Initial Public Offerings (IPOs)

Street Of Walls Investment Banking Technical Training

In this Initial Public Offerings (IPO) chapter we will cover six key topics:

Initial Public Offerings Overview

Involved Parties
Listing Considerations
Valuation Methodologies
The Greenshoe Option
Registration Statement

Initial Public Offerings Overview

An Initial Public Offering (IPO) is the means by which privately held companies transition into publicly
traded companies. Hence the phrase, taking a company public. From an organizational standpoint,
taking a company public is one of the biggest decisions a companys board of directors will make in the
companys lifetime. The transition from a privately held entity to a public one has a substantial impact
on how the company operates.
An IPO is also one of the most tedious projects an investment banker will work on for a couple of
reasons. For one, it requires coordination across a large team of involved parties: the companys
management, the companys legal counsel, the companys auditors, underwriters, and the
underwriters legal counsel will all have a view on issues that impact each participant. This group of
stakeholders must reach a consensus on every decision for the process to smoothly progress through
each step. Also, the IPO process is tedious because of the vested interest of board members,
company management, and company employees. The companys board and management are likely
not acting only as fiduciary to shareholders, but participating in the process as shareholders too. Thus
the board and management have a responsibility to act upon the best interest of all shareholders, but
in some situations, this may run contrary to what is best for the board member or management
executive individually. This agent-principal problem can lead to a lot of possible complications in the
IPO process.
Why Choose to Go Public?
There are several reasons that companies might decide to undergo an IPO, including:

Providing liquidity for a parent company or employees: Existing shareholders (generally

employees, management, and board members, and often venture capital investors), use an
IPO to monetize all or some of their equity stake. Without the IPO, it is often difficult to
translate the paper value of the shareholders equity positions into cash, because it is difficult
to sell the positions without a market for trading them.
Access to the capital markets: Proceeds raised through an IPO are not solely for the benefit
of selling shareholders. Proceeds can be used to fund organic growth and expansion, retire
existing debt, or expand capacity in other capital markets. All other things being equal, public
companies have more financing alternatives available, including bank debt, senior debt,
hybrid/mezzanine capital, or equity-linked alternatives.
Establishing a currency for growth: As states, public companies have more funding
alternatives available to manage operations and growth. One example of this is that publicly
traded stock can relatively easily be used as a currency to fund acquisitions without using
cash or incurring additional debt. The acquiring company simply exchanges its shares for the
equity shares of the company being acquired. This not only fortifies the acquirers balance
sheet, but also enables the target shareholders to participate in the anticipated upside of the
combined company.
Establishing a transparent value for the enterprise: Following a successful IPO, the
companys board and management team will have a readily available measure with which to
determine the value of the company, as well as compare it with that of other companies.

Additionally, the board and management can now measure value creation over a defined time
period, and compare it to the value creation of peer companies.
Branding/prestige: A public stock offering potentially strengthens visibility and name
recognition for both current and new customers and stakeholders.

IPO Timeline
From start to finish, the IPO process generally takes about four months. This typical time frame
includes any organizational structuring, due-diligence processes, legal documentation, investor
marketing and pricing, and evaluation of market conditions. There are a few reasons the process could
take longer, however.
Given that boards and management teams have a vested interest in maximizing proceeds, both for
themselves as well as for the sake of all selling shareholders, market conditions can play a
considerable role in determining timing. Directly following a market crash, for example, a company may
decide it is not the best time to go public. As a result, in periods of significant market volatility, a
substantial IPO backlog can develop. This was the case in the second half of 2008 and in 2009
following the financial crisis.
Additionally, regulatory review might hold up an IPO. For example, the SECs review of the companys
registration statement may result in a large number of comments and changes that need to be
addressed before the registration will be approved. This can delay finalizing an effective registration
statement and prospectus.
The following graphic displays the various elements of an IPO process, and the timing of those
elements under normal conditions:

Involved Parties
Every IPO has a series of parties involved in the process. Investment banks are responsible for
underwriting and running the overall IPO process, but the process requires significant input from
auditors, regulators, legal counsel, and public relations groups (not to mention the company
management itself). Following is a brief summary of the role that each outside party will play in the IPO
management process.

Investment Banks
The IPO syndicate group is comprised of investment banks that will serve as either book runners or
co-managers. The book runners lead the IPO process. They perform the majority of the work required
to take a company public, and are included in the process from the outset. Co-managers perform a
subordinate role they provide additional distribution of the shares being sold. The co-managers are
often specifically selected to reward lending relationships (for example, if the co-manager lends money
to the company), or for targeted sales of shares to investors within a specific geographic region.
Book runners are referred to as such because they will manage the order book for the companys
securities once the IPO is placed into the market. Book runners are also responsible for the following:

Advising the client on timing of the IPO (from a market opportunity viewpoint)
Maintaining transparency around may current or future dividend policy
Organizing and executing the IPO roadshow (a kind of sales tour promoting the shares being
sold) during the investor-marketing period.
Determining, justifying and positioning the targeted valuation of the company (determining
share price, and the implied valuation for the company based on that price)

