This essay was originally published on the a16z blog.
Should I take my company public? Why? If so, when and how? In this post, I’ll demystify these questions and provide a framework for answering them.
If you think of companies as having a similar trajectory to human development, starting from seed stage to growth, getting to an initial public offering (IPO) is like getting a license to drive. It holds companies to a higher standard of accountability — for financial discipline, disclosure, planning and delivering to plan, and even strategic direction. Mark Zuckerberg has described how, because Facebook was held to a higher standard after going public, the company embraced mobile sooner than it would have … therefore setting it up for a stronger future.
The most important companies — including the next generation of big franchises — are likely going to end up being public. Try to name all of the important multi-decade technology franchises that are private; it should be easy … it’s a small list. Going public has other advantages as well: Besides providing liquidity for employees and investors, it provides companies with M&A currency to help them acquire other companies, more stability for acquiring otherwise elusive customers, and more resilient capital if private capital becomes problematic. Being IPO-ready can actually give founders more options and more control over their destiny.
But when should companies go public? The answer is simple: when they’re ready. In fact, to-IPO-or-not-to-IPO is not the right question; the question is how to be ready and ensure that a business is “working”. Since I spent years as an investment banker — focused specifically on taking tech companies public — I’m sharing the below list from the vantage point of what public investors look for to determine whether “it’s working”. Think of it as public investors’ wishlist for companies seeking to IPO. And regardless of desired outcome, it’s a checklist for building a robust and enduring business… and a business you can take public whenever you decide it’s time.
First and foremost, public investors look for evidence of a strong, healthy, thriving business — and top-line growth is the best indicator of this. Rate of revenue growth also factors significantly into the level of interest among investors leading up to the IPO, as well as the actual valuation at time of IPO. In fact, valuations for tech companies are more highly correlated to revenue growth than any other financial metric. McKinsey, for instance, found that “changes in top-line growth deliver twice the valuation gain that margin improvements make”.
High growth rates indicate one or more of the following: (1) that new customers are buying the product; (2) that existing customers are buying more or additional products; and (3) that churn among existing customers is significantly lower than new customer growth. It’s also proof that there’s a reasonable monetization model in place.
Other metrics — such as users, subscribers, bookings, billings, and gross merchandise value (GMV) — can corroborate the evidence of top-line growth in a business as well. However, when it comes to assigning a multiple for the purposes of valuation, public investors still tend to rely more heavily on revenue growth to represent the momentum of the business. Revenue growth also has a “consistent definition” that has been determined and agreed upon according to generally accepted accounting principles (GAAP) for each company given its business model — it’s the only top-line growth metric that is reviewed and certified by independent accountants.
To count a company among the true leaders, public tech investors like revenue growth rates above 30% in the two forecasted years after the IPO. This is because a company growing its revenue consistently above this bar is more likely to be winning against competitors in a large addressable market.
Still, this number can vary within the context of the holistic investment story for the business. Companies considering growth investors for example may go public sooner since those investors like to participate in the high-growth phase of a company’s life, and waiting too long before transitioning to the public markets could deprive these public investors of the opportunity to enjoy that growth. Other companies, meanwhile, may have good reasons for waiting longer. Ultimately, founders need to decide on a forecast revenue growth rate that they’re comfortable with to successfully run their business.
#2 Revenue at Scale
Not only should a company seeking to go public prove that it can grow — and grow fast — but it should show that it can grow at scale. This is partly a law of large numbers mindset: It’s much harder to show high growth rates when numbers are large than when they are small. So if a company is growing fast and is generating a large amount of revenue, it’s more likely that the growth will be sustainable and not the outcome of random events or a fad.
“Scale” is an overused word though. What exactly do I mean by scale? For public investors, the rule of thumb for scale is around $100 million in revenue. There are exceptions of course; this number is more of a desired threshold than a clear line. It gives investors a sense of comfort around the number of years it’ll take for the company to actually attain $1 billion in revenue.
