#14 What happens in an IPO? (Part 1/2)

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Hi, Vivek here. Hope you are staying indoors. Covid is not over yet.

Few points before we jump into the piece.

  1. This is a beginner's guide to IPOs. Like really basic. So feel free to jump out if you are a finance star.

  2. I worked on 2 IPOs and a re-IPO (yes, this happens) during my time at Goldman Sachs which helped me add a bit more detail to this piece.

  3. The IPO process is largely similar across countries. There are differences of course but only when you get into the finer details like registration forms, eligibility criteria, etc. I have kept the piece US and India centric but it applies to other regions as well.


Describing the IPO process normally can get really boring. So I decided to tell it through the lens of a fictional story. Here we go.

Step 1: Path to Profitability

Investor Raj walked to the elevator nervously excited. Today was going to kickstart the culmination of years of hard work and patience on one of his investments - TinyPanda.

Incorporated by Founder Lata after she created an exceedingly good file compression algorithm, TinyPanda built a compressor app to be sold to consumers. Lata spent all her savings and hired 2 developers to help her build the first version of the app. As the number of app users grew to 1000+, Lata had to hire a few more people - customer support staff, marketers, etc. She needed more money to hire these folks and turned to friends and family for help. When the app crossed 10,000 users, even money from friends wasn't enough. She needed a larger sum. It was time to raise money from an institutional investor (in this case, a venture capitalist).

It was around this time that Raj and his team first met with Lata. Impressed by the performance of the product and aware of the growing data storage needs for even a layperson, Raj decided to write a cheque.

The consumer app, however, plateaued in growth after 20,000 users. Raj realized that while Lata had a quality product in hand, she was selling it to the wrong set of people. Raj and Lata worked hard to pivot TinyPanda to a file storage software product (built on top of the compression algorithm) that could be sold to corporates. The revenue needle did move up a bit but they soon realized they were in a heavily competitive space which included giants like Google and Dropbox.

Back to the drawing board again, they pulled back the file storage product and decided to sell only the compression algorithm as a subscription service - a compression layer between the place where information is generated and where information is stored. The sell was simple - pay a monthly amount based on the amount of data compressed and save loads on data storage costs. It was a masterstroke. TinyPanda didn't need to compete with file storage companies anymore; it could be used along with them. And the more data corporates stored (which was bound to grow), the more TinyPanda earned. Growth exploded with the new model and TinyPanda was set on a clear path to profitability.

It was now time for Raj and all the other investors who had backed Lata during the tumultuous journey of all the pivots to begin thinking of their 'exit' - so they could en-cash their shares and make a good return for all the risk they took. With the kind of money TinyPanda was raking in, all the investors agreed that taking the company public was the best exit scenario compared to selling TinyPanda to another company.

It was for this reason that Raj found himself on this elevator heading up to the conference room on the 7th floor. The board of directors of TinyPanda were meeting to discuss when and how to take the company public.

Theory time!
Hello, this is Bala. You haven't met me yet but I am a character who appears later in the story. I will be jumping out of the story to explain certain concepts to you from time to time. Let's begin.

What does going 'public' mean?
It's when a company decides to offer its shares to a larger group of people - individuals like you and me (called "retail investors") and institutions like mutual funds, pension funds, etc (called "institutional investors") which are mandated to invest their money only in trustworthy public companies. Since it's the first time the company is doing such a thing, it's called "Initial Public Offering (IPO)". Before going public, the company's shares are largely held by the founders & their family and/or by venture capitalists and private equity firms. Going public is also called 'listing' since the share is listed on a stock exchange like the Bombay Stock Exchange (BSE) or the New York Stock Exchange (NYSE) during the IPO. Once listed, anyone can start buying or selling shares of that company via the stock exchange which wasn't possible when the company was private.

Are all the shares issued new?
There are two kinds of shares being offered in an IPO.

  1. Existing shares held by current investors. These shares (called "secondary offering") just exchange hands during the IPO from current investors (who are "exiting" the investment) to new investors. The money raised from these shares goes to the investors' pockets and not the company's coffers.

  2. New shares. These shares (called "primary offering") are created during the IPO process. The money from these shares goes to the company's coffers. If you are investing in the IPO, it wouldn't matter to you which share you are buying since they are all priced the same. Most IPOs have both kinds of shares on offer and secondary shares, typically, are the larger component. This makes IPO more of an "exit event for current investors" than a "fundraising round for the company". This is a very important distinction to keep in mind and look out for while evaluating IPOs. In TinyPanda's case, it's primarily going to be an exit event.

