An initial public offering (IPO) is the process through which a privately held company issuesshares of stock to the public for the first time. Also known as "going public," an IPO transformsa small business from a privately owned and operated entity into one that is owned by publicstockholders. An IPO is a significant stage in the growth of many small businesses, as it providesthem with access to the public capital market and also increases their credibility and exposure.Becoming a public entity involves significant changes for a small business, though, including aloss of flexibility and control for management. In many cases, however, an IPO may be the onlymeans left of financing growth and expansion. The decision to go public is sometimes influencedby venture capitalists or founders who wish to cash in on their early investment.Staging an IPO is also a very time-consuming and expensive process. A small business interestedin going public must apply to the Securities and Exchange Commission (SEC) for permission tosell stock to the public. The SEC registration process is quite complex and requires the companyto disclose a variety of information to potential investors. The IPO process can take as little assix months or as long as two years, during which time managements attention is distracted awayfrom day-to-day operations. It can also cost a company between $50,000 and $250,000 inunderwriting fees, legal and accounting expenses, and printing costs.Overall, going public is a complex decision that requires careful consideration and planning.Experts recommend that small business owners consider all the alternatives first (such assecuring venture capital, forming a limited partnership or joint venture, or selling shares throughprivate placement, self-underwriting, or a direct public offering), examine their current andfuture capital needs, and be aware of how an IPO will affect the availability of future financing.
According to Jennifer Lindsey in her book The Entrepreneurs Guide to Capital, the idealcandidate for an IPO is a small-to medium-sized company in an emerging industry, with annualrevenues of at least $10 million and a profit margin of over 10 percent of revenues. It is alsoimportant that the company have a stable management group, growth of at least 10 percentannually, and capitalization featuring no more than 25 percent debt. Companies that meet thesebasic criteria still need to time their IPO carefully in order to gain the maximum benefits.Lindsey suggested going public when the stock markets are receptive to new offerings, theindustry is growing rapidly, and the company needs access to more capital and publicrecognition to support its strategies for expansion and growth.Advantages of Going PublicThe primary advantage a small business stands to gain through an initial public stock offering isaccess to capital. In addition, the capital does not have to be repaid and does not involve aninterest charge. The only reward that IPO investors seek is an appreciation of their investmentand possibly dividends. Besides the immediate infusion of capital provided by an IPO, a smallbusiness that goes public may also find it easier to obtain capital for future needs through newstock offerings or public debt offerings. A related advantage of an IPO is that it provides thesmall businesss founders and venture capitalists with an opportunity to cash out on their earlyinvestment. Those shares of equity can be sold as part of the IPO, in a special offering, or on theopen market some time after the IPO. However, it is important to avoid the perception that theowners are seeking to bail out of a sinking ship, or the IPO is unlikely to be a success.Another advantage IPOs hold for small businesses is increased public awareness, which maylead to new opportunities and new customers. As part of the IPO process, information about the
company is printed in newspapers across the country. The excitement surrounding an IPO mayalso generate increased attention in the business press. There are a number of laws covering thedisclosure of information during the IPO process, however, so small business owners must becareful not to get carried away with the publicity. A related advantage is that the public companymay have enhanced credibility with its suppliers, customers, and lenders, which may lead toimproved credit terms.Yet another advantage of going public involves the ability to use stock in creative incentivepackages for management and employees. Offering shares of stock and stock options as part ofcompensation may enable a small business to attract better management talent, and to providethem with an incentive to perform well. Employees who become part-owners through a stockplan may be motivated by sharing in the companys success. Finally, an initial public offeringprovides a public valuation of a small business. This means that it will be easier for the companyto enter into mergers and acquisitions, because it can offer stock rather than cash.Disadvantages of Going PublicThe biggest disadvantages involved in going public are the costs and time involved. Experts notethat a companys management is likely to be occupied with little else during the entire IPOprocess, which may last as long as two years. The small business owner and other top managersmust prepare registration statements for the SEC, consult with investment bankers, attorneys, andaccountants, and take part in the personal marketing of the stock. Many people find this to be anexhaustive process and would prefer to simply run their company.
