This article will cover the stereotypical journey of a high-growth private company to an eventual public listing on the stock market, and discuss the reasons behind an IPO.
Picture an entrepreneur with a business idea which she believes people will be willing to pay for. She founds a startup, hires a few employees, and begins developing the idea so that it can eventually be brought to market and generate revenue for the company. Of course, there will be expenses; her employees will have to be paid, an office space must be rented, equipment must be purchased. Additionally, it is probable that the business will not breakeven or turn profitable for some time, if at all. Perhaps the entrepreneur has saved up enough capital (money) to meet these initial expenditures. However, chances are that if she wishes to continue growing her business, and her costs continue growing, she will eventually reach the point at which she needs to think about financing. Some of her options include taking on debt through a bank loan, or presenting her business idea to a venture capital firm. If granted a loan, the entrepreneur has to make regular interest payments to the bank and finally pay back the principal amount (the actual loan). Generally, the riskier her business proposal is or if she does not put up collateral, which are assets that the bank can seize should she default (i.e., not pay back her loan), the higher the interest rate, because the bank needs be compensated for taking on more risk.
Venture capital firms, on the other hand, don’t make loans. Instead, they seek to become part-owners of her company, so that they can eventually sell their stake when the value of her firm increases as a result of the company delivering more revenue, more profit and owning more assets. In other words, the venture capital firm purchases an equity (ownership) stake which is typically around 20% from the founder in exchange for providing both capital and aid to the entrepreneur such as providing expert advice and important business connections. Throughout this entire period, the company remains private, which means that the public can neither view its financial information nor acquire ownership. The entrepreneur and other owners may decide that this should remain so, perhaps they wish to retain complete control of the company or avoid regulatory scrutiny by authorities such as the SEC (Securities and Exchange Commission, which polices capital markets).
However, let’s assume the owners feel that the company has not yet fulfilled its potential and that there is significantly more growth ahead, which would translate into more profit for the investors down the line should they decide to sell their stakes. Neither private sources of funding nor the profits generated by the company suffice to finance this continued growth and expansion. As a result, the owners decide to tap the public markets and take their company public, which is typically done via an initial public offering (IPO). IPOs are typically considered once a company reaches a valuation of approximately €1 billion. They are a time-consuming and expensive process, primarily because a large amount of paperwork is involved and the fees of experts and underwriters (investment banks) must be paid. In essence, in an IPO, new shares (ownership units) are created from scratch and sold to the general public, which includes both retail investors (normal citizens with savings to invest) and institutional investors (insurance companies, pension funds, hedge funds, etc.). In addition to this, once a company is public it is forced to abide by strict rules set by various regulators, such as being required to have a board of directors and publish quarterly reports.
The initial sale of new shares to the public, the proceeds of which fill the company’s coffers, is described as the primary market. Any transactions between buyers and sellers past this point are conducted in the secondary market. Considering that normally only institutional investors with deep pockets transact in the primary market – when buying shares as a retail investor you are not actually funding the company; you’re simply exchanging ownership with a seller. IPOs can provide a very large amount of capital to companies that they can utilise to finance rapid expansion. For instance, the IPO of Alibaba Group in 2014, which is a diversified Chinese e-commerce giant, brought in approximately $25 billion. Nonetheless, IPOs can be attractive to the owners for other reasons. Firstly, they allow the owners to sell their shares at the market price, which typically exceeds the private value of their shares prior to the IPO. This can be incredibly lucrative: Rickard and Bjorn Oste, who co-founded Oatly Inc., a company which produces oat-based food products and which went public yesterday, netted a paper profit of $562 million from the IPO. Secondly, once public, a company benefits from the liquidity of the stock market which refers to the ease with which ownership can be traded back and forth. If the owners of private companies wish to sell their stake, they typically have to undergo a long and difficult process to find a suitable buyer which is a problem that a public listing solves. Furthermore, this liquidity makes the use of stock options more viable which are incentive plans that grant stock to employees subject to certain conditions.
Thirdly, a company’s stock acts as a currency. For example, when one public company acquires (buys) another company (either private or public), it can offer both cash and its own stock to that company. This is particularly advantageous when the stock of the acquirer trades, for whatever reason, at a large premium (more than it is really worth), as this gives the acquirer a more ‘valuable currency’ to transact with. As a side note, IPOs are typically completed in the hot phases of a bull market (when stock prices are rising quickly across the board) to take advantage of investors’ positive sentiment and higher risk tolerance as this could drive a higher valuation. This is why record numbers of IPOs in a specific year could point to a ‘market top’, which refers to a point in time in which the stock prices of companies have been bid up too high, losing their correlation with the fundamental conditions of businesses, which could precipitate a market downturn. Coincidentally, the second half of 2020 featured an extraordinary and speculative recovery from the Coronavirus-induced March crash and there was a record number of IPOs in the U.S. that same year. Far less companies go public in a bear market (when stock prices are weak or falling) as investors are skittish and risk-averse during this time – when of course they should take advantage of the existing discounts.
Back to the entrepreneur. As the part owner of a public company she has several choices before her: cash out completely; cash out in part or over time; or do neither and use her influence to drive the company on to greater achievements. From the perspective of a retail investor, IPOs are excellent because they allow us to actually invest in companies whose products we love; just make sure you are investing, not speculating.
Johan Lunau – 21/05/21