Back to the story.

Step 2: Board Resolution

Seated alone in the conference room, Founder Lata had mixed feelings. The board members, in this very room a few minutes ago, had voted to kickstart the IPO process for TinyPanda - the company she founded 6 years ago. Lata was both anxious and happy about the impending change TinyPanda was about to go through.

Anxious because the IPO process involved intense scrutiny of the company's business plan and financials. It would be the first time TinyPanda's value would be determined, not just by a handful of people like in previous fundraising rounds, but by a larger group of public market investors - a real test of the company's worth. This process was also going to be mentally and financially taxing coupled with the risk of falling through (like WeWork's IPO did) - a public relations disaster.

At the same time, Lata was also happy because going public did have its benefits. The intense scrutiny, while a source of anxiety initially, would also pave way for trust and transparency - foundations on which a long-lasting company is built. This trust would also ease their efforts to raise funds from banks (in the form of loans) instead of selling part of ownership (equity). The ensuing media coverage would strengthen the brand easing hiring and possibly attract new customers as well. And most importantly to her, it was an opportunity for all the employees of TinyPanda to get rewarded for all their hard work by exercising their stock options during the IPO.

This decision to take TinyPanda public wasn't a sudden move. Things like this don't happen on a whim. The vision of TinyPanda as a public company was set more than 18 months ago after the company cracked the right model of selling its product and profitability became a reality. Over the next few months, Lata spent time readying the company in anticipation of a potential IPO. This meant figuring out the right organization hierarchy and structure, hiring key management personnel (hiring a stellar person to head sales, a chief financial officer with a solid track record that future public investors could trust, etc), putting legally required checks in place (called "corporate governance"), rechecking if all the legal registrations are in place, and creating a solid growth plan for the future.

With the board now having given a green light to start the IPO proceedings, it was time to choose an investment bank that would advise and lead the process.

Step 3: Choosing the Investment Banker

Banker Bala smiled, clearly pleased with himself (yes, it's me, the same Bala you met earlier). He was sitting in the corner office on the 18th floor of JP Murugan, a large investment bank. A decade spent here and he was now the managing director of the equity capital markets division. And he smiled the same smile every time his plan worked to perfection. He had just gotten news that TinyPanda had chosen JP Murugan to advise on their IPO.

Analyst Anil was sitting at his desk observing Bala's office through the corner of his eye. Boss seemed to be in a good mood. Great! Good time to have a chat with the boss. Anil’s summer internship was coming to an end soon and he wanted to maximise his face-time with the boss. Apparently, that would help him score brownie points and hopefully convert this internship to a full-time job offer. Anil walked over to Bala's office and peeked in.

“Hey Bala, good time to chat? Thought I will catch up and check how my internship is going.”

“Hey Anil, come in. Great timing actually. You remember the TinyPanda RFP that you worked on for the last 3 weeks? We just got the mandate.”

“Oh that’s great to hear. Seems like our RFP pitch did the trick".

Anil remembered that the RFP or “Request for Proposal” that Bala was referring to was an invitation TinyPanda sent to investment banks. The banks got 3 weeks to prepare & submit a pitch to TinyPanda about why they should be chosen to advise on the IPO. Around a dozen banks had gotten the RFP. And 6 were shortlisted to present in person at TinyPanda's office based on which the final advisors were chosen.

Bala laughed loudly at Anil's innocent statement.

"Anil, tell me what did we include in the pitch deck we sent them?"

Anil excitedly started listing down what had gone into the RFP (brownie points, remember?)

"Well, we included our understanding of the data compression market and how TinyPanda's product fit into the market. And why we thought it is such a great business. We also included what we thought TinyPanda's valuation should be. Post that, it was mostly about us - our past experience of advising on other software IPOs and how we are global leader in IPO advisory, the details of the team who would we involved in TinyPanda's IPO, and lastly, our strategy on marketing TinyPanda's IPO and the support we will extend them even after the IPO."

Bala listened patiently, nodding his head at every point.

"Ok Anil, what do you think the other banks would have pitched?"

"Umm, I guess the same things??"

"Exactly! The services offered by investment are what we call 'commoditized'. There's hardly any difference between what each bank offers. It's not like our advice is better than Citibank's. Most of the big banks have been around so long that most of this process is figured out and set as a template. So the RFP pitch, while necessary, doesn't actually influence the end result much. It is just a task on the checklist that we have to tick."

