By Edward D. Hess,
Distinguished Executive in Residence and
Adjunct Professor of Management, Goizueta Graduate School of Business
Most entrepreneurs dream of going public as the way of realizing wealth for themselves, their investors, and their employees and as the ultimate scorecard validating their success, vision, and self-worth. Yes, there are instances where entrepreneurs have become very wealthy by going public. But the overwhelming evidence is to the contrary.
I. The Probability of an IPO
First, the probability of you building a business which can go public is against you. Very few companies successfully, on average, make it through the IPO funnel.
- On average, over 1 million new businesses are formed every year;
- It is estimated that 80% of those new businesses fail within five years;
- Of the 20% that survive five years, 80% of them fail within the following five years;
- Thus, a business has about a 4% chance of surviving for 10 years;
- On average, from 1970 – 1997, 400 companies go public each year and the average age of firms going public from 1980 – 1998 was 7.5 years.
II. Can you cash out via an IPO?
So assume you are the successful exception: You make it 7.5 years and you hit an IPO window – a good market for your industry. Can you cash out a meaningful amount of money in an IPO? The answer to that question requires you to understand the IPO process and an insider’s ability to cash out – how much and when. The market realities are:
- An IPO in and of itself is not a real or true exit event whereby an entrepreneur can realize significant cash upfront from the transaction;
- As part of the IPO, the entrepreneur will be precluded (locked up) from selling any meaningful portion of this stock for 6-12 months;
- Even after the lock-up expires, market realities – liquidity in the stock and the market’s perception of an owner’s bail-out will preclude the owner from cashing out a large amount too quickly at any one time;
- Your ability to exit over time depends on good market conditions and you meeting market growth expectations every quarter for a significant period of time; and
- Taking this into account, research studies show that 70% of IPOs under-performed the general stock market over a five-year period after they go public. Based on research from 1980 – 1997, IPOs under-perform the market on average by 22%.
If an entrepreneur is looking to take a sizable chunk of cash out of the business free and clear upfront, an IPO may not be the best way to do it: he or she should explore a sale or merger, with a cash price and/or unrestricted, very liquid public company stock or explore a cash recapitalization.
So let’s stop a minute and summarize: First, the likelihood of building a company which can go public is not high. Secondly, if you are one of the fortunate ones, an IPO is not usually a liquidity event for key insiders. IPOs are a costly high-risk way to exit or liquefy. So what are IPOs really good for? To raise growth capital to be used in expanding the business, e.g., through more store openings (ala HomeDepot) or product expansions or acquisition of competitors. IPOs allow you to raise growth capital at a cost of capital cheaper than private equity capital.
III. An IPO changes your life
Let’s assume you decide you want to go public. What else should you consider?
- IPOs are costly (8-10% of proceeds raised) and take 6-12 months to accomplish. During the time period of going public, market conditions can deteriorate OR other people in the same line of business can beat you to the market and the market can become saturated for your type of business; OR those people can beat you to the market and taint the investors’ appetite because of their poor market performance. So being in line to go public is not a guarantee you will do so successfully.
- Going public is a very time consuming process which dilutes management’s focus on the business. The business can deteriorate during the process either killing the IPO or the deterioration could show up during the first quarter of being public which will seriously hurt your stock price. Going public is a time consuming emotional process. Understand this and have someone “minding the store” while you spend your time with accountants, lawyers, and investment bankers trying to go public.
- Once you go public, the entrepreneur must spend significant amounts of his time away from the business communicating with analysts and investors or stating it another way, a public CEO’s job is different than an entrepreneur’s job. A public CEO must now manage new and different constituencies: Wall Street and mutual fund analysts; investors; newspaper business writers; and in some cases, state and local governments. Some entrepreneurs will not do well in these public forums. Even if they do well, who replaces the huge management void in the business? Again, understand this and plan for it.
- Lastly, your fate is not totally in your hands. Factors outside your control can impact your stock price: the economy, negative industry revelations; negative competitor revelations; a large institutional shareholder dumping its stock for its own reasons which have nothing to do with you, and the normal ups and downs of your business.
The reality of the public marketplace can sometimes be brutal. If you want to go public, understand what you are getting into – the risks and the opportunities. Really focus on why you want to go public and if it is to exit in whole or in part, take the time to compare the possible results of an IPO to a sale, merger, or recap. In the private market space, you have the luxury of being able to work through downturns, surprises, and momentary setbacks. The public market expects growth every quarter, and the public market is fickle and not very forgiving.