In the course of announcing the terms of their highly anticipated IPO, the founders of Google revealed much of their thoughts about the going-public process. The decisions to adopt a dual-class share structure and to forego quarterly earnings forecasts demonstrate the reluctance Larry Page and Sergey Brin must have had in taking their company public. The use of a Dutch auction for the IPO indicates quite clearly that they were not particularly enamored with the current method of conducting an offering. Few companies at the time of their IPO have the clout of Google to play by their own rules and to receive the kind of publicity Google has for its decisions. The owners and managers of other private companies certainly have their own opinions about the going-public process; it's just that they are not heard by nearly as many people. Why do these other private companies go public or not, and what do they think of the IPO process?
A new study by two BYU professors, James Brau and Stanley Fawcett, provides some answers to these questions. They sent a questionnaire to the CFOs of companies that have recently gone public, filed to go public but eventually withdrew the offering, and have remained private. The questionnaire asked the CFOs for their opinions on which factors mattered most in the decision to go public or remain private, and what affected the IPO timing. The survey also asked about the criteria used to select an underwriter, expectations of underpricing, and how best to signal the issuer value to investors. Collectively, the CFO responses offer a more rigorous account of how issuers approach the IPO process than the anecdotal evidence normally available.
The conclusions drawn from this voluntary questionnaire must be interpreted with caution. The opinions of the CFOs who chose to respond need not represent those of the entire CFO population. Furthermore, the sample of companies contacted went public or withdrew their offering during 2000 to 2002. IPO market conditions were poor for most of this period, diminishing the comparability of these opinions with those likely to be expressed during a more favorable climate. With these caveats in mind, the findings are consistent with a number of common conjectures, but also point to issues that are subject to an interesting interpretation.
Why go public
Strategic, not financial, considerations were the primary motivation behind most companies going public. CFOs ranked the creation of a liquid stock that could be used to make acquisition as the most important reason for going public. Fully 60 percent considered this to be an important or very important reason. The next two most popular choices, both with about 50 percent support, were the desire to establish a market value for the firm and to enhance the company's reputation. This was followed by a preference for broadening the ownership base and to enable insiders to diversify their portfolios.
Prior surveys have usually found that the desire to raise cheap equity capital and expand the pool of financing options were the top cited reasons for an IPO. That was not the case in this sample. A little over 40 percent of CFOs thought that going public to minimize the cost of capital was important. But only 27 percent believed that running out of private equity was a significant reason for going public. An even smaller 14 percent agreed that a high cost of debt was relevant in the IPO decision. Industry professionals have being preaching over the past few years that only companies with positive earnings and solid financials would be able to go public. These firms have less of a financial justification for an IPO, which seems to be reflected in their answers.
The responses were contingent on whether the company went public, withdrew the offering or remained private. The CFOs of successful IPOs ranked establishing a market value as their number one reason, followed by creating a liquid stock. Private company CFOs also ranked creating a liquid stock second, after the insider diversification motive. Only the CFOs of withdrawn IPOs ranked the liquid stock reason highest, followed by enhancing company reputation and diversification. Allowing venture capitalists to cash out was only the fifth most important reason for going public among the VC-backed sub-sample, and last among the non-VC-backed group.
Timing the IPO
The success of an IPO often hinges on when it occurs. Over 80 percent of CFOs identified overall market conditions as important or very important in determining the timing of their IPO. Next were the industry conditions, deemed by 70 percent to be important. The need for capital for growth was third at 65 percent. The CFOs did not give much weight to the current IPO market conditions. Only 25 percent felt that other good firms going public mattered in their decision and an even fewer 13 percent said that the first-day returns of recent IPOs were important.
The relative indifference to IPO market conditions contradicts the empirical evidence on IPO timing. Companies from well-defined industries tend to cluster their IPOs together in time. This would imply that issuers are aware of what their competitors are doing and take that into account in their own timing decision. There is also a significant positive correlation between the average first-day returns today and the IPO volume six months later. Strong returns signal a hot IPO market, which induces more companies to go public. The sample period for the survey was generally a cold IPO market, with low first-day returns and little clustering, and thus not reflective of prior, and probably future, issuers.
Two other findings on IPO timing are noteworthy. First, the presence of a venture capitalist was associated with heightened CFO awareness of the importance of going public during good market conditions. Since VCs typically have more experience in taking companies public and understand the benefit of optimal timing, this observation is not surprising. Second, CFOs at companies that sold a large fraction of their post-issue outstanding shares in the IPO ranked the need for capital as the number one determinant of the timing decision. Capital constraints, as evidenced by the larger proportional offerings, force such companies to go public at less opportune times.
Why stay private
The reasons selected for why their company would not go public varied between the three types of CFOs. The CFOs of withdrawn IPOs almost unanimously cited bad market and industry conditions as being very important in their decision not to go public. The only other factor that mattered to them was that their stock price was deemed too low, undoubtedly a consequence of the bad market conditions. The combination of these two factors led to the withdrawal of the offering, which they otherwise were eager to pursue.
Private company CFOs identified quite different reasons for not going public. Once again two factors stood out. The first was the desire to maintain decision-making control and the second was a preference to avoid ownership dilution. Google's proposed dual-class structure is a clear example of the insiders trying to maintain the control benefits of a private company while being public, and reveals their hesitation at even trying an IPO. As might be expected, the CFOs at companies that successfully completed an IPO did not assign much importance to any reason to remain private, although their overall response pattern most closely resembled those of private company CFOs.
