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🩺 Anatomy of an IPO: What happens when a company “goes public”?

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Hey All,

Founders + Funders is back after a late summer break. I hope many of you were also able to take some much-needed time off before we fall back into the swing of things. And, for us in the startup industry, post-Labor Day looks to be a welcome return of something that’s been sorely missing for some time: IPOs.

While the IPO freeze isn’t completely thawed yet, this is exciting news for many employees, especially those at late-stage startups who have been patiently waiting to realize the value of what they’ve created. My colleagues and I at Secfi Wealth have been speaking to many of them as they look to prepare for an impending IPO. But, often, the first question we get is “what happens in an IPO?”

It’s a question you may not ask yourself until you’re finally in it. But even if your company isn’t quite there yet, you may be curious about the process. So, this week, I thought I’d dig in and explain what actually happens when a company IPOs.

🏦 First, what is an IPO and why do companies do it?

An initial public offering (or IPO) is the debut of a company on the big stage of the stock market. It's like opening the doors of a theater for the public to buy tickets. Up until that moment, only a select few, like the backstage crew and VIPs, had access. But now, regular folks can become part-owners of the company by buying shares on public stock exchanges, sharing in the excitement and potential profits.

Not all businesses that exist go public. There are nearly 4,000 companies currently trading on public exchanges in the US (according to the CRSP US Total Market Index). But there are, of course, many more businesses that exist. Think about your local coffee place or your favorite restaurant, or even your favorite online clothing store.

But it’s a common topic among startups and tech companies. Why? Well, usually the reason going public is their goal can fall into one (or more) of the following reasons:

1. They want to raise capital for further expansion

Realistically, public markets are where the money is. The global stock market is worth roughly $100 trillion. While it is becoming more common for startups to stay private longer, and raise later and later rounds (will we eventually see a Series M??), it’s difficult to go on forever — especially if they want to continue seriously growing. And going public is a way to raise more money to expand the business.

Plus, it’s a wider pool of capital to pull from, like sovereign wealth funds and pensions,  endowments that invest in publicly traded stocks. Basically, if a company wants to hit the gas pedal (and many tech startups do), going public is often a foregone conclusion to raise more cash.

2. To generate liquidity for early investors and employees

When startups raise money from VCs, those investors hope that they will eventually make money on their investment (duh). And many VCs are often focused on a certain startup stage: seed, Series A to C, late-stage, etc. Sometimes, they build their business on special expertise at a particular stage of a company's maturity. They make their bets and wait for them to hopefully pay off.

While it’s possible that some early investors could see returns through other means — like seed investors getting paid out during later stage fundraises — an IPO is often the pinnacle of success for early investors. It means they’ve funded/helped build a business that is established and successful enough to attract capital from all over the world.

Employees are also hoping to make money from the company they help build, and probably why you read this newsletter — because you have equity in your company, or have been given the option to acquire it. Like your company’s VCs, you want to see a return on the investment you’ve made into your company.

Going public is the most obvious way to make a return on those investments (and then some, fingers crossed).

3. Greater visibility and PR

Becoming a public company is like unveiling your artwork in a gallery. Before, only close friends and art aficionados got to see your pieces. Now, anyone can walk in, admire your work, and even buy a painting (aka a share).

As much as it’s a money move — raising capital and returning investor capital — an IPO is also a public relations (and marketing) campaign. Not every company is as universally known as a Netflix or an Uber but even for those that are, going public can be seen as a strong move by a well-built and formidable company. Assuming the stock does well, of course.

Going public also comes with rules and regulations intended to create a more level playing field and standardization for all investors.

📑 How does the IPO process work and how do they decide on a price?

The first step to going public is to have alignment between buyers (the market investors) and sellers (the company). I discussed this in an earlier F+F issue. To state the obvious, no company wants to go out there and have it fall flat. But, before I talk about timing, let me give an overview of the nuts and bolts of the process.

First, a company files an S-1 form. This is an SEC registration form that is a requirement for any company that wants to IPO. For all intents and purposes, the S-1 includes all details about the company: finances, management, future business plans, potential risks, and more. It’s essentially a window into the company for any prospective investors. That said, it’s not necessarily exhaustive, but is the first window for many into the company’s operations.

Next, the company, along with investment bankers, meets with potential investors. You may have heard the term “roadshow” thrown around. Not totally unlike a VC funding round, a company’s executive team will start meeting with, or presenting to, investors. Basically, they’re pitching the IPO and getting indications of investor demand and at what price point, so they can price it. This isn't an exact science – it's a mix of market trends, company performance, and investor appetite.

Finally, investors in the IPO receive an “allocation” of stock at the IPO price. Then the stock is listed on the exchange and can begin trading hands between those who have stock and those who want stock. The price moves around to balance supply and demand. Oftentimes newly IPO’d stock “pops” on the first day of trading. In fact, the average first day return from the IPO price has been ~19% historically. That doesn’t mean all IPOs go up, there’s a wide range of potential outcomes, but on average, IPOs are underpriced relative to where they end their first trading day.

Theories about why IPOs are underpriced abound. Some people think underpricing attracts attention, so it’s a form of marketing. Others say it’s compensation to the underwriters for taking risk. Still others claim it's a loose conspiracy to extract value from the selling shareholders. Regardless of the reason, the fact remains, most stocks rise on their first day of trading.

