Companies go public for many reasons. One of the most common is to raise capital to finance expansions, acquisitions or both, explains Bill Demers, Canadian IPO leader at EY in Toronto. For instance, the business may be expanding; an IPO provides the necessary cash flow without adding debt.
IPOs can also be an exit strategy, notes Salma Salman, national IPO practice leader at KPMG in Toronto. Venture capital or private equity investors who supported the business for four or five years want their principal back, plus returns, and an IPO can provide business owners with that liquidity. Or, it could be the business owner who’s making the exit; she may be close to retirement and sees an IPO as a way of cashing out.
Going public can boost a business’s prospects for success because it “enhances prestige, brand image, public profile and credibility,” notes an EY guide to IPOs. Another benefit: “higher valuations than private enterprises since greater disclosure of information reduces uncertainty around performance and increases value.”
But IPOs have drawbacks some companies may not be willing to accept, the EY guide explains. These include:
- regulatory reporting requirements and investor relations obligations, which can be time- consuming and distracting;
- high costs associated with the IPO process and continuous disclosure requirements, including underwriter, accounting and legal fees; and
- constraints on a business owner’s freedom to act, as major decisions now require board or shareholder approval.
When the drawbacks outweigh the benefits, business owners needing an exit strategy can sell to a strategic buyer (e.g., a competitor) or a private equity firm, notes Demers. Those who need money to expand can use private placements.
It’s a go—now what?
Demers says companies should start preparing 18 to 24 months prior to the anticipated IPO date. They will need several key specialists.
- Underwriters (investment banks): They structure the share offering and serve as market makers for the initial sale.
- Corporate accountants/auditors: They prepare (or update) financial statements dating back at least three years.
- Securities lawyers: They help prepare prospectuses and marketing materials for submission to the securities regulator.
- Human resources consultants: They help devise pay packages that will withstand shareholder scrutiny. Also, public company executives face questions about compensation that private owners don’t have to deal with.
Before investors buy into an IPO, they need to be convinced the issuer has a compelling growth story. Whether the issuer can tell such a story depends in part on market conditions.
Say a mining company wants to IPO, but the sector as a whole is in the middle of a rough patch. Demers says the owners should still make all the necessary preparations, but reconsider the timing of the decision to go public and wait until market conditions improve. It’s critical, he adds, that the company act as if it’s public during this waiting period, especially when it comes to financial statements, governance, compensation and MD&A (Management Discussion and Analysis).
The retail allocation of an IPO’s share offering is divided between each underwriter according to their individual stakes in the deal.
But that’s not how it works with institutions, explains Peter Miller, head of Equity Capital Markets, Canada, at BMO Capital Markets.
Most major Canadian investment banks have relationships with “virtually every institutional client in Canada and the U.S., and the larger players in Europe.” So unlike retail, where underwriters can only access the subset of the investing public that’s signed up with their parent firm’s retail arm, on the institutional side, each member of a typical underwriting syndicate can claim ABC Pension Fund as a client. Which underwriter does the fund make its order with, and why? “This comes down to convention, and the convention comes out of practicalities,” says Miller. Say there are nine syndicate members, plus a lead underwriter (bookrunner). “When you go out on a road show, [only] the bookrunner schedules and hosts institutional meetings. Imagine if you were a big [pension] fund manager—you don’t want calls from 10 people.
“So let’s say [ABC Pension Fund] puts in a $10-million order. They’ll give the $10 million to us [as lead underwriter] just before closing, and we will hold that money on behalf of the syndicate. We will take our 5% or 6% commission off the top of the aggregate and, on closing, we deliver the net amount to the issuer. The issuer will give the shares to us. We then give those shares to [ABC Pension Fund]. We’re acting on behalf of the entire syndicate.”
Fly on an underwriter’s wall
The most important players in the IPO process—apart from the company going public—are the underwriters. Peter Miller, head of Equity Capital Markets, Canada, at BMO Capital Markets in Toronto, explains how investment banks bring companies to market. The lead underwriter’s first step is to conduct intensive financial and legal due diligence. “If it’s a mining company, we may bring in specialists, such as engineers or geologists,” Miller explains. All of this is done with an eye toward preparing the prospectus and ensuring it meets the regulator’s requirement for full, true and plain disclosure.
“Part of drafting the prospectus is crafting the investment story—why we think this will be a successful company. Likewise, we have to [explain] the risks,” adds Miller.
In this initial stage, the lead underwriter is also doing valuation work that will help determine the IPO price. Different metrics drive valuations in different sectors, Miller explains. Such metrics include earnings, EBITDA, cash flow and asset value. Then, “we have to determine the appropriate multiple.”
The result is a range (e.g., $15 to $17 per share) that will be used when the IPO is marketed to institutional investors and select retail brokers.
Forming a syndicate
At this point, the prospectus is ready and the lead underwriter begins recruiting more investment banks to finance the offering and bring it to market. This group of banks is called the underwriting syndicate. Here are some of the questions Miller asks when assessing candidates:
- Who’s likely to provide good investment banking advice for the company after the IPO?
