meeting.

You spend the day discussing the offering, the required registration forms, figure out who’s doing what, and determining the timing for the filing.

And then you have similar all-hands meetings like this throughout the rest of the process.

It’s actually quite boring for you as a junior banker attending these because you don’t participate too much — you’re mostly just there to take notes.

Ongoing Due Diligence

After that initial kick-off meeting, all the bankers, accountants, and lawyers involved need to do a lot of due diligence on the company to make sure that their registration statements are accurate.

Common tasks here include:

· Customer Calls — This is probably the most interesting task, because sometimes you hear crazy / interesting things from customers that you’d never learn about otherwise.

· Industry / Market Due Diligence — You’ll have to research the market, speak with experts, and figure out where it might be headed in the future.

· Legal and IP Due Diligence — Lawyers handle most of this — it consists of reviewing contracts, registrations, and other documents.

· Financial and Tax Due Diligence — Accountants do most of this and comb through historical financial statements, tax returns, and so on, and look for irregularities.

Part 3 — The S-1 Filing

The end result of this entire process, which might take months, is the S-1 Registration Statement (names vary in other countries).

This is where all the juicy information comes out — historical financial statements, key data, who’s selling shares and how many they’re selling, the company overview, risk factors, and more.

When Facebook filed its own S-1, there were so many visitors that the government’s site actually crashed.

The company waits 30 calendar days for comments from the SEC (or equivalent organization in other countries), and the legal team responds to everything once they hear back.

Note that the company never lists projected financial statements in its S-1 — they might have projections internally, of course, but they’re not part of the registration statement.

Part 4 — Pre-Selling the Offering

Once the S-1 is filed and the team is working through revisions, the company can hold a pre-IPO analyst meeting where they educate bankers and analysts on the company and “teach” them how to sell it to investors.

It can also start speaking to investors and issue a “red herring” (preliminary prospectus), which bankers draft (similar to the S-1, but shorter and more focused on sales).

Companies are encouraged to wait until the SEC responds to the S-1 with comments before printing the red herring.

This document may omit the offering price, underwriting discounts / commissions, discounts / commissions to dealers, the amount of the proceeds, and so on — it’s just about selling the company’s story to investors.

Once this document is in place, pre-marketing starts and usually lasts around 2 weeks.

Research analysts meet with institutional investors 1 on 1 and tell them about the company, and sales teams at banks maintain close contact with investors and figure out what they think — do they like the sector? The company itself? What price will they pay?

Based on feedback from these meetings and their own internal valuations, banks set a price range for the offering.

With some companies this can be enlightening; with Facebook it was quite boring because the company had already been actively traded on secondary exchanges long before the IPO, so everyone knew what the rough price range would be.

Picking Investors to Market To

A bank doesn’t just pick the investors randomly — they select firms based on criteria like:

· Brokerage Commissions — If you’re making tons of money from certain institutional investors, they’ll be high on the priority list.

· Interest and Track Record — If the firm never does tech investments, for example, the bank may just skip showing them tech IPOs.

· Potential Brokerage Fees — If a bank wants to win more business from institutions in the future it might show them a “hot” IPO as a favor.

The equity syndicate, sales, and road show management teams handle this process.

Amending the S-1 Filing

After all this pre-marketing work is done, banks amend the S-1 filing with a revised price range based on feedback from investors.

Sometimes there are dramatic shifts in the price range, but it’s more common to see small moves in one direction or the other.

Part 5 — The Roadshow

And now for the fun, exhausting part of the process: management gets to travel all over to meet with investors and market the company for 1–2 weeks.

Sometimes management teams make themselves very open and accessible and go out of their way to win over investors and answer questions.

This process is extremely important because orders are also taken at this time — investors can state how many shares they want and what price they’re willing to pay.

Management gets daily updates on what the orders are looking like, and the banks involved in the process all try to one-up each other by claiming that they won the biggest orders from investors.

During this time, bankers keep getting more and more feedback from investors and may further revise the price range.

It’s a tricky balancing act because no one wants to leave money on the table — bankers want a higher share price so they can earn higher fees, shareholders who are selling obviously want a higher price, and the company wants as high a price as possible to maximize their cash proceeds.

But if the price range is set too high, bankers may have to revise it downward, which sends a negative signal to the market.

During this time, the company might also increase or decrease the number of shares it’s offering — but if it does that too much (in either direction) it may be taken as a negative sign because investors might think the company doesn’t know what it’s doing with the proceeds.

There’s been a lot of debate over both the size of Facebook’s offering (as a percentage of the company, small, but very high in absolute dollar terms) and the price.

Relatively few companies worldwide are actually worth more than $100 billion USD, sand many observers think that Facebook may be overvalued at its current price range and that growth could be flattening out.

Part of what makes Facebook’s valuation so uncertain is that its future business might be far different from what it looks like today — advertising revenue might not even be significant in 5–10 years and payments, mobile, or something else entirely might take over.

Part 6 — The Pricing Meeting

Once the roadshow is over and the order book is closed, the management team will meet with bankers and decide on the final price of the deal based on the orders received.

If a deal is over-subscribed, the company will price the company at the high end of the range and will do the opposite for under-subscribed deals.

Sometimes management will deliberately price the company at a lower price (leaving some money on the table) so the stock can trade up on the 1st day of trading — always a positive indicator to the market.

Usually companies that tank after the 1st day of trading have a hard time recovering and getting back to their initial price.

Part 7 — Allocation

Once the deal is priced, the syndicate team of the banks will allocate shares to investors.

While banks try to allocate to investors who will be long-term holders of the stock, banks may be biased at times to reward investors that generate the highest brokerage commissions (e.g. hedge funds who are trade very actively).

The syndicate team usually works overnight to allocate the deal.

Part 8 — Trading

Once the deal is allocated and everyone has their shares, the stock starts trading and “the general public” can buy and sell shares.

So, How Much Do Banks Earn From All This?

IPO fees typically range from 3–7% depending on the size of the company, how well-known it is, and how much extra work and risk banks have to take on to sell it.

Yes, you read that correctly: for a $100 million offering, banks could potentially make $7 million (now you really understand why they make so much money).

But for extremely large offerings the fee drops, and it drops even further when it’s “hot” and everyone wants to be involved.

For bankers, being involved in the largest tech IPO ever is worth far more than even a substantial increase in fees because they market themselves based on their track records.

IPO Timeline

Professionals to be engaged

1. Lawyers

2. Investigation accountant

3. Auditor

4. Industry researcher

5. Tax advisor

6. Brokers

7. Marketing / PR Promoter

Due Diligence Committee (DDC)

a) Directors of company

b) Lawyers

c) Investigation Accountant

d) Auditor

e) Lead Broker/Manager