But wait … $1 billion in revenue is a lot! And it’s totally fine if the company needs time to reach that milestone. Public investors just want to see that a company seeking to IPO has a line of sight to $1 billion in revenue, since then it’s clear that the founders have a vision and a plan for sustainable and robust revenue growth. While past performance does not guarantee future results (you’ve probably heard that old saw!), for public investors, historical success is at least an indicator of more likely future success.
At the end of the day, public market tech investors want to see this trajectory because it is the mark of breakout, truly enduring companies. Finally: since it takes real management chops to lead a fast-growing company at $100 million in revenue, public investors are more likely to have faith that the management team already in place has the chops to continue growing the business towards that $1B in revenue.
Now here comes the irony: Access to more resilient capital (among other factors) is the primary reason many companies want to do an initial public offering. Yet the “worst” time to do an IPO is when you actually need the money to continue funding the business! How do we reconcile these views?
Basically, public investors want to see that the company already has enough cash on its balance sheet to fund the business to breakeven, or will soon be generating enough cash to fund the operations of the business. If your forecast financials and business plan shows a shortfall that’s intended to be plugged by the IPO, public investors will view this less favorably — that there isn’t a plan in place driving management toward building a self-sustaining business. Ideally, the proceeds from an IPO would provide reserves to fund an even higher revenue growth rate, reinforcing an already strong balance sheet.
A well-timed IPO should not just be a financing event, but also an evolution of the cap table. What you don’t want is to be forced to go back to the capital markets again once public. And remember, there are plenty of businesses that go public when they’re cash-flow positive and don’t even need the cash, for the reasons outlined at the outset of this post.
Perhaps the biggest difference between private and public companies is how (even more) seriously a company has to take profitability. All companies are expected to eventually generate net income on their income statement (and free cash flow of course) when their business models reach maturity. But in their early stages, most high-growth technology companies seeking to IPO haven’t yet begun to generate the same amount of profitability that they would at maturity.
Measures of profitability can vary widely based on the type of business and its stage of maturity. IPO investors tend to focus on:
- free cash flow for software and internet businesses with subscription-based revenue models;
- net income for hardware, semiconductor, traditional networking, and internet businesses without subscription-based revenue models; and
- EBITDA as a proxy for cash flow for businesses that may have debt on the balance sheet, such as with asset-heavy businesses.
Regardless of the particular metric, however, investors want to see a clear path to near-term profitability. For subscription-based software and internet companies, today’s public investors would ideally like to see cash flow breakeven within a year from IPO but can get comfortable in the range of 6-8 quarters to cash flow breakeven from the IPO. For the sectors and business models that focus on net income as the profitability metric, public investors would prefer to see net income generation much sooner, and will therefore be focused on earnings growth in the forecast.
It’s important to note here that fluctuations in market conditions may affect the timing of this path to profitability. In a more “risk-off” market environment (much like the first half of 2016), investors prefer to see a shorter time between IPO and demonstrable cash flow. In a more “risk-on” market environment (as with the IPO markets in 2012 and 2013), investors may be tolerant of longer runways to profitability.
Software-as-a-service (SaaS) businesses aren’t off the hook, either. Some SaaS companies may think differently about revenue based on whether they’re private or public [more on that in this episode of the a16z Podcast]. But upcoming changes to accounting laws take into account the mismatch innate to SaaS in up-front marketing and sales expenses and actual period of service delivery, and, most of these companies would still be assessed on a free cash flow basis anyway (which has adjustments that don’t fall prey to the other accounting issues). So, even for a SaaS business seeking to IPO it’s important to show two years to cash flow breakeven. There are also other key metrics (like cohort analyses) that can help indicate the health of these businesses as well.
#5 Market Size
Clearly, public investors prefer to invest in companies that have a large market opportunity — they’re looking for evidence of wide-open, huge, total addressable markets (TAM). A large TAM means that the company could reasonably become a large franchise even without extremely high penetration of that market. Larger market size also enables higher long-term growth rates.
