IPO

By Lise Buyer and Leslie Pfrang

It’s been a pretty terrific time in the IPO market this past year. According to Renaissance Capital, through December 15, there have been 271 IPOs in the U.S. in 2014, compared with 221 IPOs a year ago at this time, a volume increase of 23 percent. Thanks to Alibaba’s thunderlizard of a deal, the dollars raised by IPOs this year, $84.2 billion, exceeds last year’s total of $ 54.6 billion by 54 percent. Not bad.

Ah, but look deeper and you will see that actually, roses weren’t coming up everywhere. While 271 IPOs have been completed so far this year, conservative estimates suggest that more than 350 companies filed S-1s, a difference of nearly 30 percent. For every 3 deals that filed and went public this year, at least one did the training, filed an S-1 and didn’t make it to the starting line. Of course, we need to back out those companies that filed late in the year, targeting a 2015 transaction. If we aggressively estimate that 20 fit that pattern, we still have more than 50 that didn’t get the job done as planned. When you consider the time and expense required for an initial filing, that is a big number.

What’s the difference and what price “optionality”?

Bankers and others can be convincing when suggesting companies take advantage of the relatively new option to file confidentially: “Get on file now, then choose your timing later, but you’ll be ready.” Factually correct? Yes. Good for your business, your P&L, your employees or your IPO? Not so fast. Preparing for an IPO too soon is neither a cost free nor risk free option.

The ongoing and elevated expense, distraction, loss of momentum and sometimes embarrassment (Box anyone?) that accompany a premature “go” decision can easily outweigh any timing flexibility benefits.

OK, but IPOs do take a long time. How do we know when to start?

At January board meetings, following the “year in review” appraisals, many private company boards will have the “Is this the year to go?” conversation. (By “go,” we mean schedule a bake-off and hire bankers.) In advance of those meetings, we offer five questions every board should ponder before dropping the green flag:

1) Can your sales and financial teams accurately forecast results for the next few quarters? Did you nail your forecasts last quarter? If answering either of these is anything other than a rock solid “yes”, then take your time. Public investors show no mercy to companies that miss an early quarter. Worse still, the brickbats courtesy of angry investors will be but mere annoyances relative to the grenades your employees, customers and partners may lob through your door if you miss an early public quarter.

2) Do you have the right team in place? No really, are you sure you have the right team in place, not just for the IPO but also for the long term? Step back and take a cold, clear look. The team that helped you get this far may be gifted, battle-tested and composed of friends. That doesn’t mean it’s the team for a fast-growing public company. Public investors want to know that the C-suite in place for the IPO can scale the organization. Newly public companies juggle enough knives when adjusting to the market’s spotlight. There’s little bandwidth for concurrently integrating new senior leaders.

3) Is your business model stable and ready for public scrutiny? Admittedly, there are companies (like Twitter) where even 12 months post-IPO the model remain an enigma. We grant that if your business has north of 200 million active users, investors may cut you some slack. However, for most, a more stable model correlates to a larger crowd of investors rallying around your IPO’s order book. Are you hoping to migrate to a subscription model? Do you see significant price changes or regulatory updates on the near-term horizon? Launch that new model or absorb the changes before you step on the IPO court. In the eyes of investors, a foot-fault of your own making — or because someone else moved the lines in a way you could have predicted — will cripple your stock’s performance.

4) Are you ready for an intense audit? The reason most companies on the IPO trail get thrown off course is because their audits aren’t ready on schedule. Audits won’t be rushed. The drill-down scrutiny on every last decimal point is much more intense when your auditors know you’re preparing for an IPO. The size of your audit team and number of questions will often triple during this process.

5) Is your company really strong enough to support the valuation you expect? For this point, we will excuse readers at health-science companies, but for those selling products and services, size matters. Management teams tend to be optimistic. Bankers, reflecting experience, tend to be conservative. Your finance team may produce a model projecting revenues over the next two years of $X and $Y. By the time bankers have helped you “refine” them, your forecasts (for the sell side analysts) will likely be closer $.7X and $.8Y. Expect similar treatment (in the opposite direction) for your expense projections. It is those banker-adjusted numbers from which your initial valuation range will be determined. Do the exercise in-house to be sure the projected valuation, based off a hacked-up model, will be acceptable before hiring banks and kicking off a process. The more directly you face the conservative forecast reality, the better prepared you will be for the go/no go decision.

Lise Buyer and Leslie Pfrang are partners at Class V Group, a consultancy for firms looking to go public

You may have noticed: The market has been hitting the skids as investors grow nervous over a broadening array of concerns from Ebola to expected interest rate hikes. In fact, as of the market’s close yesterday, U.S. stock indexes had fallen almost 10 percent since the beginning of last week — nearly enough to constitute an official correction.

Things aren’t looking so great for recent tech issuers, either. Despite their highly celebrated IPOs, the shares of Yodlee, Wayfair, Hubspot and even Alibaba are down from their first day “pops,” and that “doesn’t work for IPO investors,” notes Kathleen Smith, a principal of Renaissance Capital, which manages an exchange-traded fund that tracks recent IPOs. “All these IPOs are not showing post first-day performance, which makes it hard for [other, still-private companies] to come out.”

The IPO market is tied to the whims of the stock market, of course, but there are specific reasons that new tech stocks are sinking, says Smith. First and foremost, she says, the issue is linked to who, exactly, is acquiring new shares. “All this year, we’ve had a different set of buyers. It’s not the individual investors or small cap managers who, 10 years ago, might have talked up the stocks they were buying. They aren’t big commission generators for Wall Street, so it’s harder for them to get allocations,” she says.

Smith thinks new issuers have been pricing their shares too richly, too. “It’s all about price discovery,” she says. “Public market investors aren’t tolerating excessive valuations. If companies think they come out at high valuations and watch their shares continue to rise, well, we’re not in that kind of market.”

There’s also the so-called Alibaba effect to consider, notes John Fitzgibbon, founder of the research firm I.P.O. Scoop, which tracks IPOs. He compares the anticipation that surrounded the Chinese e-commerce giant’s September 19 IPO to what happened when both Facebook and Google went public, saying that in all three cases, public market investors have struggled with what next to get excited about. “The circus has left town,” says Fitzgibbon. “Alibaba was a one-day event. And now we’re back to the reality of the stock market, which is performing under the shadow of the [broader] stock market.”

Fitzgibbon characterizes the market’s recent gyrations as a “healthy, sobering pullback.” Stocks are “bought on hype, held in greed and sold in fear. That’s your cycle,” he says, while declining to speculate about whether investors are likely to buy, hold, or continue to sell in the immediate future.

Smith sounds more convinced that continued trouble lay ahead. “Private investors must be feeling nervous,” she says. “I know Box has talked about coming public. I see big companies in the pipeline. And a lot of them, I wonder about.”

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