More than surprised at what Bala had just said, Anil was thinking about the long nights he had spent on the RFP pitch and cursing himself for wasting his time. He quickly pulled himself together and asked

"So what actually helped us get the mandate?"

Anil noticed the same smile spread across Bala's face that he had seen before entering the office.

"Investor Raj and I were in the same MBA class years ago. I had been building a relationship with Raj for a while now so I have first preference on all his investments that would go public. For clients like Raj, knowing that a familiar face is advising on the IPO helps a lot. Remember, in investment banking, the hands you shake are more important than the things you make. This is the reason why we hire from elite universities. As you and your peers climb up the ladder, you have access to an invaluable network."

Anil was surprised. Bala must be in a really good mood to be spilling out trade secrets like this. But he was glad this was happening. His plan to get face-time with his boss and build a relationship with him did seem to be on the right track. Anil prodded further

"I see. So because of this relationship, JP Murugan is the only one that got the mandate"

"No no no. We are not the only ones. Those pesky idiots at Silverman & Silverman (S&S) and Bakarwaleys also sneaked into the deal."

"Wait, so how does that work? Won't there be clashes if multiple people are advising?"

"No. It is typical for more than one bank to be chosen. One bank will be the lead advisor (also called "Global coordinator/GCs") which is us. The others (2-3 banks) will play a supporting role (called "Joint Bookrunners/JBRs"). Since we are the lead bank, we will drive the process. The JBRs will come in where we need them, usually towards the latter half of the process when we are marketing the IPO to many institutional investors. So the number of JBRs on a deal depends on the size of the IPO. A larger IPO size means marketing to more investors and hence needs more manpower/banks. The oil company Saudi Aramco for example hired more than 9 banks when it was planning its $100B IPO. TinyPanda is expected to be a billion-dollar IPO at least. Hence the need for 2 other banks."

"So isn't that a good thing for us? Our work reduces because of the division of labour"

"Nah. Because even the fee gets split between the banks. So you know already that the IPO fee is around 2-3% of the IPO deal size. That % doesn't increase when there are more banks. It just gets split among the banks. We as the lead bank get the largest share but it still sucks to lose some share to those idiots at S&S."

Anil was taking a mental note of all the things he had just learned when Bala's desk phone rang. He knew the meeting was up. Anil excused himself and walked out of the office to the grunt work that awaited him now that they had got the IPO mandate.

Theory time. Bala here again. I already bored that useless Anil with a lot of gyaan (he's definitely not getting a full-time offer). But I want to bore you as well.

Understanding the structure of investments banks and what all services they offer is critical to understanding the IPO process better. So here's a quick explainer.

Investment banks fall into two buckets.

  1. The really big investment banks called “bulge-bracket banks”. Goldman Sachs, JP Morgan, Citi, and Barclays are global examples. In India, you have the investment banking arms of banks like SBI and Kotak.

  2. The smaller investment banks called “boutique banks” like Cantor Fitzgerald in the US and O3 capital in India.

Bulge-bracket investment banks are typically preferred in an IPO because of the broader range of services they offer compared to boutique banks. This is also the primary difference between the two. Bulge-bracket banks have a suite of offerings that broadly fall under 4 divisions.

1. Investment banking division - While they are called investment banks, technically, investment banking is one division inside them. This division offers advisory services when a company want to buy or sell itself to another company (mergers & acquisitions) and when a company wants to raise funds from the market (capital markets). An IPO falls in the latter category. The teams here mostly work on valuing companies, creating pitches (like in RFPs) and executing the deals (IPOs, mergers, etc)
2. Sales & trading division - The sales part of this division are mostly on the phone trying to convince institutional investors to buy shares of a company they think is good. If a client ends up saying yes, the trading part of the division comes in. The traders actually punch in the order on the computer and execute the buy or sell order. Zerodha and Robinhood are for retail investors like you and me to buy/sell shares. Institutional investors and hedge funds use the trading division of these banks to execute large buy/sell orders.
3. Equity research division - This division publishes the reports on companies that rate the companies' stock as either buy or sell or hold.
4. Asset management division - This division typically takes money from very very rich people and invests that in different places with the aim of maximizing returns. They are managing the assets of these rich people and hence the name.

There are more services offered by each of the divisions but I have covered only the most important ones.

In contrast, boutique banks usually have only the investment banking division. An IPO requires the services of the first three divisions and hence the preference for bulge brackets. So bulge-bracket banks also include details like the global reach of their sales division and the depth of experience of their equity research division in the RFP pitch. These matter for the IPO.