Typically, one book runner is named the lead-left book runner and acts as the lead coordinator in
documentation, organization and coordination of the roadshow.
While not acting as legal advisors, the book runners are intimately involved in legal drafting and
negotiations throughout the process. Each book runner should be focused on confirming that the
reported financials included in the prospectus agree with the information gathered in the due diligence
process, and with the companys projected financial model (if provided). Equally important, the
investment banks are responsible for working with the companys management to draft the best
possible marketing story in the prospectus. The details of the IPO story depend on the companys
industry, but the general structure includes:

Investment highlights
Industry overview
Company description
o Business and product overview
o Managements discussion and analysis of operating results
o Customer overview

Company strategy
o Market share opportunities
o Research and product development
o Growth objectives

Dividend policy

Consolidated financial data and capitalization

Management biographies (particularly important in sponsor-led IPOs or high profile, highgrowth IPOs)
Legal Counsel
In an IPO there are two sets of legal counsel involved: one represents the company, and the other
represents the investment banks. These advisors are responsible for running legal diligence, drafting
the prospectus, advising on necessary disclosure policy and communicating with the necessary
regulatory bodies. Generally, the work will be divided up such that if one set of counsel (say, the
companys legal team) is focused on due diligence or regulatory matters, the other counsel (say, that
representing the investment bank consortium) might be responsible for writing the draft of the
prospectus.
The underwriters counsel acts as an aggregator of information for the book runners. It is responsible
for collecting, consolidating and communicating the book runners comments to the companys counsel

on all legal documents related to the offering. The underwriters counsel must also provide the
underwriters with clean legal opinions (10b-5 filing) and representations and warranties to protect the
underwriters from potential frivolous lawsuits (particularly from investors in the stock if the value drops
significantly after the IPO).
Auditor
The companys auditor assists the company in putting financial controls in place, preparing audited
and pro forma financial statements, complementing accounting due diligence, and providing a comfort
letter at the end of the process, confirming the accuracy of the financial information disclosed in the
prospectus. The auditors role is extensive in aggregating and verifying financial information, but it is
not involved in marketing the transaction.
Investor/Public Relations
The company can choose to use an external investor relations team or utilize an internal team to
interact with investors prior to and after the roadshow. More often than not, middle-market and large
companies have an in-house investor relations group responsible for this important task both during
the IPO process and afterward.
Listing Considerations
U.S. companies generally choose to list their securities for trading on either the New York Stock
Exchange (NYSE) or the NASDAQ stock market, primarily because investors continue to view the U.S.
stock market as the global leader in market liquidity. Additionally, investors in a United States
registered IPO benefit from an extensive SEC review and U.S. GAAP accounting safeguards. That
said, certain global brands target dual-listed shares to raise capital in multiple operating jurisdictions,
and to increase and entrench brand recognition. Recently, companies have targeted developing capital
markets because of their growth potential from the consumer sector. A notable example is a series of
Hong Kong exchange listings for high-end European fashion and consumer brands.
The NYSE and the NASDAQ share requirements that relate to the board of directors, its audit
committee, and its compensation committee. First, NYSE and NASDAQ require that a majority of the
board of directors be comprised of independent directors (in relation to company management). The
size of the board is influenced by this requirement, which will either limit managements presence on
the board or result in the inclusion of additional independent directors. Second, a public company must
have a three-member audit committee composed entirely of independent members, which is defined
both by reference to NYSE or NASDAQ rules, as well as Section 10A of the Securities Exchange Act.
The audit committee must have at least one financial expert, and all audit committee members must
be financially literate. Finally, NYSE requires that listed companies have a compensation committee
and a nominating/corporate governance committee, each composed entirely of independent directors.
The NASDAQ requirement is very similar, but slightly more flexible, in that compensation decisions
and nominations may be made by a majority of the independent directors of the board not a defined
committee.
Valuation Methodologies
Trading Multiples: Comparable Companies and Precedent Transactions
IPOs are generally marketed and priced on a per-share trading multiple basis, with comparisons drawn
between a companys multiples and those of public operating peers and recent similar IPOs. Investors
generally choose trading multiples over a discounted cash flow analysis (DCF) because a DCF can be
inaccurate where there is little or no dividend payment history; there can also be uncertainty as to
when a dividend might be instituted.
Most companies avoid instituting a common dividend at the time of an IPO for two reasons. First, once
a dividend is instituted, the market will usually expect the company to consistently pay a quarterly
dividend on an on-going basis (and may even have hopes for dividend increases). Second, a large

