5 Things Founders Need to Know Before an IPO

Getting through the arduous IPO phase is a whole other challenge. It’s the final hurdle before going public. But how do you get there and what should you do to prepare yourself for the process? This information isn’t something that you just come across in the ordinary course of business, and in the hectic early days of a startup, it probably doesn’t even seem relevant.

Below is a guide that can help you understand and prepare for an IPO.

IPO definition

What is an IPO?

An IPO is an initial public offering. This is where shares in a private company are offered to the public in a new issuance of stock. Before undergoing the IPO, a company is considered to be private. Shareholders in private companies might include the founders, family and friends, venture capitalists and any other early investors.

Committing to an IPO is a big step for a private company to make. Ultimately it can provide a company with a lot of new capital, but there also comes with it regulation and transparency requirements that need to be adhered to. The credibility that a public listing provides can help with things like negotiating terms of new funding making raising capital less expensive.

Typically, an IPO happens when a company has achieved significant growth and has a high enough valuation. Valuation isn’t the only feature to consider during preparedness for an IPO, having a proven track record of profitability and possessing strong fundamental KPIs are also important qualifiers.

The shares in the private company are priced based on underwriting typically performed by a major investment bank. This bank then attempts to sell a proportion of the new shares to institutional investors within its network. The remaining shares are offered up for public sale.

Once a company has ‘gone public’, the previously held private shares are converted to public shares, and their value becomes the trading price.

During this time the original private shareholders may sell some or all of their shares, releasing profits. Alternatively, they may continue to hold them in hope of further gains.

When the time is right, IPO

Founders can think about going for an IPO from day 1, it may actually be the sole goal of the founders. But that’s different from being ‘ready’ for an IPO. Founders and leaders within the business may be up to the task and anxious to go public, but in many ways it’s the business as a whole, on a more granular level, that needs to be prepared and ready.

The key teams within the business, and the people that occupy key roles, also have to be up to the task and able to go through the process of the IPO.

The business and its employees are the elements of IPO readiness that are more within the control of founders. This is not so of the wider market conditions which pose an important part of timing consideration when it comes to an IPO for a startup.

When it comes to a potential IPO there are a number of factors to consider before taking the decision to pursue it.

· Is the business resilient and scalable?

· Do teams within the business (legal, financial) have the ability and skill to complete the processes required of a public company?

· Are the market conditions favourable?

In order to get to the point where an IPO is possible, the business will already have undergone substantial growth. This isn’t the end of the growth journey though, founders and business leaders will need to have a plan for growth that incorporates an IPO and forecasts the next 2, 5 and 10 years, potentially even further. An IPO can unlock a large amount of capital for a business and there needs to be a plan of what to do with it. An IPO cannot be completed without one. Once a company becomes public, shareholders will start holding it accountable, and a company that rests on its laurels will find itself with some very unhappy shareholders, this makes having a scalable business plan a priority.

If an IPO is on the radar for a startup, the business needs to be in a stable condition, with a plan and the know-how to scale the business and be successful post IPO. There will be no ‘perfect’ time when it comes to market conditions, but once the company has a solid foundation, opportune conditions can be seized upon.

Growth and profitability, a fine line

Growth is something that public investors will be looking for. Investors aren’t looking for opportunities for their capital to stagnate, there are plenty of savings accounts and government bonds around for that.

The growth potential of a company is an indicator of the possible success it might go on to have. Understanding growth will mean something different to each investor. As they complete their due diligence, they may consider revenue growth or other metrics such as subscriber or booking growth amongst others.

However an investor looks for value in a share, they will need to see that there is potential for growth in future, otherwise they will invest elsewhere. Growth should be baked into the business plan of a startup considering an IPO in such a way that the public is convinced.

Likewise, when it comes to profitability, this is also an element of the business that needs to be taken much more seriously post IPO. Before going public a startup can be valued based on potential market opportunity and the promise of profits to come. However, once businesses mature, they are expected to generate profits and have a plan to increase them.

Some high profile tech stocks went public without being profitable, so it can be done. There will need to be a convincing and tangible plan of how to get from IPO to profitability though. Investors will look at various metrics and KPIs as a way to assess profitability. These might include free cash flow, EBITDA and net income. For companies looking at an IPO these metrics, and those indicating growth will need to be assessed and the impact on them of following the business plan will need to be considered.

Check your market

This might sound obvious, but founders need to know that there is a market out there capable of sustaining your business after an IPO has been completed. Otherwise, what’s the point in going through the IPO process in the first place?

There is no perfect time to go public. There is no benchmark that says companies should go public after achieving £50m in revenue. It really depends on the individual business and the industry and regions it operates in. The key to being IPO ready is the availability of a market opportunity that can sustain the growth planned over the next 2-5 years.

If the honest answer to this is no, then a startup needs to re-think the viability of, and motivations for, completing an IPO. Before going public businesses are able to be more dynamic and are able to reallocate resources more freely, so it’s much better to consider the market conditions before an IPO than it would be afterwards when the options would be more limited.

Finding out that market opportunities are limited is not the end of the world, there are moves that can be made to diversify the offer to reach a wider audience. Such as looking at markets in other countries or pivoting the business model towards areas of business with greater margins and growth.

What happens during an IPO is that the incumbent business model is sold to the public market, and potential shareholders need to be convinced of its sustainability. If the market to carry out the business plan doesn’t exist, or if the business model is in transition as a reaction to this, shareholders will not be convinced. This will impact the IPO share price. These issues need to be sorted out before the IPO and the growth plan for the business needs to be realistic, profitable and capable of achieving growth goals in the short, medium and long term.

Reduce and remove singular risks

By singular risk, we mean something discreet that has the potential to threaten a business. This could be a particularly large contract with a customer or an over-reliance on one supplier.

When businesses mature and look to go public there should be a certain level of risk diversification across the operation. This isn’t just good practice, it will be a market expectation and by not considering it this will be factored into the IPO share price and will have a negative effect.

For example, Zynga, a mobile app game designer, went public based on the success of its game Farmville. However, this relied entirely on Facebook hosting it, and had Facebook decided to remove access for the game, a huge driver of revenue (and major part of the business plan) would have been lost at a stroke.

To avoid falling into this situation founders should focus on avoiding these singular risks. This may not always be possible, especially while undergoing rapid growth, but being aware of them and planning for how to progress through to a lower risk situation, should be a key consideration of founders.

Investors look at public companies in terms of size, scale, financial forecasting and growth potential. Large singular risks threaten all of these metrics. Avoiding them should be an important concern for all founders considering an IPO.

In Summary

We’ve covered what an IPO is and how business models can impact an IPO share price. There are some important considerations when making the step from private to public company.

Founders need to start thinking of their motivations for going through an IPO early on. If this is where the business is headed, then the business model can be tailored to make the process easier. The sooner this is done, the smoother the IPO process will be. If founders are able to run the company as if it’s public before an IPO, this will allow internal processes and reporting cycles to be established ahead of time. This might highlight areas of the business that need improving, or parts of the offer that need to be differentiated.

Ultimately, public investors are demanding and expect listed companies to have a plan to achieve growth and profitability. If these aren’t realised, the board will be held accountable and eventually the share price will see an impact. The sooner that businesses can establish the internal workings and business models needed of public companies, the more likely they will be successful.

The IPO process is a big milestone (and hurdle) in any startups growth journey. During this time it’s a certainty that you’ll need to partner with third-party professionals for advice.

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