Initial Public Offerings
Initial Public Offerings
A company that is in the process of selling shares to the public for the first time must navigate a minefield of competing interests.
Introduction
A company that is in the process of selling shares to the public for the first time must navigate a minefield of competing interests.
The purpose of going public is to raise equity capital and this involves diluting current shareholders in exchange for an inflow of cash. Naturally, shareholders do not want to give up part of their ownership interest at a bargain price. At first glance, this would argue for trying to maximize the valuation of shares in public offerings but doing so carries significant risks in the long run.
It is considered embarrassing for shares to open for trading on public markets below the offering price. It can also be demoralizing for employees, especially those who have received substantial stock-based compensation, because the media often equates a falling stock price with a business that is failing. No company wants to repeat the outcome of Birkenstock’s recent initial public offering.
The best way to navigate these treacherous waters is for current owners to take great pains to disclose as much as possible about the business without compromising its competitive position. Although Warren Buffett took control of Berkshire Hathaway as a public company, his approach to issuing Class B shares in 1996 serves as an example for companies in the process of going public.
It is helpful to consider the players involved in the initial public offering process to better understand their point of view which will always be driven by incentives.
Current Owners
Owners of the business prior to a public offering will view the event based on whether they have a short or long term mindset. Owners who are participating in the offering will naturally want to get top dollar for selling their shares, especially if they are exiting entirely. Owners who are not participating but are looking toward the exit in the near-term will also prefer a high valuation. On the other hand, owners who plan to hold their interest indefinitely should prefer a price that adequately compensates for the dilution of their interest while attracting other long-term oriented owners.
The composition of a company’s board of directors will determine which owner constituency dominates the process. If short-term oriented owners are dominant, they will seek to “dress up” the company as much as possible. Tactics might include using aggressive accounting methods and inventing non-GAAP metrics that present the business in the best possible light, even if the metrics are not particularly relevant to the long-term prospects of the business. It is important to note that this need not involve outright fraud. Presenting a rosy portrait within the confines of securities regulation is par for the course on roadshows.
If the board is dominated by long-term oriented owners, it is more likely that the roadshow and securities filings will be candid. Owners who view the IPO process as an opportunity to raise capital to expand the business should not want to attract new shareholders who will quickly become unhappy. There is no point in painting a rosy portrait if the reality is more challenging. In extreme cases, existing owners could even lose control of the company if the offering is large enough and new owners decide that they were seriously misled.
The bottom line is that long-term owners are concerned about how the company will use the equity capital that is being raised and the types of owners who they will partner with. This is a rare mindset because there are few truly long-term oriented owners and boards do not always represent owner interests very well.
Executive Management
If a company is managed by its founders, there is little difference between the outlook of current owners and executive management. However, when founders and other large owners have delegated management to executives, it is important to examine their compensation structure to understand incentives and agency problems.
Top management should hold significant amounts of stock outright with stock-based compensation structured with a multi-year vesting period. There should be large ownership requirements relative to the executive’s cash compensation.