But quantifying the size of a market opportunity can be tricky. The TAM can’t just be a theoretical number; for public investors, it should be both credible and proven. The classic way to calculate market size when companies are disrupting an already-established market is by measuring existing revenues of legacy players. Many third-party research publications use this methodology to derive their market sizes for established markets. For newer, less established markets, however, TAM is established through third-party research publications (commissioned or otherwise) along with detailed bottoms-up and tops-down analyses. [We share detail on the difference between a bottom-up and top-down analysis for market sizing here.]
Financial results also help support a company’s case for its large addressable market; for example, robust growth at scale is a good indicator of market size.
#6 Competitive Landscape
Another important aspect of evaluating TAM and the overall IPO opportunity is the competitive landscape for a given company. Who are the competitors — directly, indirectly, adjacently, up and down the stack?
At the end of the day, investors want to pick winners. When a market is crowded with competitors, it suggests that the barriers to entry are too low, making it more difficult for a public investor to gain deep conviction about the prospects of one company over another. That’s why industries with a highly fragmented competitive landscape tend to get much lower valuations. The players are all constantly nipping at each other’s heels/customers too closely, so it’s hard to pick the clear winners.
An addressable market that’s crowded with competitors therefore tends to be a less attractive “fact pattern” (in analyst lingo) to public investors — unless the company can establish clear differentiation against those competitors. For example, it’s really attractive if a company has built barriers to entry/ a highly defensible moat (like strong network effects). Or when a company is creating a market that has no clear competitor. In existing markets, public investors will favor the company that’s systematically taking the customers of the dominant, established vendor in that category (think Workday vs. Oracle).
It seems obvious, but is worth reiterating here, that public market investors want to make sure the company won’t be a one-hit wonder. Remember, they’re looking for the next great franchise. That’s why market-leading companies have multiple products that they can sell to customers. Even if the company is currently winning the market with just one or two foundational products, it usually has other products in play that are on a similar path to adoption.
Many consumer-facing companies may initially go public with one main product, but then develop other products as they expand their scale. The evolution of companies like Apple and the FANG companies — Facebook (social network), Amazon (bookstore), Netflix (mail-order DVDs), and Google (search engine) — is a prime example of this.
For enterprise software companies, product expansion can be demonstrated through the “land and expand” model, where a company establishes a beachhead presence among a segment of customers and then rapidly expands feature packages from there. In this way, the company increases its foothold in the enterprise, isolates competitors, and gains not just new users but more existing users. Since repeat buying from existing customers tends to be cheaper (as a16z partner Mark Cranney likes to say, “the best place to sell something is where you’ve already sold something”), it requires less incremental sales and marketing investment. Which in turn further supports the company’s narrative of margin expansion as well as profitability.
#8 Unit Economics
Most high-growth technology companies exhibit characteristic high top-line growth but low earnings margins. Since they haven’t reached full maturity yet, there’s no “steady state” in their financial models. But investors want a sense of what the earnings margins could look like for the business when it matures.
So how do public investors gain confidence that the company can achieve those earnings margins over the long term? By examining the revenue and costs of a business model, expressed on a per unit basis — in other words, they want proof of sensible “unit economics”. So for a consumer software company, unit economics would be an analysis of the revenue and costs associated with delivering the software to a single user, disaggregated from company-wide costs such as marketing campaigns. Unit economics help isolate “core” costs of the business from the overall costs, and therefore is a good proxy for thinking through long-term margins.
Another way to articulate a unit economics story would be through a cohort analysis [see #10 here]; for example, by analyzing the revenues and costs for a set of customers who bought software in a particular year over time. In both cases, the earnings margin achieved on a per-unit basis should give investors a sense of what the earnings margin could be when the business matures.
Public investors want to invest in companies with leadership teams they feel like they know and trust. Sometimes this trust is built over time as the company meets public investors and explains their viewpoints on managing the business and the results they’ve achieved so far. Other times the trust is more easily bestowed because the team has existing relationships or a track record of experience at other public companies.