Another disadvantage is that an IPO is extremely expensive. In fact, it is not unusual for a smallbusiness to pay between $50,000 and $250,000 to prepare and publicize an offering. In his articlefor The Portable MBA in Finance and Accounting, Paul G. Joubert noted that a small businessowner should not be surprised if the cost of an IPO claims between 15 and 20 percent of theproceeds of the sale of stock. Some of the major costs include the lead underwriters commission;out-of-pocket expenses for legal services, accounting services, printing costs, and the personalmarketing "road show" by managers; .02 percent filing costs with the SEC; fees for publicrelations to bolster the companys image; plus ongoing legal, accounting, filing, and mailingexpenses. Despite such expense, it is always possible that an unforeseen problem will derail theIPO before the sale of stock takes place. Even when the sale does take place, most underwritersoffer IPO shares at a discounted price in order to ensure an upward movement in the stock duringthe period immediately following the offering. The effect of this discount is to transfer wealthfrom the initial investors to new shareholders.Other disadvantages involve the public companys loss of confidentiality, flexibility, and control.SEC regulations require public companies to release all operating details to the public, includingsensitive information about their markets, profit margins, and future plans. An untold number ofproblems and conflicts may arise when everyone from competitors to employees know all aboutthe inner workings of the company. By diluting the holdings of the companys original owners,going public also gives management less control over day-to-day operations. Large shareholdersmay seek representation on the board and a say in how the company is run. If enoughshareholders become disgruntled with the companys stock value or future plans, they can stage atakeover and oust management. The dilution of ownership also reduces managements flexibility.It is not possible to make decisions as quickly and efficiently when the board must approve all
decisions. In addition, SEC regulations restrict the ability of a public companys management totrade their stock and to discuss company business with outsiders.Public entities also face added pressure to show strong short-term performance. Earnings arereported quarterly, and shareholders and financial markets always want to see good results.Unfortunately, long-term strategic investment decisions may tend to have a lower priority thanmaking current numbers look good. The additional reporting requirements for public companiesalso add expense, as the small business will likely need to improve accounting systems and addstaff. Public entities also encounter added costs associated with handling shareholder relations.The Process of Going PublicOnce a small business has decided to go public, the first step in the IPO process is to select anunderwriter to act as an intermediary between the company and the capital markets. Joubertrecommended that small business owners solicit proposals from a number of investment banks,then evaluate the bidders on the basis of their reputation, experience with similar offerings,experience in the industry, distribution network, record of post-offering support, and type ofunderwriting arrangement. Other considerations include the bidders valuation of the companyand recommended share price.There are three basic types of underwriting arrangements: best efforts, which means that theinvestment bank does not commit to buying any shares but agrees to put forth its best effort tosell as many as possible; all or none, which is similar to best efforts except that the offering iscanceled if all the shares are not sold; and firm commitment, which means that the investmentbank purchases all the shares itself. The firm commitment arrangement is probably best for the
small business, since the underwriter holds the risk of not selling the shares. Once a leadunderwriter has been selected, that firm will form a team of other underwriters and brokers toassist it in achieving a broad distribution of the stock.The next step in the IPO process is to assemble an underwriting team consisting of attorneys,independent accountants, and a financial printer. The attorneys for the underwriter draft all theagreements, while the attorneys for the company advise management about meeting all SECregulations. The accountants issue opinions about the companys financial statements in order toreassure potential investors. The financial printer handles preparation of the prospectus and otherwritten tools involved in marketing the offering.After putting together a team to handle the IPO, the small business must then prepare an initialregistration statement according to SEC regulations. The main body of the registration statementis a prospectus containing detailed information about the company, including its financialstatements and a management analysis. The management analysis is perhaps the most importantand time-consuming part of the IPO process. In it, the small business owners mustsimultaneously disclose all of the potential risks faced by the business and convince investorsthat it is a good investment. This section is typically worded very carefully and reviewed by thecompanys attorneys to ensure compliance with SEC rules about truthful dis-closure.The SEC rules regarding public stock offerings are contained in two main acts: the Securities Actof 1933 and the Securities Act of 1934. The former concerns the registration of IPOs with theSEC in order to protect the public against fraud, while the latter regulates companies after theyhave gone public, outlines registration and reporting procedures, and sets forth insider tradinglaws. Upon completion of the initial registration statement, it is sent to the SEC for review.
