IPO is not a Four Letter Word
In late December 2014 I was talking on the phone with the CEO of one of our promising portfolio companies. During that conversation I began to sense that he believed his company value would cap out in the several-hundred-million-dollars range, and that their most likely outcome would be to get acquired by a larger company. I started wondering why he was assuming that, and asking why he wasn’t thinking bigger and wasn’t thinking about an eventual IPO. Given the market opportunity ahead of them I certainly felt that his company had the potential to be a strong, stand-alone, publicly traded company.
His first response to my question was telling: “That’s a great question. I’m not sure I understand what an IPO really is.”
Then it dawned on me: He is part of an entire cohort of Founders/CEOs who have come of age professionally at a time of hostility toward the notion of taking a technology startup company public. Many of these CEOs aren’t sure what an IPO is. Maybe they understand it in broad conceptual strokes, but they may not understand it in detail. They aren’t sure how it works mechanically or what the pros and cons are for their business. Then they hear public figures who they respect telling them that going public is a bad idea, and it removes any motivation they may have had to try to understand it. As a result, they continue to assume that an acquisition is the only possible outcome for their company, and they set their sights to this (typically lower) outcome goal. I believe that this lowered goal-setting is very damaging for the CEO and their company’s potential to grow and scale successfully, because it creates a set of limiting beliefs in the mind of the CEO and management team that are subconscious and insidious, and therefore difficult to address head-on. As a result, the beliefs eventually manifest as reality and limit the growth potential of the company, and therefore it’s ultimate value. Our thesis at Subtraction Capital is that, regardless of what path they ultimately take (IPO, acquisition, stand-alone private), most Founders/CEOs should build their business as if they are eventually going to be a publicly traded company in order to drive to the best outcome.
What is an IPO?
[Readers who already know should skip this part.]
Let’s start by addressing the basics of an Initial Public Offering, or IPO.
At its core, an IPO is the same as other financing rounds for a company. The company is selling shares of its stock to investors, with the intention of using the proceeds from that sale to fuel growth in its business. Rather than call this financing round by a name like “Series X”, it is called an Initial Public Offering because it is the first time that the company is selling shares of its stock to investors on a publicly traded stock exchange like the NASDAQ or the New York Stock Exchange (NYSE). These two exchanges have some differences, but for purposes of this discussion they behave almost exactly the same. The first public purchasers of the company’s shares are typically mutual funds, who have large pools of capital and relationships with investment banks who introduce them to companies that are getting ready to sell shares on the public market. This is one of the primary roles of investment bankers in the IPO process: To introduce the CEO to the investors who will initially buy the company’s publicly traded shares, and also to help the company tell the story in the way the public market investors want to hear it. Note that the bankers are also referred to as “underwriters” because they are actually buying and selling shares of the company’s stock as part of the IPO process, and therefore taking some risk along the way.
Publicly traded stock exchanges are, by definition, available to the general public. Because of this, the Securities and Exchange Commission (SEC) – the part of our Federal Government whose mission is “…to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” – requires the company to disclose a huge amount of information in public documents, so that public market investors have the information they need to make an informed decision about investing in the company. These disclosures are first presented in a “prospectus”, which is often referred to as an “S1″, the technical document name code used by the SEC. The prospectus contains, among other things, a description of the business, an analysis of the risks that the business faces, and a presentation of the audited financial results of the company for several prior years. Generally speaking, other than a qualitative discussion about the business goals and objectives, the prospectus does not focus on predictions about what will happen in the future. It mainly summarizes what has happened in the past.
One of the important technical things that happens during the IPO process is that the preferred stock the company issued to its private investors typically converts to common stock, and most convertible debt instruments and warrants to purchase shares are either converted or exercised into common stock. This reduction in stock classes and contingent instruments has the effect of making the company’s capitalization table much simpler. [Bill Gurley of Benchmark recently mentioned this decalcification of the cap table as an important benefit to companies that go public, which I tend to agree with]. Investors, employees and others who own shares in the company prior to the IPO have to sign a “lock-up” agreement where they agree not to sell their publicly tradeable shares for some time period after the IPO (typically 6 months). This is usually a requirement of the underwriters so they can make sure that the stockholders who invested in the company as a private entity don’t flood the market with shares they want to sell until the stock price has stabilized. Those investors have typically been invested in the company for years already by the time it goes public, and have substantial unrealized gains that they would like to get access to, so they are eager to sell when they have liquidity. [If this topic interests you, Henry Ward of eShares has started a great discussion about how different investors on a cap table have different motivations and time horizons.]
Why don’t Founders/CEOs aspire to take their company public?
There are many reasons why a Founder/CEO may not be thinking about an IPO as an attractive long-term goal for their company. This is not a comprehensive list, but I think sufficient to illustrate the point.
1) Not understanding what an IPO is
I addressed that above…
2) Fear that going public would create a lot of cost and overhead to running their business in the form of legal disclosures, financial reporting, Sarbanes Oxley rules, etc.
