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How Businesses Raise Funds Through IPOs

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This post is part of a series called Funding a Business.
The Pros and Cons of Having Private Equity Firms Invest In Your Business
How to Raise Funding for a Business

Welcome to the home stretch.

In our eight-part series on Funding a Business, we’ve looked at a variety of options, from crowdfunding to venture capital. Now, for our final tutorial, we’re going to learn about initial public offerings (IPOs).

First you’ll find out what an IPO is, and how the process works from beginning to end.

Then you’ll understand the pros and cons of IPOs as a way of funding a business, and examine some of the key ingredients of a successful IPO.

At the end, we’ll look back over the whole series and put the pieces together. By then you’ll have a clear idea of the range of options available to your business at different stages of its growth. You’ll know which ones make sense for your particular situation, have a clear idea of the potential downsides, and know how to raise money successfully.

1. What is an IPO?

You hear about IPOs in the news all the time, usually involving popular tech firms like Facebook and Twitter, with headlines about how many billions of dollars were raised.

But what is an IPO exactly? Let’s get clear on how the process works, using Facebook as an example.

The company, of course, had grown rapidly after its launch in 2004, and had secured funding first from an angel investor and later from venture capitalists. By 2012, Facebook was so big that it needed access to much larger amounts of funding to continue its growth. The answer was an IPO.

What that meant was that Facebook went from being a private company to a public company. Before the IPO, the company was owned by founder Mark Zuckerberg and other key employees, with the venture capitalists and other investors also taking minority stakes. There was no way for the rest of us to get a piece of it. Now, we can become part owners of Facebook simply by logging on to our brokerage accounts and clicking “Buy.”

Here’s how the process worked. On February 1, 2012, Facebook filed a document with the Securities & Exchange Commission, announcing that it was planning to go public, and giving details of the company and the offer. You can still read it online here. Essentially it says that Facebook planned to sell a big chunk of the company’s shares, and hoped to raise $5 billion.

Investors then analyzed the offer and decided whether they wanted to invest. Wall Street banks like Morgan Stanley and Goldman Sachs agreed to underwrite the deal, meaning that they signed up to sell shares to big investors, and guaranteed to buy any unsold shares. Mark Zuckerberg and his colleagues went on a roadshow, meeting potential investors and talking to them about the deal.

Finally the shares were priced at $38 apiece, and investors bought themin fact, there was so much demand that Facebook ended up raising $16 billion, $11 billion more than it had expected. Facebook shares then began trading publicly on the Nasdaq exchange, with millions of people able to buy and sell pieces of the company every day.

So that’s how Facebook’s IPO worked. The process for other companies is exactly the same, although the amounts raised are usually smaller. The median IPO size is $126 million in the US and $256 million globally, much lower than Facebook’s, but still a substantial amount of funding for any company. The original owners usually retain a stake in the company and stay in control, but the general public ends up owning the majority of the shares. The most popular venue for IPOs is the New York Stock Exchange, followed by Hong Kong and then London.

Now that we’ve looked at the process, let’s consider the pros and cons of IPOs for companies looking to raise capital.

2. Advantages of IPOs

The first advantage should be obvious from the amounts of money we’re talking about, but beyond the money, there are also other reasons to hold an IPO.

Large Amounts of Funding

As we saw with the Facebook example, an IPO can be a great way to raise huge amounts of capital. Angel investors and venture capitalists helped the company grow in the early years, but their investments were dwarfed by the $16 billion infusion when the company went public.

Access to the public markets means access to millions of investors, big and small, and the money they provide can turbocharge a company’s growth and help it reach the next level.

Going Back For More

Remember, the “I” in IPO means “initial.” Although this is your first public offering of stock, it doesn’t have to be your last. Once your company is listed on the stock exchange, it’s easier to go back and raise more capital in the future by selling more shares.

Or, on the flipside, if your company is generating lots of cash and is in a healthy financial position, you can easily buy back shares. Apple has bought back $40 billion of stock in the past year. Being publicly traded gives a company a lot of funding flexibility.

Higher Profile

When you announce you’re going public, you immediately attract media attention. The frenzy over the IPOs of companies like Facebook and Twitter is extreme, but even smaller firms get publicity during the IPO process.

And then after the IPO, when you’re trading as a public company, think about all those investing columns and stock tips, all those analysts and pundits poring over your quarterly earnings reports and recommending your stock as a buy, sell or hold. It’s all publicity, which gives your firm more credibility and can lead to new business.

Your Own Currency

When you go public, shares in your company become a kind of currency. Many public companies give stock to their employees as a reward and incentive for good work, for example. Private companies can do this too, but it’s more attractive when the shares are easily tradable.

Public companies often use their shares as a currency for acquiring other businesses as well. Comcast recently agreed to acquire Time Warner Cable for $45 billion, but is not planning to pay in cashit is offering its own shares as payment. Using stock to fund either part or all of a corporate acquisition is very common, and gives companies the ability to make large deals without having to raise additional funds.

3. Disadvantages of IPOs

Those advantages sound pretty compelling, but like all of our other funding options, there’s a price to be paid. Here are some of the downsides of IPOs:

Expensive and Complicated

When you go public, you’re committing to a very complicated process, and entering a heavily regulated world. You’ll need to hire IPO consultants, lawyers, auditors and underwriters, beef up your accounting department, and create a whole new investor relations team.