As the public face of the company to the investment community during and after the IPO, the CEO and CFO in particular need to gain a reputation as trustworthy stewards of capital, able to competently steer the business towards success. But not all startup CEOs and CFOs will be proven, so how can public investors learn to trust them? By the way they’ve managed their business to date: How are the company’s historical financials and performance? How did they gain market share? Do they understand what levers got them there or didn’t? Can they articulate a vision for the company’s future? And so on.
a16z general partner Jeff Jordan (who was previously CEO and executive chairman of OpenTable and oversaw its IPO) actually recommends that CEOs and CFOs start meeting with public market investors a year or two in advance of their initial public offering. Why? Because this way they can build relationships — and soft track records of delivering performance (“you said you would do $100 million last year, what did it end up at?”) — which also helps build trust.
Finally, even though they aren’t required for making judgments on the leadership ability of the CEO/CFO, there are other partners — such as the right auditors — that companies seeking to IPO should start building relationships with early on as well.
#10 Sales & Marketing
Besides a strong CEO and CFO, public investors will also want to see proven head of product and sales or marketing. It’s the only way to address target customer needs, continue generating an ever-growing revenue base, and help guide new features and products.
A growing sales force is one of the strongest ways of making sure products actually get in front of potential customers. This is true even for products that have a viral, “bottoms-up motion” into the enterprise (e.g., a stronghold from a loyal base of grassroots users). Without a strong top-down enterprise sales and go-to-market motion in place, competitors could still easily come in and grab the most lucrative part of the customer base on top.
Finally, the combined engine of product, sales, and marketing provides critical inputs to the financial forecast guidance used to set investor expectations. The professionals who help set these targets should be the very ones to help meet them.
#11 Financial Operations
The operational machinery required to sustain all of the above is key for building a healthy company, regardless of whether a company is going to IPO. But for an initial public offering, it’s especially critical that there be full-strength financial operations in place.
Meeting the quarterly reporting demands of being a public company means issuers have to be able to produce and publish audited financial results within a specified time frame — quarterly. In order to do this well, a company needs to have appropriately skilled financial staff and financial policies, procedures, and systems in place. These should have already been tested and refined over several quarters before IPO; it’s the only way a company can improve its financial reporting speed and accuracy to the threshold required for a public company.
A common complaint about the pressures of more stringent financial compliance is that the burden falls disproportionately on smaller, growing companies because established companies have a huge staff in place that can already handle it all. Even if, for example, Sarbanes-Oxley (SOX) is uncommon among emerging growth companies — and the JOBS Act has actually lengthened the number of years to comply with SOX post-IPO — it still represents a daunting threshold to many startups. But a16z co-founder Ben Horowitz argues that if the company leadership is good enough operationally to comply with SOX and similar standards, then they’re basically good enough to do anything. In other words, it sets a high bar for what it means to operate a business responsibly, with the requisite operational practices and machinery in place. [You can hear more about this anecdote in this episode of the a16z Podcast].
#12 Other Policies and Procedures
It may seem like “just housekeeping” or an administrative requirement, but formal HR policies — a code of conduct, employee handbook, etc. — provide more than just good workplace hygiene. They provide a playbook for communicating the values and expectations of management to employees (and vice versa), which in turn affects the company’s ability to control and execute on its plans.
Since it can take a while to establish and refine such human resource operations, companies should draft their policies sooner than later, and with the help of legal counsel. It’s not just the mere existence of the policies that matters here though: Are the policies included in the new-hire onboarding process? If someone asks, do people know where to find the documents? Is there a human resources operation in place that has the know-how to handle sticky problems as well as organizational culture issues as a company scales?
Operationalizing policies this way helps prevent and address any potential human resource and litigation issues that invariably arise with any growing business. It’s in a company’s best interest to have these in place regardless of when they IPO.
#13 Vetting Issues
Before submitting to the scrutiny of underwriters and public investors, the company should dig up any skeletons in its closet to make sure there’s nothing to detract from its core narrative en route to IPO. Public investors will want to see these “referendum” key issues managed — including everything from senior leadership backgrounds to regulatory constraints to significant business model shifts.
For example, the backgrounds of senior management can become an issue if they misrepresented anything or have had significant legal issues in their past, even personally. The best way to mitigate this is for a company to run its own background checks on key management team members and board members ahead of time — ideally, this happens prior to the decision to hire. Either way, having time to manage issues is key here.
