IPO Series #4 – The Cast of Characters – A Lesson in Incentives
KEY LESSON: Every external party in the IPO has a different time horizon. Know who will stick around and who will leave right after the bell rings.
For most companies, the IPO marks a major transition in shareholders. The investors who companies have dealt with for years are going to start exiting, and a whole new horde of barbarians investors is about to coming pouring through the gates.
I have found that companies spend a huge amount of time and energy picking their bankers and lawyers and auditors for the IPO, but they spend very little time getting to understand investors. The problem with this is that the day after the IPO, all the bankers and lawyers go away (the auditors stick around, but you can’t have it all). Yet the vast majority of the IPO preparation is spent with just those people. So companies are spending too much effort on the constituents that will be around the least.
So in this chapter, I want to walk through the players in the IPO process. And most importantly, I want to look at each groups’ incentives and time horizons. These matter a lot, but this description is going to poke some tricky truths. I have kept things as non-cynical as possible, but many people may extrapolate from these comments and find a bit of controversy. That is not my intention. Remember, if the IPO process at times seems nonsensical, I think we can all agree that there is one party responsible for that – the Federal Government.
I present the list below roughly in the order in which management teams meet them.
The Lawyers – My thinking on attorneys has changed a lot in recent years. Having a good corporate lawyer is one of the most important resources a management team can have. They know a lot, they are legally bound to be your most zealot advocate. Well-chosen attorneys will provide counsel on many topics that are beyond the scope of any CEO to do on their own. That being said, securities lawyers are a special niche case of attorneys. They will bill a lot. They will ask you an exhausting amount of questions. They will probe every dark cavity of your operations. They will require you to perform things that seem like unnatural acts. Remember, they are not looking to make your life difficult. They are there to help you avoid the things that will make your life truly difficult. And keep in mind, that after the IPO, you can go back to relying on your corporate lawyer.
The Auditors – The audit regime of being public is one of those unwieldy realities of today’s public markets. The ‘reforms’ that came out of the 1990’s .com scandals (e.g. SarBox) are on the border of being punitive. They give the auditors tremendous leverage over a company’s operations. They will also remain with long past the IPO. For most companies, the audit costs of being public are something like a $1 million a year, and up. Like I said, blame the government. Many of the SarBox rules feel like a form of taxation paid through the auditors rather than the IRS. Just keep in mind that they are there to help, and often having a rigorous audit and control regime in place provides a great layer of insight into a business.
The Bankers – Bankers have a bad reputation. They are seen as mercenaries (remember, no cynicism here), who will move from one transaction to the next. So be it. That is their job. There are roughly a dozen major (aka ‘bulge bracket’) investment banks out there and a 30 or so regional or specialty brokers. In a future chapter, I will explore how to pick them. For the most part, a company will have six or seven serve as underwriters on the IPO.. After that, most companies will only engage with one of those banks ever again. A banker’s job, especially IPO bankers, is to sell a company’s shares to the public markets. Management teams want their bankers to have lots of deals under their belt so that they get good at it. The fact that they will move on immediately afterwards to someone else is a positive, but be prepared for this. Each bank will have a ‘relationship’ banker who can become a trusted advisor to the company. But there will also be dozens of other bank employees who know little about the company or industry. Do not be put off by their brisk nature or the fact that they are a great friend today, who forgets you tomorrow.
Research Analysts – I am now four chapters into this and just now getting to the role I know best. Analysts are employees of the investment banks, but they have an important hybrid role. They are a bridge between the world of being private and the world of being public. Handled well, they are an important megaphone for getting the company’s story out in a way that it can shape. Once the IPO happens, companies lose much control of their story. The analysts will be the last opportunity to entirely control a company’s message. Analysts have to walk a tightrope. They want to support their bankers, but they also want to protect their reputation among investors. They are legally divided from their bankers, but at some level both sides have the same CEO. The bankers can generate tens of millions in fees, analysts generate hundreds of thousands or a few million in brokerage commissions. On the other hand, analysts only do a small number of IPOs every year. The rest of the time they have to get in front of investors and defend their ideas. Reputations matter a lot to them.
Management teams should pick bankers based on the analyst team because the analysts are going to be around, following the story for years. But there are also dozens of other analysts out there. The first group that ‘covers’ a stock will help shape the company’s first impression on Wall Street, but with time other analysts will likely join the fold.
I am now going to start looking closely at incentives. All the groups listed above get paid only when there is an IPO transaction. At some level, this is going to bias even the best of them to get the IPO out the door. With analysts, we start to see groups who value something very different. Analysts care about two things. First, they do not want to be embarrassed. If you promise them something and then do the opposite in a week, they end up looking bad. The key lesson of this chapter is that expectations matter, so be very careful when setting them. Later in the series I will devote a whole chapter to this topic. Secondly, analysts want access. They want access to information, so that they can publish notes that do not sound like the other 10 or 20 analysts covering a stock. This is not the same as inside information (that really does them no good). They will come with questions about products and operations and customers. Their lifeblood is information, manage closely how you dole it out to them. But they also want access to you. They are going to invite you to non-deal roadshows and to attend conferences. Public investors pay them to provide this access. Be prepared for this. Analysts can be a great resource in getting a message out, but the price for that resource will largely be measured in management’s time.
Salespeople aka Brokers – The key audience for the analyst are their sales people, or brokers. Salespeople sit on the cash register for the brokerage operations, and pay the analysts’ salary. Their job is to get in front of investors and to manage the brokers’ relationships with these clients. By definition they are not going to be experts in your stock. The analysts’ job is to provide the salesforce with enough information that they can make a concise presentation to their clients about a pending IPO. This is not an easy job, filled with as much logistics as actual salesmanship. Typically, company management teams do not meet salespeople until fairly late in the process. I always found this strange. Companies should know what a salesforce is capable of when picking their underwrites. Some sales teams are very specialized, focussed on a particular region or investor class. One very well-known bank has a sales force that actually has a very poor reputation among institutional investors, but can execute any IPO by bringing in their high net-worth clients. This is usually a bad idea for the company, but one that is only realized when it is too late.
Sales people are paid for trading volume and client (i.e. investor) relationships. They are going to ask dumb questions. They are going to make mistakes about some very key points about a company. Set those aside, because they are a very important resource in getting the story out there. At the very least, like all sales people, they are usually a good bunch to spend time with. Get to know about them as early in the process as possible. And keep in mind that they will also be around long after the IPO. They will remember a good or bad process, and will have a definite impression of a company’s management team, and they will communicate that bias to their clients – the investors.
In the next chapter, I will take an in-depth look at all the types of public market investors that a management team may encounter.
This is the fourth chapter in my Series “A Practical Guide to IPOs”. The series began here and you can find the previous chapter here.