The IPO Process and Associated Valuation Considerations
The IPO Process and Associated Valuation Considerations
The process of taking a company public can be arduous and can present many unique challenges. A typical IPO process timeline can often range anywhere from four to 12 months, depending on many factors, including company size. The rationale for companies deciding to “go public” also varies. A few common reasons include:
- Gaining the ability to access capital markets in an effort to raise money
- Creating the flexibility to acquire companies with publicly traded stock as the currency
- Attracting and retaining talented employees through employee benefit and stock option plans
- Being able to diversify and reduce investor holdings
- Providing liquidity for shareholders
- Potentially enhancing a company’s reputation
While considering the benefits associated with pursuing a public offering, companies also need to address potential negatives or common opposing arguments to “going public.” The main argument against an IPO is the increased expenses associated with the process. In nearly all cases, the costs associated with an IPO are significant and generally include underwriting fees, legal and professional fees, accounting fees, and management opportunity costs for time spent.
There are also a series of ongoing fees associated with public filing requirements and earnings releases. Loss of control can become an issue; however, shareholders and management teams can often avoid this issue by structuring the share offering terms accordingly. Loss of privacy is also important to consider, as extensive financial information will be made available to the public, including officers’ compensation and the company’s global marketing position and strategy. Finally, public companies are exposed to increased scrutiny and regulatory requirements related to company performance and management. Shareholders expect to realize steady growth and expect to see results in-line with analyst estimates.
After properly weighing the pros and cons of taking a company public, the next steps in the process revolve around the preparation and filing of a registration statement with the U.S. Securities and Exchange Commission (SEC) and the ultimate sale of shares in the open market. These general steps are summarized in more detail below.
1. Board Approval
After management properly discusses and proposes the idea of “going public” with the company’s board of directors, the IPO process can begin. In this stage, it is common for management to present the company’s past performance, objectives, and strategy going forward.
2. Assemble an IPO Team
The next step will often incorporate the assemblage of an IPO team. The team needs to be committed to the significant time requirements and will often include members of management, a securities lawyer, company counsel, underwriter, and an accounting firm. It is also common for the company to assign a chief financial officer who has prior experience with the IPO process.
3. Reviewing and Restating the Financial Statements
A critical component to the IPO process includes a review of recent historical financial statements and, if necessary, a restatement in order to comply with U.S. Generally Accepted Accounting Principles (GAAP). Since audited financial statements must be included within the company's registration statement, this step may be time consuming, particularly if any problems associated with accounting infrastructure, financial disclosure, or overall transparency of the company's financial statements require correction. In addition, the company should start preparing interim financial statements to expedite the registration process, as they may be required depending on when the registration statement becomes effective.
4. Selecting an Investment Bank
Given the prominent role an investment bank has within the IPO process, it is prudent for management to diligently select an investment bank and formalize an arrangement through a letter of intent. The letter of intent will contain the investment banking fees, the size of the offering, the price range, and other parameters.
5. Drafting the Registration Statement
Form S-1 serves as the basic registration form for IPOs to be sent to the SEC and is the principal focus throughout the process. Form S-1 is composed of three main aspects: regulatory, marketing, and liability protection. There are several items that are required in the registration statement, including:
- Overall business and management structure description
- Industry trends and risk factors
- Management discussion and analysis
- Disclosure of officers’ compensation and any related party transactions
- Capitalization summary
- Audited financial statements
- Discussion on the impact of dilution to existing shares
- Intended use of public offering proceeds
- Dividend policy
6. Due Diligence
The investment bank and audit firm perform detailed due diligence investigations in conjunction with the drafting of the registration statement. These examinations focus on the company’s performance, market position, competitive dynamics, risks, objectives, suppliers, and customers, among other items. It is common during the due diligence process for changes to be made to the registration statement prior to submittal to the SEC.
7. SEC Review
Once the Form S-1 is filed with the SEC, it is reviewed by the staff of the SEC’s Division of Corporation Finance, which often consists of an attorney, an accountant, and a financial analyst. The SEC has 30 days to perform its initial review and provide comments on the registration statement, which may result in various follow-up questions and suggested revisions. Once the SEC declares the registration to be “effective,” the company may proceed with the sale of securities to the public.
8. Syndication and “Road Shows”
It is common for companies to send a preliminary prospectus to interested investors in an effort to form a syndicate of investment banks that may participate in the process of selling portions of the overall offering. Although a draft prospectus can be distributed prior to receiving feedback from the SEC, companies are encouraged to wait and incorporate any and all changes that arise from the SEC review process.