Other issues could include pending or possible litigation against the company, and even regulatory constraints. With those types of issues, it’s best to anticipate concerns ahead of time and work with legal counsel to properly manage them so that they can be succinctly explained. Preparation and communication is key here.
Interestingly, other referendum issues for public market investors could include the introduction of new pricing models for existing products, or significant business model transitions. The business model changes that tend to give public investors pause are the ones that cause disruptions or fluctuations in financial performance, thus reducing predictability. For example, if a company has moved from a perpetual licensing model (where customers make one-time purchases for a version of software) to a subscription model (where customers make ongoing payments for use of software as a service over time). This is not to say that the company can’t and shouldn’t adapt and evolve its model! But it will have to show predictability and control over its business.
#14 Legal Compliance
Besides the financial compliance and human resources best practices outlined above, there’s a whole set of legal concerns to be aware of as well, both en route to IPO and to be ready to immediately operate as a public company post-IPO.
For instance, all companies — regardless of whether public or private — with customers outside the United States need to ensure that they are in compliance with the Office of Foreign Assets Control (OFAC) and the Foreign Corrupt Practices Act (FCPA). This involves scanning their customer databases and conducting other diligence to ensure they aren’t doing business with government-sanctioned or corrupt entities. Non-compliance can lead to fines or even company leaders going to jail due to violating export restrictions. With freemium models, there are often tricky issues related to export controls because the software is freely available. And if there’s hardware involved, there can be concerns about third-party resellers, even if the company doesn’t sell directly to dangerous actors themselves. Some of this may seem like mundane technicality on the surface, but I’ve actually seen IPOs derailed by not having one’s ducks in a row here!
Most of the legal and compliance efforts post-IPO involve Regulation Fair Disclosure or “Reg FD”, the SEC-mandated rule around selective disclosure and insider trading. Among other things, it requires companies to disclose material information through prescribed channels (for example, press releases on newswires and official company blogs) that provide a fair outlet to market participants.
Other important regular securities reporting and disclosures associated with public companies include the annual (form 10-K) reports and quarterly (form 10-Q) reports. Companies are also required to immediately file a Form 4 if there’s any change in ownership — which of course includes stock option grants and exercises — for any company officer/shareholder owning more than 10% of the company.
Finally, there’s a lot more legal paperwork involved with institutional stockholders and advisors in general (such as ensuring proxies for important corporate meetings and actions), than there are for private companies used to engaging only with VCs. There’s too much to describe comprehensively here, but the point is that companies will need to have a better handle on all this when under public scrutiny. Setting up the appropriate reporting infrastructure just in time for an IPO isn’t a great idea since the company needs time to pressure-test the process. It’s best to work with internal and external legal counsel, finance, and operations to operationalize all this well in advance of a potential IPO.
#15 Proper Governance
Finally, part of proper governance for a public company includes having a board of directors in place that meets certain criteria. This is meant to serve as a backstop for public investors, reassuring them and ensuring that management is truly acting in the best interests of the company.
One such criterion is that a majority of the board directors be independent — i.e., not made up only of friends, investors, or auditors. Another criterion is the existence of an audit committee, compensation committee, nominating/corporate governance committee, etc. The goal of these committees is to provide independent guidance and oversight to the company’s management team on behalf of shareholders around key company actions.
Ideally, a company would professionalize its board in this manner well before going public. Not only can it take a while to find the right board members for a company, but the board can also provide useful advice and hold CEOs to an even higher bar as the company prepares to go public. For example, the board can serve as an initial sounding board for reporting quarterly results.
Board members also bring insights and expertise from their experience that could be extremely useful to the business; who wouldn’t want to take advantage of that?
If there’s one theme that comes through over and over above, it’s about the importance of predictability … which is why I’m calling it out as a separate item here.
If public investors get a sense that predictability around the business is not in place, it can literally sink a company seeking to IPO. Why? They prefer to invest in a business where the management team can articulate a strong and accurate view of the current results and future direction. Businesses that have lumpy or erratic performance make investors skittish because it suggests that the management team doesn’t know what to expect and therefore isn’t in control of the results; this results in diminished valuation and volatility in stock prices.
