As we zero-in on year-end 2023, the IPO market appears to be opening up a little. While there is cautious optimism around this emerging trend, it’s clear that the volume of transactions and valuations seen in 2020 and 2021 are unlikely to be seen again any time soon. Today, pent-up demand for an exit combined with reduced access to private capital is leading to a companywide focus on costs and less of a “growth at all costs” approach by management teams. This is a period of “survival of the fittest” for many VC-backed companies.
The majority of my clients operate in the Life Sciences space and many Biotech companies are currently evaluating the potential value of an IPO at the next value inflection point. While enrollment of patients and read-outs from clinical trials take time (and are typically on a time scale that cannot be condensed), once those clinical results are available and positive, these companies need to be poised to move quickly to an IPO if the markets are favorable. Most importantly, any company preparing to go public via an IPO needs to lay a strong foundation for success in the public markets.
When considering the IPO option, I offer boards and CEOs four recommendations:
- Align around the strategic value of the IPO to the company and understand investor and C-Suite incentives
- Evaluate the pros and cons of crossover rounds
- Carefully choose the right length for the lockup period
- Build a strong foundation for becoming a public company
Achieve C-Suite and Board Alignment on Strategic Issues and Incentives
Management teams in pre-IPO companies should be having early discussions with the Board to align their thinking about the strategic issues surrounding an IPO versus alternative exit pathways. Management should also make sure they are aware of the sometimes conflicting agendas of various investors and also their own preferences and interests when it comes to taking the company public vs. exiting via a sale to a third party.
An IPO strategy often favors early-stage investors as all stock is converted to common stock and the value to each investor is pro-rata of their percentage equity holding. In contrast, an M&A transaction can favor later-stage investors (depending on their preference rights and conversion features) as later investors may be more willing to take their returns at the expense of earlier and lower-ranking preferred stock, particularly in the case of a company with a declining valuation.
Evaluate the Pros and Cons of a Crossover Round
As part of the preparatory steps to an IPO, there is often consideration given to a crossover financing round or top-up round. While bankers may float this idea as a good option for the company to raise additional capital, there are clear pros and cons to this approach. On the positive side, crossover rounds may produce a stock price uptick prior to the IPO. On the flipside, however, this price uptick can also reduce flexibility in setting the IPO offer price. While a top-up round can be a good strategy for securing a key anchor investor for the IPO, a crossover round often requires pre-commitments to the IPO (which potentially mitigates some IPO downside risk), but still requires the same fees paid to the bankers.
Consider the Right Length for the Lock Up Period
A third consideration for both investors and management when evaluating an IPO “go/no-go” scenario is the length of the lock up period for company insider equity holders post IPO. This is important because many IPOs result in an initial increase in stock price post launch followed by a decline. According to a Wall Street Journal article from 2022, 87% of companies listed in that year ended up later trading below their IPO issue price. So, while investors and management may be anticipating a certain return on their investment based on the IPO issue price, their actual return might end up well below the issue price by the time the lock up ends. And for Life Sciences companies, in addition to market conditions outside the control of management, delays in clinical trials and/or disappointing data surrounding key milestones can have a disproportionate impact on the market capitalization since these companies are pre-revenue.
Build a Strong Foundation for Becoming a Public Company
There is a well-documented path describing the actual timeframe and requirements of an IPO. This includes a diverse set of pre-IPO activities, from appointing bankers to drafting the S-1, investor roadshows, and board strategizing, all leading to the actual listing. But there is additional groundwork that needs to be pursued internally within the organization for an IPO to be successful. And in my experience, many management teams underestimate the magnitude of the requirements for becoming a public company from an accounting, finance, and corporate governance perspective. A CFO should anticipate that it will take a minimum of twelve months to implement the items below to become well positioned for a successful IPO.
IPO financial requirements worth noting include:
- Quarterization of the financial statements together with an audit
The financial statement periods (number of years) to be included in the IPO registration statement depend on the company’s characteristics and the timing of the document’s submission. Smaller reporting companies (SRCs) and emerging growth companies (EGCs) generally have the option of presenting only two years of audited annual financial statements in a traditional IPO, while all other entities must present three years. Note that in any event the accounting quarters will need to be audited.
- Transitioning from private to public company audit procedures
Public company audits require more robust disclosures, segment reporting, temporary equity classification of redeemable securities, and earnings per share calculations. While audits of private companies are subject to AICPA auditing standards, auditors of issuers undertaking an IPO must apply PCAOB auditing standards and will need to perform additional procedures and issue a new auditor’s report that addresses these PCAOB standards.
- Revaluing stock-based compensation
In a Life Sciences IPO, company valuations must transition from 409A methodologies (to avoid cheap stock issues) to quarterly valuations closer to the IPO. There will be particular scrutiny from the SEC for any options issued within two years of the IPO.
- Set up new financial systems, controls and processes
All companies preparing for an IPO should undertake an IPO-readiness gap assessment with respect to financial systems, controls, and processes. A public company’s management will need to address its compliance with controls and procedures in its post-IPO filings with the SEC.
- Upgrade ERP systems
Most early-stage companies will still be using QuickBooks for their accounting needs. However, any company preparing for an IPO should plan to implement an ERP system. The implementation process for a new ERP system is a long and involved process in and of itself, including selection of the ERP software solution, choosing an implementation specialist, the system set up and data migration, and validation of that.
- Re-evaluate board composition, committees and corporate governance All board committees must establish charters and board committees need to include a compensation, audit, and nominating/corporate governance committees. Recruiting for financially savvy board committee members can take time and is sometimes harder, so prepare accordingly. Independent directors will also likely need to be added to these and the full board.
- Plan necessary headcount additions in finance and accounting
Many Life Sciences companies, particularly in the pre-revenue Biotech space, will have lean finance and accounting teams while they are in the clinical R&D phase of development. While this works well in keeping overhead low, there is a point in time where segregation of duties and augmenting these teams will become necessary. Typically, in-house FP&A expertise will be required along with an SEC accountant to support public company reporting requirements.
An experienced CFO can be an indispensable partner to their CEO and board as they move through the evaluation of the IPO go/no-go decision and begin making the investments necessary to build the foundation for becoming a public company. Make sure you have the right talent in place in the C-Suite when moving in this direction. Our partners at FLG have taken over 200 companies public over the course of their careers. Any one of us would be happy to assist you.