In order for potential investors to learn more about the company, the underwriter will arrange meetings referred to as “road shows” that are attended by the company’s key management team. Management will often make a short presentation highlighting the key selling points, industry trends and risks, competitive environment, and overall performance. It is at this point that potential investors are invited to ask questions directly to management about the prospectus and the business overall.
9. Determining Price and the Offering
By the time the registration statement has been filed after making the appropriate edits from the SEC, the company and its underwriter have generally agreed on the tentative price and amount of securities being offered. The determination of the price is often based on a number of different factors, including the performance of the company, analysis of cash flows, guideline company multiples, current market conditions, and even feedback received during the syndication and “road show” procedures. The company’s shares are typically on the market for three to five days after the pricing of the offering before the closing date.
Valuation-Related Issues May Arise During the IPO Process
The overall IPO process is laborious and can present a number of complicated issues. There are often a number of valuation-related issues that arise during the process that can pose both financial reporting and/or tax reporting concerns.
The most common valuation-related issue relates to an estimation of the filing company’s share price during the reporting periods leading up to an IPO. Aside from abiding by Fair Value standards, there needs to be a supportable “story” behind changes in share price over the life of the company. Valuations of the share price need to properly incorporate pre-IPO transactions and the rights and privileges of the company’s equity, which could vary significantly across different equity classes (e.g., common shares vs. preferred shares). Further, relying upon expected IPO prices established during the syndication or “road show” process as an estimate of value prior to the ultimate IPO may significantly over-estimate pre-IPO prices. The value of a private company before and after a successful IPO can vary dramatically due to changes in risk, marketability, and other factors.
As previously discussed, the registration statement filed with the SEC requires up to three years of audited financial statement information in accordance with U.S. GAAP. As a result, any equity-based compensation awards, embedded derivatives such as preferred stock or debt-related conversion features, or other similar instruments that are linked to the value of a company’s underlying equity, need to be reported at Fair Value within the audited financial statements. Accordingly, retrospective valuations may be required in order to comply with the Fair Value standard and the increased scrutiny associated with the financial statements. Moreover, the valuation of such instruments and the company’s underlying equity may be an arduous process in and of itself given the prevalence of complex capital structures in pre-IPO companies due to prior capital infusions (e.g., multiple financing rounds involving private equity funds, venture capital investors, mezzanine debt lenders, etc.).
There are also a number of tax-related implications that could arise if pre-IPO valuations are not adequately performed. Section 409A of the Internal Revenue Code regulates the treatment of nonqualified deferred compensation for federal income tax purposes. As a result, there can be material tax implications to recipients of equity-based compensation awards that were issued at prices below Fair Market Value. Therefore, retrospective valuations may be required in order to confirm whether or not any transactions related to such awards were performed at a price below Fair Market Value.
In addition to providing supportable assessments of equity and related-instrument valuations for a company pre-IPO, there are a number of additional valuations that may be required in order to comply with the audited financial statement requirement of the registration statement process. Some examples include determining supportable Fair Value estimates for identifiable intangible assets, goodwill, or contingent consideration assets and/or liabilities that may have come about from past or new acquisitions. Similarly, any third-party investments or financial-related instruments must be presented on a Fair Value basis within the financial statements.
Preparing for the IPO
As the U.S. market continues to attract IPO candidates, a number of private company management teams looking to “go public” will soon face the numerous challenges that arise during the IPO process. In order to prepare for such a task, it is important for the management team to surround itself with experienced professionals who have the expertise of working through the IPO process. This will better prepare management to face any unforeseen issues that may arise.
This is an updated version of an article originally published in the Fall 2013 issue of the Stout Journal.
- According to the SEC’s Regulation S-X, companies are required to include balance sheets for the prior two fiscal year-ends, while income statements and statements of shareholders’ equity are required for the prior three fiscal years. There are certain exceptions to these requirements based on the nature of the company and the tenure of its operating existence.
- The complexities of valuing a private company with a complicated capital structure and/or prior to an IPO are outside the scope of this article. However, the issues that arise during these valuations are meaningful enough to have spawned considerable attention in the marketplace; so much so that the American Institute of CPAs has created an accounting and valuation guide dedicated to the topic: “Valuation of Privately-Held-Company Equity Securities issued as Compensation.”