- Who’s likely to trade the stock in the aftermarket (e.g., the TSX)?
- Who’s going to provide credit to the company on an ongoing basis?
- Who will provide good research analysts?
- What’s the retail distribution strategy?
His team scores candidates based on these and other criteria and presents a proposal to the issuer, which signs off on the syndicate.
It’s now time to market the IPO through a road show. Marketing materials (e.g., slide presentations) are based on the prospectus and must be approved by the securities regulator. They also get posted on SEDAR.
The road show addresses both institutional and retail investors. “We target retail by speaking to brokers,” says Miller. These brokers are from the syndicate’s retail channels (see “Who gets what?”). Those from outside the syndicate generally don’t get access.
“We also put together a confidential information memorandum that summarizes key facts from the prospectus,” he explains. This is commonly referred to as the greensheet.
He adds, “It’s for internal use and it’s only for the brokers. It’s a tool they can keep at hand to understand the highlights [of the IPO] when they speak with clients.”
The road show isn’t just for marketing; it’s when institutional investors put in orders, Miller explains. This is called bookbuilding. The lead underwriter is called the bookrunner because it’s taking the orders.
“Let’s say the marketing range is $15 to $17 per share. Institutional clients may say, ‘I’m willing to buy two million shares anywhere in that range’; or they may say, ‘[I’ll buy] two million shares at the low end of the range, but only one million shares at the high end.’ ”
Every institutional order goes onto a spreadsheet that shows who made the order, its size and the day it came in.
Throughout the marketing period, orders may get revised. “On the last day of the roadshow, we see what all the demand is. We then send a message: ‘Books closed at 4:00 p.m. Wednesday,’ for example. That means all the orders have been submitted. Practically speaking, those orders are firm. If you put in an order for four million shares [within the $15 to $17 range], you’re good for four million shares.”
But buyers may not get what they ask for, notes Miller. That’s because the IPO could be oversubscribed, meaning there just aren’t enough shares to meet demand. So, the next time a client complains that only the big players get their IPO orders filled, let them know even the largest institutions sometimes go home disappointed. “For example, on a transaction like [restaurant franchise giant] CARA [Operations Ltd.], which was multiples of 10 times oversubscribed, everybody is getting cut back. If a deal is 20 times oversubscribed, everybody gets 5% of what they ask for.”
Who gets what?
In virtually every IPO, underwriters will allocate one part of the shares to institutional clients, and the other part to retail.
“The split is different on every deal,” says Patrick Meneley, head of Global Corporate and Investment Banking at TD Securities in Toronto. “Some deals are more retail-oriented; some are more institutional-oriented.”
Take a one-million-share IPO that has four underwriters. And, say the lead underwriter has 40% of the overall offering, while the other three have 20% each. Now assume the syndicate decides that the share allocation will be 75% institutional, 25% retail.
That means 250,000 shares will be offered through the retail brokerages of the underwriting syndicate, explains Meneley. The lead underwriter will get 40% of those 250,000 shares and sell them through its retail arm. The other three underwriters will each get 20% of the 250,000 shares and sell them through their respective retail arms.
To help decide on the split between institutional and retail, underwriters examine demand trends for previous IPOs in the issuer’s sector, says Peter Miller, head of Equity Capital Markets, Canada, at BMO Capital Markets. They also look at aftermarket demand and the composition of the shareholder base over time.
For example, REITs are typically popular with retail investors; junior mining companies less so, Miller explains.
He adds that, while each underwriter is entitled to its percentage of the retail allocation, they’re free to give up some or all of that allocation if demand is weak.
Miller says it’s not unusual for one underwriter to see excess demand in its retail channel, while another sees less uptake. The underwriter with less demand can put the shares back into the pool; the lead underwriter then reallocates them among dealers with hotter demand.
IPO ends, exchange trading begins
At this point, the lead underwriter presents the order book to the issuer and gives pricing advice.
Miller notes the issuer may want to see strong trading on the aftermarket. So, even if IPO participants are willing to buy at the high end of the pricing range, the issuer may still choose the low end in the hope that, when these initial buyers later offer their shares on the TSX, the broader public will show robust demand.
The underwriters then sign an underwriting agreement with the issuer. Each underwriter is legally liable for its portion of the share offering. Typically, the lead underwriter gets a larger share than the others. “So, if it’s a $100-million IPO and we have 30%, we’re on the hook for $30 million,” explains Miller.
All money from institutional investors is given directly to the lead underwriter (see “Convention counts”). On the retail side, underwriters collect the money coming in through their respective retail brokerage channels; each then passes its aggregate amount to the lead underwriter. This allows the lead underwriter to cut the issuer one cheque. If the underwriters’ commission is 6% on a $100-million IPO, the issuer gets $94 million.
The IPO is now complete. All shares have been purchased from the underwriters by institutional and retail clients and are reflected in these clients’ accounts. No trading has happened yet on the stock exchange—these clients have to wait until the company’s listing becomes active before they can offer shares for sale on the exchange.
Once that predetermined date arrives, they’re free to sell their shares the same way they would any other shares in their portfolios.