In our story, you can see that the investment banking division has already come into play - they are the ones who deal with the RFPs. We will see the role of the other divisions later as the story progresses.

Before we jump back into the story, another quick point about the IPO fee.

2-3% of the IPO deal size as fee might seem small but actually are a money-maker for banks. 2% of a $1 billion IPO translated to $20 million. And given a team of around 5-6 people from a bank work on it for around 3 months (cumulatively across different weeks of different months), it comes to around $1 million per employee per month.

This obviously gets lower when there are multiple banks involved. The lead bank could get 50% of the $20 million while the 2 JBRs get 25% each. The % share is different for each deal based on how much work is allocated to each bank. But say, even at $500K per employee for just one deal, it is profitable for the bank.

Geography too determines the fee. IPOs in the US cost anywhere between 2-5%. Europe is around 1-3%. Asia (including India) costs as low as 0.75% to max 2%. The stock exchange where you are listing will determine the geography - best to choose a bank that has a strong presence there. However, you can market the IPO share to investors across the globe and not of that country alone. So you will also need a bank that has a global reach. Again, another reason why bulge-bracket banks are preferred.


Oooh, this is getting long. Take a break. Get coffee. Popcorn. Whatever. Just come back quick because I am insecure about you leaving the piece mid-way. Really, please come back.


Step 4: Kick-off Meeting and Due Diligence

There was a lot of bustle in the TinyPanda office that day. More than 20 people had crammed into the conference room for the official IPO kick-off meeting. There was Founder Lata and her CFO, the investors and the bankers from all the banks involved. There were also the auditors and lawyers who had just been chosen.

Only the 20 odd people gathered in this room knew that TinyPanda had officially started preparing for an IPO. No one outside this room knew. No one else was supposed to know. This was a highly confidential process and everyone was covered by non-disclosure agreements. The term for such a group working on a confidential IPO process is, and clap for the creative name here, the "working group".

3 hours later...

Lata yawned as she walked out of the conference room to get a cup of coffee. She could have asked the assistant but she needed a break. This meeting was taking forever. They had been discussing the potential timelines of the IPO, what registration forms to file with the regulators and deciding who does what. As soon as they would settle on a timeline, one of the bankers or lawyers would point out a problem and the discussion would start all over again. It was frustrating but Lata also knew this was necessary. The kick-off meeting, however, would end soon. It was what came after that Lata was dreading - due diligence.

During the due diligence (DD) phase, the bankers, auditors and lawyers would dig deep into the company - to check if everything is as they say it is. Over 4-6 weeks, Auditors would pour over the financial statements of the company (profit & loss statement, balance sheet, cash flow statement). Bankers call customers and do reference checks. Lawyers check if all the necessary corporate governance systems are in place as required by law for a company going public. And Lata would have to be available at all times to answer questions and fix any gap that might be uncovered during the DD phase. And she had to do all this while continuing to run and grow the company. The next few months were going to be hard but she had weathered much harder times. She was going to get through this. She had to if taking TinyPanda public would help create a foundation for the company to last decades.

With renewed enthusiasm and a cup of steaming coffee in hand, Lata headed back to the conference room.

Step 5: Preparing the S-1

Due diligence began right after the kick-off meeting. No time to waste if they had to meet the timeline of listing within the next 6 months as decided in the meeting. In parallel to the DD, the bankers and lawyers got to preparing the S-1.

Hey hey hey, your boy Bala here. Sorry for breaking your flow but need to give a quick bit of info about S-1 here.

A US company planning to list its shares on a US stock exchange has to file the S-1 form with the regulator SEC or Securities Exchange Commission. The S-1 is a 300-600 page long document that covers various bits of information about the company like what it does, the risks it faces, its financial statements, management details, the IPO details and company ownership structure. The format of the S-1 is pre-defined by the SEC so that the company discloses all information that is necessary for future investors to take an educated call on whether to invest in that company. The SEC gives a nod to the company to go ahead with its IPO plans only after thoroughly checking the S-1.

Here is Uber's S-1 if you want to take look at what the document looks like.

The S-1 filing is also the first time the company's plans to IPO are made public. You and I, the media, anyone can download the S-1 from SEC's website. The company is also legally required to follow up the S-1 filing with an official press release stating its intention to IPO. Up to the S-1 filing, only the working group, as mentioned earlier, are aware of the IPO plans (unless the founders announced the plans in public beforehand which happens sometimes).

