A Practical Guide to IPOs – Chapter 12: The Numbers Game

KEY LESSON: Optimize the model for a secondary offering, not the roadshow

In this chapter, I am going to walk through how to prepare a financial model for the analysts and the roadshow. There is no way for me to avoid putting some numbers in this. I know that the number of readers falls by half for every equation in a text, but if you have made it this far down the funnel, a few numbers probably will not hurt that much.

I was tempted to use a real-world example, but that proved cumbersome, and potentially libelous, so this example is a purely fictional company. They do something on the Internet, and here is their financial model:

Year -1 0 1 2 3 4 5
Users 100 200 350 525 700 850 1000
Growth 100% 75% 50% 33% 21% 18%
Interactions 1.0 1.5 2.0 2.7 3.6 5.0 7.0
Growth 50% 33% 33% 36% 39% 40%
Rev/user 1 1.1 1.2 1.3 1.4 1.5 1.6
Growth 10% 9% 8% 8% 7% 7%
___________________________________________The Line___________________________________________
 Year  -1 1 5
Revenue 100 220 420 682.5 980 1275 1600
Growth 120% 91% 63% 44% 30% 25%
EPS -2.00 -0.50 0.00 1.00 2.00 3.00 4.00
100% 50% 33%

This is their internal five-year model. This is what, in their heart of hearts, management really believes they can achieve. There is a big line in the middle of the model. Items that appear “Below the Line” are common figures that are comparable across companies. “Above the Line” are the company specific metrics, which the company can (mostly) choose to publish or not publish at its own discretion.

The IPO happens in Year 0. Prior to the IPO (Year -1) revenue is meaningful, and continues to grow substantially. The company is losing money at the time of the IPO, but is on track to break even in the following year. The Above metrics also show nice growth trends, but notice that the company thinks “Interactions” are going to really accelerate in a few years. Also note, that revenue per user is barely growing.

Investors will likely value the IPO based on Year 1 numbers, but to keep things simple, I am just going to assume that the company is valued on Year 0 figures, which is more common with unprofitable companies. Digging in a little bit deeper, let us look at the quarterly numbers in Year 0.

The company’s revenue model looks something like this:

Quarter 1 2 3 4 Total
Model Revenue 20 30 70 100 220

The company should not give out these numbers. There are all kinds of things that can go wrong, and the company is under no obligation to give out this model. Instead, they should give out a more reasonable estimate. I would suggest some like this:

Quarter 1 2 3 4 Total
Company Model 20 30 70 100 220
Roadshow Guide 10 20 50 60 140

This looks reasonably conservative, lots of rooms for reality to attack. But I can hear the CEOs howling (literally, I have had howling arguments with CEOs about this). These numbers look so low. The company can grow revenue 100% in Year 0, only guiding to 40% seems like underachieving. Remember, at this stage, there are no points for impressive growth, the focus is building credibility with the Street.

Here is how this plays out. The company reports 20 in revenue in the first quarter. Wow, big blow-out. Everyone is super surprised. The analyst chorus sings “Great Quarter Team!”. Crucially, at this point, the company also guides second quarter revenue to 25, even though they are on track to deliver 30. So the next iteration of consensus numbers looks like this:

Quarter 1 2 3 4 Total
Company Model 20 30 70 100 220
Roadshow Guide 10 20 50 60 140
Consensus After
First Quarter
20 25 60 70 175

That first quarter number is a locked-in, actual number. The Street expects 25 in the second quarter and 175 for the full year Again, the CEO growls that this is too low, but notice what happened here. The full-year estimate just went up by 25% (from 140 to 175). The analysts raised expectations for every quarter. This is the trickiest part. Management teams need to budget for this sort of compounding. Investors want to extrapolate, since we can just drag the mouse in Excel and we’re done with the model. When companies beat expectations, investors factor that in to future quarters.

The problem persists as the company reports more quarters, but the management team is careful to guide each sequential quarter up only a little bit.

Quarter 1 2 3 4 Total
Company Model 20 30 70 100 220
Roadshow Guide 10 20 50 60 140
Consensus After
First Quarter
20 25 60 70 175
Consensus After
Second Quarter
20 30 65 80 195
Consensus After
Third Quarter
20 30 70 90 210

By the time the company reports numbers for the third quarter and guides for the fourth, analyst models are converging on actual numbers, and management is looking pretty good to investors. The Street will perceive them as competent and in-tune with their own business. And as the company reaches that, they can branch out more and find their own voice.

Of course, there is one problem with this approach. The company is going to be valued as some multiple of these numbers. If they guide to 140, their IPO valuation will be 36% lower than if they guide to 220. There is no getting around this, but the goal is to give up a little today for a greater gain somewhere down the road. People tend to forget that a company’s market cap is just a nominal figure. It has no actual meaning until you sell a stock, then there is meaning to the value for you the seller, but market cap is just a notion we use to think about the company in a particular point in time.

Instead of optimizing the IPO valuation, companies need to plan for a secondary offering further down the road. Obviously there is risk in this, the markets may change, business conditions may change, but waiting has its benefits. From investors’ points of view, IPOs are a very risky proposition. By contrast, nine months after the IPO, the Street is familiar with the company and has developed some trust of management. Management can earn this trust by beating numbers and showing consistent business sense. If the company executes well in the months after its IPO, the valuation it receives at the time of the secondary offering should be higher than that at the time of the IPO.

It pays to wait, but this is one of those key concepts that gets lost in the rush of conflicting incentives. The bankers get paid as some percentage of IPO proceeds. In fairness, I think most bankers personally recognize that it is in their best interest to participate in a secondary, but the incentives are still in place. Bankers get paid annual bonuses that are the bulk of their income. Having a big fee from an overpriced IPO today may be more attractive than a smaller fee today and something that gets paid out in the next bonus year.

A bigger issue may be the company’s board, with venture investors eager to exit. I want to be balanced here. I think that the decision makers involved in these processes want to be fair and honest. The problem is that human nature does not like to wait. Venture investors face this as much as anyone. They have been in some of these investments for a long time, they have other things to do and other funds to raise. Even those participants with the best intentions can find it hard to wait, and unfortunately, there are also people out there with less good intentions.

Ultimately, the biggest challenger to this strategy is the management team itself. CEOs and CFOs have to face down their own temptations. They have to contend with the full range of human emotions. And there is also the fact that they are making a big bet on their own internal models. Do they really trust that far out number? No one likes to think too much about secondary offerings because they raise questions about what the future looks like.

This is Chapter 12 in my series “A Practical Guide to IPOs”, you can find the Eleventh Chapter here, and the beginning of the series here.

One response to “A Practical Guide to IPOs – Chapter 12: The Numbers Game

  1. Pingback: A Practical Guide to IPOs Chapter 12B – Telling a Good Story with Above the Line Numbers – DIGITS to DOLLARS·

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