Above all, investors want reassurances that an “issuer” (the company that is IPOing or issuing shares) will be a good steward of their investment, and that the company leadership really, deeply understands the business. Does the management team have enough control to know what levers to pull or knobs to turn and when — whether it’s to attain cash flow breakeven, adjust spending in order to supercharge growth, or respond to shifts in a very different financing or competitive environment?
Think of missing expectations that the management team has set with public investors as similar to having bad personal credit: Regardless of the extenuating circumstances, missing a loan or bill payment could be a sign to creditors of not having one’s affairs in order. Similarly for companies, missing forecasts creates a lot of noise in the market around performance expectations (and puts companies in what public investors call a “penalty box”). Even if a company performs well, the noise can crowd out the signal.
And yes, generating accurate forecast financials is one of the hardest things for growing companies or companies moving into new markets to do. Especially since it’s done under the constant and sometimes merciless scrutiny of the broader investment public and media. But a company seeking to IPO must be able to give the investment community guidance around future performance and demonstrate the ability to perform within that guidance. Being able to communicate expectations appropriately is part of the art and science here.
To take it one step further, simply meeting expectations isn’t always enough to catalyze a positive inflection in stock price — it’s also important to beat street expectations that have been set based on company guidance. What really gets public investors excited is the notion of a “beat and raise”, which is when a company exceeds expectations for a given quarter or year and then also raises the forecast guidance beyond expectations. This motion has all the trappings of a management team that has shown conservatism in their guidance and communication with public investors, but aims to execute toward ambitious results that far exceed expectations.
Everyone loves a surprise to the upside! The goal, as with everything else so far, is to avoid surprises to the downside — with public companies, it’s all about the “known knowns” (what you know) and “known unknowns” (what you don’t know).
It’s ironic that going public means being transparent, yet the process of going public is obscure — it seems to be the one topic that doesn’t get discussed as openly among CEOs. Hopefully this post helps demystify the process of IPO readiness a bit.
Of course, there are other items we haven’t covered here, from setting the price of an IPO to what founders can do to protect their control after going public (the tradeoffs of a two-tier stock structure for example) and other things to get their house in order. It’s also worth noting that a number of the thresholds mentioned in this post can shift over time, and some shift more quickly than others. As mentioned previously, we have seen recently that the amount of time to cash flow breakeven or profitability that public investors will tolerate can shift according to market conditions; plenty of companies have gone public outside these numbers and have still done well. Yet other items, such as the amount of revenue that constitutes a scale business or the amount of revenue growth that keeps a company in the high-growth category, have taken years if not decades to materially change.
That’s why, beyond which thresholds to meet and the broader question of to-IPO-or-not-to-IPO, many of the items in this checklist are good rules of thumb in any market. But the checklist is about more than just good hygiene — it’s really about discipline and a focus on building a healthy, sustainable business. These are all things founders should be doing anyway: paying attention to cash flow and balance sheet, thinking through their product roadmap and pricing, ensuring great governance, nurturing company culture, and so on.
Predictability and the ability to control one’s business is clearly the mantra here. There’s another recurring theme threaded above as well, which is that the investment narrative really matters, and is tied to the financial profile of the company and industry category. Just as one’s “story is their strategy”, being able to articulate your company story beyond marketing is key on the road to IPO. Part of that story is how your company is going to go from being a growth company to a cash-earning company to, in the long-term, a value company.
All world-class companies follow this kind of trajectory. Everyone wants to invest in a company that’s built to last.
Nicole Irvin is a partner on Andreessen Horowitz’s corporate development team, where she focuses on supporting portfolio companies prepare for potential IPOs. Previously, she worked on a number of tech IPOs as an investment banker at Morgan Stanley's West Coast Investment Banking Division. Prior to that, she worked at Accenture. Irvin has a MBA from Columbia Business School and a BA in Molecular Biology from Princeton University.
This article originally appeared on Recode.net.