Unfortunately some of this is true, but it should not deter you. Being a public company does subject you to an increased set of reporting requirements. When Sarbanes-Oxley (or “SOX”) was enacted in mid 2002, it was a big incremental step in the level of reporting and scrutiny that a publicly traded company had to bear. For companies that went public in and around this time (like PayPal), this created an enormous amount of work because the act was so new. Lawyers, bankers, accountants, SEC reporting managers at companies, and even the SEC itself were not yet familiar with the new regulations, and it was extremely challenging to understand how they applied to specific circumstances. But that was over 10 years ago. Fast-forward to 2015 and everyone involved in the IPO process or SEC reporting for a public company knows what these rules are and how to apply them. Yes it is still work to do it, but there are much more complicated things you’ll have to do if you want to build a company that is strong enough to go public, so you can handle this.
3) Fear that being a publicly traded company will force a focus on short term results at the expense of long-term, innovative thinking
I think the best way to address this is the way Keith Rabois addressed it in his recent conversation with StrictlyVC: Look at the counter-examples. Apple, Google, Amazon, Intel. The list could go on. These are some of the most innovative companies on the planet. Can you innovate and think long term when you are a public company? Absolutely. [Keith’s comments are great and he also addresses some of the advantages of being a public company in that same interview.]
4) The market turmoil of 2008-2009 spooked a lot of millennials
My sense is that this “No IPO” sentiment is strongest among CEOs in the millennial generation. The financial market crisis of 2008-2009 may have had an interesting impact on them by causing them to shy away from focusing on what was happening in the stock market. Maybe this was a positive thing, as I generally feel like people are overly fixated on (and therefore distracted by) daily gyrations in the public markets. Whatever the reason, it feels like this generation is not as interested in what the public stock market has to offer them, so they haven’t invested much time in developing a good intuition about how it works.
5) Respected public figures say it is a bad idea
When an entrepreneur hears a successful and respected capitalist (venture or otherwise) say that going public is a sign that a company’s best days are behind it, they have a tendency to believe it. But if there is one statement I would use to counter this sentiment, it is this: Think for yourself. To say that going public is categorically a bad idea just can’t be right. To be clear, I am not “Pro IPO”. At Subtraction Capital we believe that venture capital is a boutique trade. Innovations are, by definition, new. Every market is different. Every founding team has its own strengths and weaknesses. In totality, all of those things intersect in a very unique way for every company. To be dogmatic about anything in such a sea of nuance is dangerous. At the very early stages of company formation venture capital can be more like a factory model. At the late stages you pretty much just need capital to scale. But in the Series A, B and C stages, where you are really doing the heavy lifting of company building, you need a highly nuanced approach to building your company and mapping its arc. Every company should be evaluated differently. Is IPO the right goal for your company? I can’t answer that, but you should at least be asking yourself that question vs. just assuming that it is not.
Why not setting a goal of going public can be bad for your company
Regardless of why a Founder/CEO doesn’t think that an IPO is an attractive outcome to aim for, I think that this perception creates a set of limiting beliefs in the mind of the CEO and the management team. These limiting beliefs manifest themselves in a variety of ways, many of which actually reduce the ability for the company to scale quickly and withstand the pressure it would have to endure to prepare for and become a publicly traded company. Ultimately this can lead to a self-fulfilling reality that the company can’t scale toward going public, thus reducing the companies strategic alternatives and therefore it’s long term value.
I believe the most common manifestations of these limiting beliefs are:
1) Companies don’t hire a management team that is as strong as it should be
For many Founders/CEOs this one is difficult to calibrate, because realizing this may require they have worked with a team of people who have taken a company public. I feel fortunate that I was lucky enough to have a front-row seat during PayPal’s IPO process. Yes that was 13 years ago, but those memories are so vivid it feels like only yesterday. PayPal’s leadership team was incredible and is perhaps on it’s way to being legendary. Is is also a great example because many of them are now public figures so you can almost get a sense for what it might have been like. Imagine yourself sitting in a conference room with Peter Thiel, Max Levchin, Roelof Botha, Reid Hoffman, and David Sacks having a discussion about preparing to go public. Close your eyes and imagine what that might be like. As individuals those guys are now some of the most powerful creators in Silicon Valley, yet at that time all of their collective energy was harnessed together. PayPal’s IPO was incredibly difficult because of the shifting regulatory landscape I mentioned above (SOX), the disruption PayPal was causing in the banking system (which banks and regulators were fighting), eBay’s attempts to snuff out PayPal, investor’s memories of the then-recent dot com bust and, of course, the tragedy of September 11th 2001 (only five months before PayPal’s IPO). I doubt that a lesser team could have prevailed against the same backdrop of circumstances. I do believe that a lesser team can take a more typical company public in a more typical market environment, but let’s hold this team up as an example of a gold standard that we should try to aim for. And to be fair, it wasn’t just the leadership team inside of the company either, it was also the team of investors who had assembled around the company to help support it.
