Going Public vs. Being Acquired

We occasionally hear from our readers with interesting questions that they have and that they would like us to answer & write about. This post and the few that follow will be on one such topic that has come up a few times from readers in the past: taking a company public and better understanding an IPO. In this mini-series, we’ll discuss when/why a company may IPO, advantages/disadvantages of an IPO versus being acquired, factors that make a company ready for an IPO, and the IPO process itself.

Moreover, because the goal of Requests for Startups is to support entrepreneurs, we’ll begin to more formally solicit ideas for interesting topics we should write about in the future. Please submit your ideas here, and as always, we would love your feedback on this mini-series, and the newsletter more generally, via email.

Why/when to IPO

Going public via an IPO or being acquired are two mechanisms by which startups seek liquidity. Timing of an IPO depends on industry. Typically, a company chooses to go public when:

1. The company has made significant progress often in the form of sustainable profitability, solid revenue growth, or other material milestones. There has been substantial analysis done that demonstrates what companies look like at the time of their IPO by reviewing their S-1 filings — here are many excellent SaaS benchmarks.
2. Existing investors, founders, and employees are seeking liquidity and would prefer additional financings via the public markets, which may allow for higher valuations that mean less dilution for existing shareholders. As expected, public excitement and high demand for the stock can drive up its valuation. Various studies (like this one) seek to explain the valuation premium that IPOs engender over acquisitions in other ways — one such study suggests a 22% markup, and others (like this one) indicate there is no such premium in certain scenarios.

In some cases, a company may require significant growth capital, but if the company already has a high valuation, private market investors may not find the opportunity to invest as appealing as earlier stage companies that have greater potential upside, thus making an IPO an effective fundraising strategy. The IPO market, however, is volatile — IPO volume varies from year to year. This year has been a slow IPO year, meanwhile we’ve seen companies raise private capital at very high private valuations, like Uber and Airbnb. Pitchbook reports that we’ll see the fewest number of IPOs in 2016 since 2009 after the market crash. Companies exploring both an IPO and a potential acquisition engage in a “dual-track” process typically led by investment bankers.

A potential acquirer may take interest in a company around the time of an IPO, as an IPO implies that the acquirer may need to pay a significant markup on the company’s valuation after the IPO. In this sense, the IPO market and the private M&A market are coupled: if there are lots of IPOs happening, acquirers are more keen to make acquisitions, as they may lose the chance to pay favorable prices if the seller is no longer privately held.

Advantages of going public:

1. Potential to raise money at a higher valuation than on the private market, as described above.
2. A public company can effectively use its stock to make acquisitions. Using stock can be more effective for a public company because their stock is liquid, while as a private company it is not, and thus may be less palatable to a potential seller.
3. Public visibility can allow for additional, favorable fundraising later on the public market. This is great should the company need to raise additional growth capital. This also gives the company additional credibility with potential customers and employees.
4. Liquidity for founders, investors, and employees — the ability to sell shares on the public market.

Disadvantages of going public:

1. Significant legal & disclosure obligations and information provided to shareholders. This also applies to the company’s officers and directors, who can be heavily scrutinized.
2. Required disclosure of specific types of transactions, including stock option practices and executive compensation.
3. The process is both expensive and time consuming for the management team. We’ll discuss the process in a later post.
4. Restrictions on stock sales. There is typically a 6-month lock up after the IPO to protect the stock against price volatility as it’s new to the public market. This means shareholders can’t sell their stock in this time window. There is also much regulatory scrutiny around stock sales for fear of insider trading. The SEC’s Rule 144 restricts the amount of stock that can be sold by major shareholders in any 3-month period to prevent major price fluctuations or impact on liquidity. It also may look bad to the public market if a significant stockholder is dumping a lot of stock.

Advantages of M&A:

1. If the deal is all in cash, the company can get immediate liquidity instead of relying on the public markets. However, in a stock deal, SEC Rule 145 is similar to Rule 144 and applies to the company that is acquired if they will be receiving stock in the acquiring public company. In other words, the acquired company has similar restrictions on stock sales as they would have in the event that their company went public.
2. Potentially less market risk. In a cash deal, the seller knows what they’re getting. In a stock deal, the company that is getting acquired still bears risk via volatility in the public market price of their parent company’s stock, but this is usually less volatile than a brand new post-IPO company.
3. None of the regulatory and administrative burdens of running a public company: Disclosures, forecasts, analyst calls, shareholders, etc.

Disadvantages of M&A:

1. The company could command a higher valuation in the public markets.
2. Their upside is fixed, based on the purchase price, or is no longer in their hands, if they’re receiving stock in the parent company. If a company IPOs, they control their future upside via control & management of the company going forward.
3. Liquidation preferences could mean less upside for the founders than for early investors. Preferred stockholders will make most of the proceeds if the liquidation preferences exceed the fair market value of the company. At an IPO, preferred stock is usually converted to common stock so the liquidation preferences are nullified, which transfers upside to the founders.
4. Less control, affinity, and/or agency. Employees may be required to stick around after the acquisition but they no longer run their own company. The parent company may choose to shutdown or repurpose the acquired company’s product — Microsoft shutdown Sunrise, Dropbox shutdown Mailbox, and Twitter recently announced it is sunsetting Vine, for example.

We welcome any questions or feedback via email. In our next post, we’ll discuss factors that make a company ready for an IPO as well as the IPO process.

Source: The Entrepreneur’s Guide to Business Law, 4th Edition by Constance E. Bagley and Craig E. Dauchy. This book is an excellent resource on this topic.

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