Companies also try to price appropriately because many actually don’t want too big of an IPO pop. The reason being that if the price settles over time, they don’t want it to look like a big fall, or a crash. So, they want to set a price that looks appropriate and has room to move (hopefully up) rather than down.

This is obviously a simplified version but, at its most basic, this is what happens when a company decides to IPO.

🧐 So an S-1 definitely means the company will IPO?

Short answer: no. You’ve probably read about a number of companies that have filed an S-1 over the last year or two. Filing one is just the first step in the process. They do “expire” after a certain amount of time, so many companies will keep re-upping it to keep it up-to-date. Doing so does require time and expense, though, so some companies may opt to not refile if they decide to delay for a while.

This is one reason why, as an employee, the process can seem so murky. There’s no predetermined time table for this. Many companies are understandably hesitant to share too much information with employees until things are set in stone. As an employee, this can feel unnerving. But it’s also why it’s important to figure out your equity as early as you can. Hopefully you’ll have some knowledge that your company is preparing for an IPO, but oftentimes it’s not actually happening until it is, and the first you may hear is your company telling you that it is.

⏰ But is now the time for more companies to IPO?

As I alluded to earlier, there is most definitely a timing aspect to going public. Much of it depends on the market environment. Buyers (investors) and sellers (the company) need to have alignment that an IPO makes sense and that the price is right. One reason the drought has continued, despite stabilization in the stock markets, is due because buyers and sellers were so far apart on price.

Once the bear market hit, there was a lack of demand, aka buyers. Investors became more risk-averse and were much less likely to buy into a new company hitting the market. But, that has shifted somewhat. While the bull market has returned, the valuations of 2021 haven’t. And many companies — and their founders — have been unwilling to accept that hard truth. But Instacart, which may IPO very soon, reportedly started cutting their valuation as early as late last year. So, the first companies you’ll see going out have already swallowed that bitter pill.

The flip side of that coin is, again, no company wants to flop on the public market. Even if they’ve already bit the bullet on a lower valuation, companies want to go when the timing is right. In a down market, of course nobody wants to go. But even as the market has stabilized, many are still waiting for that “right moment.” Look, in my opinion, timing does matter but it can also be a futile exercise. Just like you, as an individual, could have bought a stock at a lower price or sold it for a higher price in retrospect, the “perfect” timing is elusive. But investors are hungry for IPOs and more companies are accepting that 2021 prices aren’t returning soon.

With Instacart, Klaviyo, and Arm being the biggest tech names in some time to file S-1s, they are going to be the ones testing the waters. The hope is that they have timed it right. Because if they are seen as successful — or, even if just one of them is seen as successful — others may follow soon after. At the very least, others may see a template for how to succeed in this market.

But if they don’t, well, the drought could continue.

🧑‍💼 As an employee, what should you know about an IPO?

Again, you likely have an idea if your company is close to an IPO but you may not know definitely until you get a memo from your company that they are actually IPOing.

Still, employees have an exciting role to play, like the dedicated cast and crew members of a movie production. You’ve spent years putting together a production and it’s finally time for public consumption. But for those who worked on it, you’ll also be under embargo for a period of time, where you can’t spill any of the plot secrets. This is known as the lockup period where employees are unable to sell their shares immediately following an IPO.

Typically, a lockup period lasts around six months from the date of the initial listing, but can vary. When your company shares all the information about your IPO, details about the lockup period should be included. Sometimes, they open the window sooner, either for a limited period and/or to sell a limited amount of shares. For example, they may let you know that, although the lockup period still remains, you have a certain amount of time (i.e. two weeks) to sell up to 25% of your holdings.

It’s vitally important to stay up-to-date on communication from your company about the IPO. You don’t want to miss updates like these, or anything else that could impact your decision making.

It’s an exciting time, for sure, but it can also feel like you’re a chicken running around with your head cut off because once that train leaves the station, you’re on the move. And oftentimes, employees haven’t even thought about their equity, let alone created a plan for it, until an IPO has become a reality. While it may feel like a problem, all things considered it’s a good problem to have.

It’s hard to remove emotion from this — both the highs and the lows — so it certainly helps to work with somebody that understands this stuff but can also bring an objective perspective while considering your personal situation. If you are looking for help, feel free to put time on my team’s calendar here.

📖 Is IPO just the technical term for going public?

An IPO is the traditional way to go from private to public company, but there are other routes to having your company stock listed on an exchange. Some companies make their way to the public market via SPACs (Special Purpose Acquisition Companies). These companies are often referred to as “blank check” companies. They are publicly traded shells whose sole purpose is to merge with a private company that wants to be public. SPACs became very popular during the pandemic peak and while they have somewhat fallen out of favor since then, don’t count them out.

Recently, some companies have opted to list directly on exchanges. This can mean they are not raising capital at all, but just moving shares from the bespoke private market onto the standardized public exchanges with all the regulatory and reporting requirements that come along with it. Direct listings allow market participants to directly set a market clearing price rather than relying on banker’s estimates of the value. Spotify, Slack, and Roblox are some of the most high profile companies that opted to list shares directly on exchanges in recent years.

You can also find a bit more info on exit types here.

Right now, we’re at a pretty exciting and crucial phase. With Instacart and Klaviyo filing and preparing to be listed very soon, many in the startup community are likely feeling like a weight is finally lifting off their shoulders. At the same time, we don’t know how they’ll perform so there’s probably a lot of nail biting going on right now too. I’m hopeful that both will do well for all of our sakes.

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