Now think about the leadership and investment team that you are assembling around your company. How does it compare?
If you really thought that going public was an option for your company, you would start constructing a team early on that can scale the company with the velocity and rigor required to go public. I’m not suggesting that you have that team in place by the time you raise your Series A, but it should be taking shape by the time you raise your B and likely be fully formed by the time you raise a C. If you don’t think you have the context to evaluate this, get out there and start meeting people of the appropriate caliber so you can see what they walk and talk like. Introductions like these are one of the most important services we provide to our Founders/CEOs. Your investors should do the same for you.
2) Companies don’t scrutinize their business model as thoroughly as they should
If you think that getting acquired is the only option for your company, you might be content to have a goal of “growing”. That might be enough for you. But if you are thinking about being a big, stand-alone, public company, you wouldn’t stop there. Right now the current market sentiment seems to be that a company needs to have annual revenue in the $100m range, and profitable, in order to be around the right scale to go public. Think hard about your business model and your market. Can you chart a credible path to profitably generating that kind of revenue in the next 3-5 years? [If it takes you 10 years to get there you are probably growing too slowly to go public.] If not, are there things you want to start changing?
3) Companies don’t build a strong enough foundation early on that can support hyper-growth and scale
Everyone knows that a chain is only as strong as it’s weakest link. The same adage holds for companies. Early on it is important to invest heavily in product development and distribution, because those are the areas that get the company started. Your product needs to be excellent, and your distribution strategy needs to be clever and highly scalable. But if your product is good enough to get swept up in the vortex of hyper-growth, you will quickly have to start investing in infrastucture to support an organization that is growing fast. If you don’t plan for this early enough, it can really hurt your ability to scale, thus limiting your potential outcome.
One of our CEOs whose company is experiencing this now recently shared a realization that “…the risk in the business has suddenly shifted from hiring too quickly and running out of cash, to hiring too slowly and getting crushed by the wave of customer demand (by delivering a poor customer experience).”
To draw an analogy, let’s say that product development (engineering, QA, product management) and distribution (marketing, sales) are the vital organs in the body. In order for these vital organs to function well at a fast pace and at scale, they need a robust set of supporting systems to deliver the oxygen (capital) and nutrients (resources) they need to do their work effectively and efficiently. We don’t want the vital organs to be distracted by poor infrastructure when we’re putting heavy demands on them – it is painful for them and it slows the entire organism down. The supporting functions I’m referring to are things like Finance, Legal, Recruiting, HR, Building Operations, IT, etc. To be clear, just because I’m calling these “supporting” functions, does not mean they are less important. They are “supporting” because their customer tends to be someone who is inside of the company. To the extent that their roles help everyone in the company operate at peak performance, they are extremely important, especially when the company is scaling quickly. At times I see companies hiring supporting functions later than they should, and as a result their vital teams go through periods of distraction that are caused by poor infrastructure, which slows the entire company down. So look around your company and think about what things would start breaking if you were growing really quickly and wanted to head toward an IPO. If you ultimately want to handle the velocity required to go public, you need to have strong foundational teams that support you.
4) Venture Capitalists want to invest in companies that they believe can go public
Venture Capitalists run a business, just like you. They have a product (a financial service) and they have customers (their Limited Partners, or “LP”s). Their customers want them to make as much money for them as possible, and then return their capital so they can redeploy it into other investments. For them to use an IPO lens as a means of evaluating an investment makes sense in this context. If a VC thinks that a company can go public someday, it implies that they think the company can get very big and that they can eventually get liquidity to return to their LPs. If you have a limiting belief that your company is not a candidate for going public, you are going to betray that belief in a broad manner of subtle ways, from the way you are building your company to the way you talk about it when you meet with a potential investor. The best VCs (the ones you want to invest in your company) are experienced and will pick up on these clues, and they will not invest. By not getting a strong investment partner to help provide the capital and advice you need, you start to limit your companies ability to scale quickly and therefore it’s outcome potential, and your limiting belief begins to manifest as reality. Our company has been on the market of custom research and academic writing services for more than 10 years.
I want to reiterate that I am not “Pro IPO”. I believe that every company is unique and it’s desired arc should be the one that is best suited to the specific team, product and market in question. What I am suggesting is that Founders/CEOs should be aware of the subconscious assumptions they are making about the potential future outcomes of their business, because in the long run they will manifest as reality. Weigh the pros and cons of being public in the context of yourself, your team, your company and the market you are playing in. Make a conscious and informed decision based on your unique set of circumstances. Don’t just believe what you hear and read. It is also worth noting that I don’t think you should focus on this until your company has achieved some amount of product/market fit and is starting to scale. But when that happens, I believe you should at least consider building toward an IPO as a desirable outcome for your business. Whether you ultimately decide to go public or get acquired doesn’t actually matter; by intentionally setting your company up with the team, business model and infrastructure that it would need to go public, you are likely to drive to a bigger outcome than if you had subconciously set your sights lower.