number of companies undertake an IPO specifically to raise capital to fund growth opportunities, not to
distribute capital to its investors. Instituting a dividend would run counter to this strategy.
The appropriate reference trading multiples to be used for IPO valuation varies by industry, but as a
frame of reference, investors generally focus on cash flow or book value-based multiples. For
example, consumer & retail company investors typically use Earnings Before Interest, Tax, and
Depreciation & Amortization (EBITDA) as a proxy of Free Cash Flow, while for Real Estate Investment
Trusts (REITs) and utility companies; Funds From Operations (FFO) is generally used. Investors focus
more on book value or tangible book value per share for financial institutions, particularly for banks and
insurance companies.
The multiple at which an IPO prices is commonly referred to as the IPO multiple. The IPO multiple, as
compared to public peers, is usually discounted given the risk profile of a new issue. This discount is
referred to as an IPO discount, and usually ranges from 10% to 20% from the average/media peer,
depending on a companys industry and growth outlook.
Discounted Cash Flow/Merger Analysis
When a company is evaluation which investment banks to select as book runners on its IPO, the
valuation framework will be more extensive. In addition to the trading multiple valuations, most
investment banks will attempt to provide an opinion for the companys value using either precedent
merger transactions or DCF analysis. The analysis will attempt to value the entire company, forming a
basis for the value of the new shares being offered (this is based on the target IPO size, share
structure for insiders, and the number of new shares to be issued).
Given that most companies undergoing an IPO do not commence paying dividends right away, a DCF
analysis will use Free Cash Flow or Free Cash Flow to Equity (net of interest and preferred dividends).
As discussed earlier in this training module, the difficulty with DCF analysis is the sensitivity of the
calculated value to the assumptions used (especially the growth and discount rates). Therefore if a
DCF analysis is to be used, it is important to be rigorous about the rates used for both.
Merger analysis will generally use a similar benchmark as trading multiples cash flow or book value
but not on a per share basis. For example, it is common practice for investment banks to evaluate the
value of a company on the basis of the EBITDA/Enterprise Value multiple. Using an observable
EBITDA/EV multiple enables the company to determine an implied value for the entire company, which
can be used to determine the value of the equity held by common shareholders (once net debt,
minority interests and preferred stock are subtracted out).
The Greenshoe Option
When an IPO price, the book runners will generally sell more shares than the company actually issues
in other words, they will over allocate the offering. This results in the book runners being in a naked
short position the book runners will need to purchase shares in the company from others in order to
be able to deliver all of the shares promised to buying investors. Doing so provides some support for
the stock in the secondary market with low risk to the book runners. In order to prevent the book
runners from taking losses in the even that the shares rise, the issuing company will implicitly issue the
book runners a call option known as the Greenshoe option. Heres how it works.
In the event that the share do not trade at a higher price when free trading begins, one of the book
runners will step into the market, buy back the number of shares over allocated to investors, and
thereby cover the bookrunners short position. This supports the price of the stock by creating a
demand in the marketplace (the bookrunners buying shares) without exposing the bookrunners to a
long position in the stock after having bought these shares. (The bookrunners responsibility for this
important task of covering the short position is commonly referred to as the stabilization agent.)
If instead the stock trades up after freeing the syndicatet, the Greenshoe options kicks in, preventing
the bookrunners from losing money on their short position in the companys shares. The Greenshoe
option allows the stabilization agent, after the deal prices and public trading begins, to purchase up to
a pre-specified percentage of the number of shares issued (15% is a commonly used figure) at the
issue price, less the applicable underwriting fees. This option typically expires 30 days after the date of

the IPO. By holding this option, the stabilization agent avoids the risk of having to purchase shares in
the open market at a high price to cover the bookrunners short position if the stock price increases;
this protects against the bookrunners taking a principal loss.
If the Greenshoe option is exercised, the company issues additional shares and receives additional
proceeds; thus, if the option is used, the IPO deal size grows. If the option is not exercised, the
bookrunners will use proceeds from the overallotment (short position) to buy shares in the secondary
market, and the company will receive no additional proceeds.
Regardless of whether the option will be exercised, investors prefer to have a transaction structured to
include a Greenshoe option. The option provides confidence that the issue will be properly managed,
because bookrunners are incentivized to support the stock price in the secondary market directly after
the IPO. This will help reduce the possibility of share price volatility in the days after the IPO begins
trading.
Registration Statement
The IPO registration statement, which like all registrations for the public sale of securities is submitted
to the SEC under Form S-1, is prepared by legal counsel and company management and has two
main parts. Part I is the prospectus the legal document used to describe the company and sell
shares. Everyone who is solicited to potentially buy the IPO shares must have access to the
prospectus. Part II includes additional information that the company does not have to present to
investors by law. However, all of the statement (both parts) are filed and available on the SEC website.
An excellent overview of the Registration Statement can be found at Inc.com.
We recommend that all current or prospective investment banking analysts look at recently filed S-1s
to garner a detailed understanding of the information included in a companys registration statement
and how it is typically presented to investors. Generally, an effective registration statement will include
the following items:

Historical and Interim Financial Statements, including relevant footnotes

o At least two full fiscal years of a companys Balance Sheet (audited)
o At least three full fiscal years of a companys Income Statement (audited)
o Interim (year to date) Financial Statements, (unaudited but reviewed)
Reporting on company performance by business segment
Earnings Per Share analysis
Disclosure on stock-based compensation practices
Company capitalization and the resulting dilution from the IPO
Description of the anticipated use of proceeds
Description of resulting reorganization, if any (from LLC to C-Corp or Publicly Traded
Partnership)