During the review process, which can take up to two months, the companys attorneys remain incontact with the SEC in order to learn of any necessary changes. Also during this time, thecompanys financial statements must be audited by independent accountants in accordance withSEC rules. This audit is more formal than the usual accounting review and provides investorswith a much higher degree of assurance about the companys financial position.Throughout the SEC review period—which is sometimes called the "cooling off" or "quiet"period—the company also begins making controlled efforts to market the offering. The companydistributes a preliminary prospectus to potential investors, and the small business owners and topmanagers travel around to make personal presentations of the material in what are known as"road shows." It is important to note, however, that management cannot disclose any furtherinformation beyond that contained in the prospectus during the SEC review period. Otheractivities taking place during this time include filing various forms with different states in whichthe stock will be sold (the differing state requirements are known as "blue sky laws") and holdinga due diligence meeting to review financial statements one last time.At the end of the cooling off period, the SEC provides comments on the initial registrationstatement. The company then must address the comments, agree to a final offering price for theshares, and file a final amendment to the registration statement. Technically, the actual sale ofstock is supposed to become effective 20 days after the final amendment is filed, but the SECusually grants companies an acceleration so that it becomes effective immediately. Thisacceleration grows out of the SECs recognition that the stock market can change dramaticallyover a 20-day period. The actual selling of shares then takes place, beginning on the officialoffering date and continuing for seven days. The lead investment banker supervises the public
sale of the security. During the offering period, the investment bankers are permitted to"stabilize" the price of the security by purchasing shares in the secondary market. This process iscalled pegging, and it is permitted to continue for up to ten days after the official offering date.The investment bankers may also support the offering through overallotment, or selling up to 15percent more stock when demand is high.After a successful offering, the underwriter meets with all parties to distribute the funds andsettle all expenses. At that time the transfer agent is given authorization to forward the securitiesto the new owners. An IPO closes with the transfer of the stock, but the terms of the offering arenot yet completed. The SEC requires the filing of a number of reports pertaining to theappropriate use of the funds as described in the prospectus. If the offering is terminated for anyreason, the underwriter returns the funds to the investors.Improving the Prospects for a Successful IpoFor most small businesses, the decision to go public is made gradually over time as changes inthe companys performance and capital needs make an IPO seem more desirable and necessary.But many companies still fail to bring their plans to sell stock to completion due to a lack ofplanning. In an article for Entrepreneur, David R. Evanson outlined a number of steps smallbusiness owners can take to improve the prospects of an IPO long before their company formallyconsiders going public. One step involves assessing and taking action to improve the companysimage, which will be scrutinized by investors when the time comes for an IPO. It is alsonecessary to reorganize as a corporation and begin keeping detailed financial records.
Another step small business owners can take in advance to prepare their companies to go publicis to supplement management with experienced professionals. Investors like to see amanagement team that generates confidence and respect within the industry, and that can be asource of innovative ideas for future growth. Forming this sort of management team may requirea small business owner to hire outside of his or her own local network of business associates. Itmay also involve setting up lucrative benefit plans to help attract and retain top talent. Similarly,the small business owner should set about building a solid board of directors that will be able tohelp the company maximize shareholder value once it has become a public entity. It is alsohelpful for the small business owner to begin making contacts with investment banks, attorneys,and accountants in advance of planning an IPO. Evanson recommended using a Big Sixaccounting firm, since they have earned the trust of investors nationwide.Finally, Evanson recommended that small businesses interested in eventually going public beginacting like a large corporation in their relationships with customers, suppliers, employees, andthe government. Although many deals involving small businesses are sealed with an informalhandshake, investors like to see formal, professional contracts with customers, suppliers, andindependent contractors. They also favor formal human resource programs, including hiringprocedures, performance reviews, and benefit plans. It is also important for small businesses toprotect their unique products and ideas by applying for patents and trademarks as needed. All ofthese steps, when taken in advance, can help to smooth a small businesss passage to becoming apublic entity.The pace of IPOs reached a new peak in 1999, when a record 509 companies went public, raisingan unprecedented $66 billion. IPO fever was fueled by "dotcoms," or new Internet-based
companies, which accounted for 290 of the initial public stock offerings that year. Thesefledgling companies went public to take advantage of a unique climate in the stock market, asgiddy investors trying to catch the next Internet fad did not demand much in terms ofprofitability. New Internet-based companies with limited track records were able to use thepublic markets as a form of venture capital. In fact, new issues of stock in dotcoms jumped anaverage of 70 percent on their first day of trading in 1999. By mid-2000,however, drops in thetech-heavy Nasdaq made investors more cautious and dramatically changed the situation forInternet IPOs. Studies showed that 40 percent of high-tech IPOs were trading below theiroriginal offering price by that time. As a result, 52 companies decided to cancel or postpone theirIPOs in the first six months of 2000. The crash of Internet IPOs demonstrates the need for smallbusiness owners to keep a close eye on market conditions and make sure their companies arewell positioned and show a strong chance of long-term viability before engaging in an IPO.