Have you ever dreamed about taking your company public — the relative ease of raising capital, the ability to use your company’s stock to buy other businesses, and the liquidity of your own shares so that you can “cash out” when you are ready?
This all sounds good, and it is. But not every business is meant to be publicly traded. There are certain unique characteristics that make for an ideal IPO. This article discusses those characteristics.
(It might be a good idea for you to look at two of my previous articles in order to provide some background on this one: Multiplying Your Wealth Through an IPOand Is Going Public the Right Move for Your Company?)
A Few Truths
Before we start our discussion, here are some facts:
*A company does not have to have a certain amount of sales in order to execute a successful IPO. In fact, a business could have a paltry level of sales and still be IPO material.
*A consistent record of earnings/cash flow is not a prerequisite to an IPO.
*A good IPO candidate can be a new, untested company.
The above may surprise you; but, I can explain the apparent contradiction. What makes a good IPO is not so much where you’ve been as where you are going. In other words, you might be running a relatively new, untested enterprise. But, if your prospects are good, you could be a wonderful candidate for an IPO.
Why is this so? Well, the market looks for opportunities that promise a good future return, a promising upside. The history of the company is not terribly important if management has a good story to tell. It is up to top management, therefore, to convince the markets that not only does it know where it is going, but it also knows how to get there.
How does management get their story across? They usually hire an investment relations firm or a public relations firm. It is up to these companies to promote the new stock and to keep investors aware of the bright future that management sees.
The Right Qualities
Now let’s talk about two specific qualities, at least one of which a prospective IPO should have in order to achieve a successful public offering.
1. Niche/Differentiation: If the company in question has carved itself out a unique slice of an industry, it is said to have a special niche. A niche can be described as any small, specialized business market. This means that the company becomes somewhat impervious to the negative changes happening in its industry since it is insulated from them because of this special segment to which it is appealing. Put simply, the business has differentiated itself from its competitors.
Here’s an example of niche/differentiation. Years ago, a friend of mine started a monthly magazine for the motorcycle industry. Specifically, the magazine addressed replacement costs for just about any motorcycle part imaginable.
At that time, the motorcycle industry was rather small and there wasn’t much room for a competing magazine. My friend found a perfect niche. His competition was virtually non-existent. He differentiated his product, the magazine, from other publications.
If he had decided to publish a news magazine, for example, he would have encountered tremendous competition. In fact, because his capital was limited, he wouldn’t have lasted long competing against the big news magazines.
Let’s say that the magazine industry goes into some sort of recession. My friend’s motorcycle publication will be only slightly affected, if at all. That’s because he’s appealing to a very narrow segment (niche) of people who have to know the cost of motorcycle parts. He has, therefore, differentiated his product.
One other example of the niche/differentiation concept: A company which has patent protection and wants to go public has, in effect, created its own niche. It can enter an industry and favorably compete with the competition assuming that its patent protection is strong.
2. Industry Fragmentation: This occurs when an industry has a lot of small players. There is not much consolidation and no one group of companies has a corner on the industry.
Why does this element of fragmentation appeal to investors? Why does it make a company good IPO material?
Have you ever heard of a roll up? A roll up occurs when a company acquires other similar companies in order to reduce costs and garner more volume. If an industry is fragmented, it is an ideal target for some sort of roll up. This means that a company can acquire a number of its competitors in order to reduce its overhead and increase its sales volume.
Focus on Future
Remember that at the beginning of this article I said, “What makes for a good IPO is not so much where you’ve been as where you are going.” If a company is in a fragmented industry, then it is quite possibly an excellent IPO candidate because it can start acquiring other companies in order to achieve some level of “critical mass”, both in volume and in increased profits.
Also, if a company starts dominating an industry and its product or service is superior, it can actually charge more for what it is selling. The smaller competition in a segment that is dominated by a few players doesn’t have much leverage when it tries to compete against the larger players who have most of the industry’s customers.
This may sound unfair, but this is the reality in the business world. It is also the reason why an IPO candidate which has good prospects of achieving a roll up in its industry is very attractive to potential investors.
Besides having at least one of the two elements listed above, IPO candidates benefit if they have certain other qualities that define an exciting public offering.
Show Some Sizzle
The investment banking community has its own unique vernacular when it comes to describing certain prospects of potential IPO candidates.
Bankers like a company that has “sex appeal” or “sizzle.” It goes back to what I said at the beginning of this article: “…the market looks for opportunities that promise a good future return, a promising upside.” Sex appeal and sizzle in a company give that extra push to describing a company’s prospects.
Finally, keep in mind that if your company is public, it can acquire other companies by using its own stock as currency. This means that if you can convince your sellers that your company’s stock is valuable, the roll up scenario will be particularly attractive in that little or no cash need be used in the acquisition process.
So, is your company IPO material? Think about it. It may just be. And good luck!
This story was originally published on October 15, 2004, and is brought to you today as part of our Best of ECT News series.