You’ll have to make regular, detailed filings with the SEC, meet with Wall Street analysts, hold shareholder meetings, and much more. The average cost of an IPO is $3.7 million, on top of the 5-7% underwriter’s fee, and then it’ll cost $1.5 million a year to comply with all the requirements of being a public company.

Diluted Ownership

When a company goes public, it involves selling large amounts of shares, which of course leaves the original owners holding less. Sometimes this is the aim: you do get handsomely compensated for those shares, after all, and some business owners use IPOs as a way of partially exiting from their company. But the bottom line is that you’ve given up a large stake in your firm, and that means giving up a large portion of future profits as well.

Giving Out Information

Wouldn’t your competitors just love to know every detail of your business, to see exactly where you make money and where you don’t, what your strengths and weaknesses are, and what your corporate strategy is?

Well, when you commit to an IPO, they can do exactly that. Huge amounts of information become public property, and anyone with an internet connection can read your annual report and regulatory filings to find out all the things that a private company likes to keep private.

Answering to Shareholders

Have you noticed how often corporate executives talk about things like “maximizing shareholder value?” That’s because after an IPO, it’s the shareholders who own the business, not the CEO or the chairman. Every quarter, companies have to publish their results and answer to the shareholders for each missed estimate or disappointing sales figure. This can sometimes lead to a short-term focus, with management doing what will make the quarterly targets, not what’s best for the firm’s future.

Shareholders get voting rights, too, and can make decisions at the annual general meeting that you have to abide by. Sometimes powerful shareholders can have a major influence on a company’s strategy, as happened recently with struggling retailer JC Penney.

4. The Ingredients of a Successful IPO

The previous funding options we’ve looked at in our series have been far from easy, but an IPO is probably the most complex of all. It involves dealing with a lot of different parties and restructuring your whole company, as well as making your offering appeal to investors both on Wall Street and Main Street.

Here are some ingredients of successful IPOs.

The Right Team

An IPO is not something you can do alone. For one thing, you’ll need expert lawyers and IPO consultants to help you through the maze of regulations and make sure you structure the offering correctly. And don’t forget the Wall Street underwriters, who’ll price the offering and market it to their clients.

You’ll probably need to strengthen your own management team as well. One of the key things that potential investors look at is the experience and competence of the company’s leadership, so it can be worth hiring a few heavy hitters, particular in key positions like Chief Financial Officer. Try to get not just talented people, but also people with experience of dealing with Wall Street. The good news is that the prospect of an IPO can be a great way of enticing talented staff to join your team.

The Right Financials

Investors will scrutinize your accounts and pick up on any weaknesses, so a successful IPO depends on having everything lined up properly. Many companies seek to boost their balance sheets prior to an IPO by raising additional capital. 

However, you don't want to go too far. Groupon was heavily criticized for using unorthodox accounting measures to show profits in its IPO filing, and ultimately had to revise its filing to admit it was actually making a loss. 

The best approach is for companies to get their accounts in good shape before filing, to be prepared for heavy scrutiny of every single number and every assumption or forecast, and to be prepared to give convincing explanations for any apparent weaknesses.

The Right Approach

Twitter’s IPO last year was very popular with investors, and part of the reason for that was the effort that Twitter executives put into wooing investors, going on an extended roadshow and answering questions about their business and their strategy.

“They paid appropriate respect to the process of having an IPO,” said Pivotal Research Group analyst Brian Wieser in a USA Today article.

Other successful IPOs, like Google’s in 2004, were also built on strong communication with investors. Founders Larry Page and Sergey Brin wrote a personal letter to investors, laying out the company’s core principles and strategies.

The Right Price

This is a tricky one. You might think you want to get the highest price possible, but it’s a little more complicated than that. Remember, the aim is to convince investors to buy, so you need to offer them a discount as an incentive. It’s common for stocks to jump 15 or 20% on their first day of tradingthis is basically a reward for the early investors.

If you set the price too high, there won’t be enough interest in the IPO, and you’ll struggle to sell enough shares and to maintain the price after the IPO. That happened with the Facebook IPO, when underwriters had to prop up the stock to keep it at its offering price of $38.

On the other hand, you don’t want to leave too much money on the table. Twitter stock soared 73% on the first day, which was great for IPO investors, but suggested that the company could have priced the stock higher and raised more money. So it’s a balancing act.

5. What You’ve Learned

As you’ve seen, an IPO is a fantastic way to raise large amounts of money by appealing to a wide section of investors. It gives a company more funding flexibility, a higher profile and a way of attracting and rewarding talented employees.

But it’s also a complex and expensive process that involves giving up a major stake in the company, exposing detailed financial and strategic information, and answering to shareholders and Wall Street analysts for every major decision you make.

In our series, we've moved gradually from options suitable for smaller firms to those for more mature companies. We've looked at self-funding a business, getting a loan and crowdfunding, and at various equity options like angel investors, venture capital and private equity.

What all of these disparate options have in common is this: they all have strong advantages, but significant disadvantages. Whenever you attract funding for your business, you'll have to give something up in return, whether that's money, control, a share of future profits, or something else. 

Our aim in this series has been to give you enough information to understand what each funding strategy involves and what its risks are, to make an educated decision about which one is right for your business, and to be successful in whichever option you choose to pursue.

If you missed any of the tutorials, catch up on the whole eight-part series on Funding a Business from start to finish.

Resources

Graphic Credit: Puzzle designed by SooAnne from the Noun Project.

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