The standard costs associated with a public listing - disclosing information to rivals, SEC reporting requirements, and the costs and fees of an IPO - were each selected by about 30 percent of all CFOs as an important reason for not going public. One somewhat surprising result is that less than 20 percent thought that officer liability, due to the Sarbanes-Oxley Act, was an important impediment to going public. CFOs of successful IPOs actually scored this higher than private company counterparts. Thus, concerns expressed by some that Sarbanes-Oxley will deter more companies from going public are not strongly supported by the views of these CFOs.
Selecting the underwriter
Three factors stand out as the criteria issuers use to select the lead investment bank. They are, in order, the bank's overall reputation, the quality of its research department, and its industry expertise. Each criterion was cited by at least 83 percent of CFOs as being important or very important. Less important, although still relevant, was the underwriter's market making ability and trading desk. Google's decision to hire CSFB and Morgan Stanley as co-lead managers, even though neither has conducted an IPO auction, is a testament to the fact that a sterling reputation is difficult to ignore.
Concerns about selective share allocations and the exclusion of small retail investors from the IPO do not figure prominently in the thinking of CFOs. About half of them claimed to have carefully evaluated the institutional client base of the underwriter when making their selection. They also ranked the bank's retail clientele base near the bottom of their evaluation criteria. What this implies is that the CFOs want their firm's shares in the hands of solid long-term investors. This is one explanation why most issuers will continue to choose the 'book-building' IPO method over an egalitarian auction process.
One factor that did not matter much in the choice of underwriter was the fees they charged. Only 25 percent of CFOs ranked the fee structure as an important selection criterion. The standard underwriting spread is seven percent, which usually declines a couple of percentage points for larger offerings. Concern was expressed a few years ago, including a Department of Justice investigation that was dropped, that the banks were colluding to keep the spreads at excessive levels. The reality is that the top tier banks are not being forced by issuers to compete on price, which allows them to get away with charging what even they admit are highly profitable fees.
The most significant indirect cost of an IPO is the initial return or price 'pop', also referred to as underpricing because the offer price is deliberately set too low. This is a cost that CFOs are well aware of and know to expect. Asked what they expected the underpricing to be, the median (mean) CFO response was 10 percent (14.9 percent). The actual underpricing for the successfully completed IPOs was 13.5 percent (27.8 percent), not far off.
Among the many possible reasons for underpricing, 60 percent of the CFOs agreed that it was important to compensate investors for taking the risk of investing in an IPO. The underpricing rationale they cited as second most important was that it allowed underwriters to curry favor with institutional investors. The moderate amount of underpricing these CFOs experienced relative to the dot.com bubble likely tempered their skepticism of underwriter practices. This is borne out by the fact that they gave low importance to spinning, flipping and reduced IPO marketing cost motives for underpricing. CFOs at private companies were not as forgiving, as they gave higher importance to these possible factors.
The choice of underpricing-as-compensation-for-risk as the most important reason can actually be interpreted as an endorsement of book-building over auctions. The risk that the investors are exposed to is an uncertain market reception to the offering. Investors are effectively insuring the issuer against this risk by buying the IPO at the offer price and the underpricing is the premium to pay for this insurance. The use of a Dutch auction for the IPO is roughly equivalent to letting the market determine the offer price. Consequently, the issuer is forced to bear the risk over the initial market reception to the offering. Book-building may result in a lower offer price because of underpricing, but by also reducing the risk the issuer may actually prefer this alternative.
It is critical for the managers of any company trying to go public to convey all positive information about the firm value to potential investors. Otherwise the company risks being undervalued in the IPO. Simply announcing that the company has a high value is not credible because everyone can do that. Certain attributes of and actions by the issuer, some of which are costly, can send signals to investors that convey a positive message about the company value.
The CFOs ranked a strong earnings history as the most positive signal, with 91 percent considering it to be important. Second, with 89 percent, was the use of a top underwriter. Committing to a long lockup was third, with 77 percent. Hiring a Big 4 accounting firm was next at 74 percent, followed by a large first-day price jump at 72 percent. The backing of a venture capitalist was rated the weakest positive signal with only 40 percent. This percentage, although not the ranking, was higher for the sub-sample of companies with VC-backing. Selling a large portion of the company, issuing warrants as part of the offering, and selling insider shares are all viewed as negative signals.
About the AuthorJason Draho is the author of the new book The IPO Decision: Why and How Companies Go Public. The book attempts to clarify how the IPO process actually works, and in the process separate fact from fiction, by imposing a logical structure on the most up-to-date IPO-related research. Topics covered include the optimal IPO mechanism ('book-building' vs auctions), the role of the underwriter in the primary and after-markets, analyst coverage, valuation, the timing of IPOs, the long-run performance of IPOs, and the financial, strategic and corporate governance benefits and costs of going public. The material is presented in a rigorous yet accessible manner and develops the intellectual foundation necessary for a constructive debate about reforming the IPO process.
James Brau and Stanley Fawcett, "Initial Public Offerings: An Analysis of Theory and Practice," Brigham Young University working paper, March 2004.
Questionnaires were sent to companies that were identified as either having successfully completed an IPO (340 addresses) or attempted and withdrew an IPO (179 addresses) sometime between January 2000 and December 2002. The CFOs of 1,266 private firms were contacted using the Dunn and Bradstreet's North American Million Dollar Database and Reference USA Database on the largest non-financial private firms. Overall, 366 CFOs provided usable surveys for a response rate of 18.8%. The number of respondents (response rate) for each category was as follows: 212 (16.7%) private, 87 (25.6%) successful and 37 (20.7%) withdrawn. The sample consisted of the following types of companies: manufacturing (35%), services (22%), wholesale trade (17%), retail trade (9%), transportation/communications (8%), construction (7%), mining (2%), and agriculture (1%).