A foreign company listing its shares on a US stock exchange has to file the F-1 form., which is like the S-1 but with additional questions around taxation and litigation since the company is from another country.

In India, the SEC equivalent is the SEBI or Securities Exchange Board of India. And companies wanting to list on an Indian exchange have to file the Draft Offer Document. The content is more or less the same as the S-1. It just goes by a different name.

It is the S-1/Draft Offer document that eventually becomes the prospectus.

Back to the story.

Lata was swamped with work as she had expected. Over and above the time she has to put into DD, Lata also had to work long hours with Bala and Raj to figure out the narrative, ie, how best to explain the company and the industry in the S-1 to make it exciting for investors. The rest of the details to be filled in the S-1 had been split between the lawyers, bankers and TinyPanda's finance team.

Lata was also in for a surprise when Bala one day told her to be prepared for the Analyst meeting. They were 2 months into the S-1 preparation and was confused about this new step. Bala explained that public companies generally have reports published about them by analysts from the equity research division (remember the 4 divisions of investment banking). For example, the analyst of Snapchat at JP Murugan's equity research division published a 2-3 page report every quarter when Snapchat releases its financial performance for that quarter. And at the end of that report, they have a 'buy the share' or 'hold the share' or 'sell the share' recommendation. But when a company is going public for the first time, there are no such reports about the company available. So the equity analysts like to do an Initiating Coverage Report (ICR) which is a bit more detailed (70 to 100 pages). Unlike the S-1 which is created by TinyPanda itself, the ICR is written by the analysts. It is their own opinion of TinyPanda and they are free to rate TinyPanda's shares as a buy or a sell. This is important going forward in the IPO process since investors can also look at a 3rd party's opinion about TinyPanda apart from reading TinyPanda's S-1.

Hey, Bala again. A small bit of trivia here.

Getting these analysts involved in the IPO process is actually a huge legal process. The investment banking divisions in all banks work inside what is called a 'chinese firewall'. They are cut off from the rest of the 3 divisions since they deal with highly private and confidential information like who is going to IPO soon and who is acquiring whom. This information cannot be passed on to colleagues in the other 3 divisions since they can use that confidential information to game the stock market (which is a criminal act called 'insider trading'). So all banks have legal & compliance teams who ensure no emails are exchanged between investment banking and other divisions without prior permission.
For TinyPanda’s IPO, I had to separately apply for permission with the compliance team at JP Murugan specifying exactly which research analyst I want to cross over the chinese firewall. And post permission, all the emails and calls between me and the research analyst are mediated by the compliance team.

Lata understood Bala's point about the ICR report providing a 3rd party opinion. It was more work for her but this was too, like everything else, important. So an 'analyst day' was arranged and the research analysts from all the 3 banks JP Murugan, S&S, and Bakarwaleys came down to question her and the CFO about the company's performance and future plans. This Q&A session would lay the groundwork for their reports. It was a gruelling 4-hour session. The analysts were ruthless but Lata was glad at the end of it. One because it was over and two, because the analysts seem satisfied with her answers.

4 months since the kick-off meeting. A day before the S-1 filing...

Lata was sitting at her desk in an upbeat mood. This was it. The S-1 had taken 3 months to complete. And it would be uploaded on SEC's website tomorrow. This also meant the media and the public get to officially know about TinyPanda's IPO plans tomorrow. Lata was looking forward to the burst of PR that would follow the next few weeks. It would be good for the company.

Technically, the S-1 was not entirely complete. While most of the sections were filled, few important details related to the IPO were not yet finalized. Like how many shares of the company would be offered in the IPO and at what price. They also were yet to decide how many shares Raj and the other investors would sell in the IPO. But that was okay. SEC/SEBI allowed a company to file the S-1/Offer document and add these details later. This was the general practice since the final number of shares and price would only be decided a day or two before the share actually started trading on the stock exchange.

What was decided in the S-1 though was that TinyPanda would list on the New York Stock Exchange (NYSE) with the stock label "TINY" (called the ticker). Lata was very clear from the beginning that they had to list on the NYSE. She also liked the ticker TINY since it was a play on what they did, ie, compress data. Luckily the label was available and she hoped SEC would approve it.

As Lata smiled at herself, feeling clever for coming up with the ticker name, the computer screen in front of her lit up. A new email had landed in her inbox. As she read the email, her smile disappeared. It was from a familiar name. And this email was sent as a continuation of a conversation that was more than a year old. Fumbling, she pulled out her phone and called Investor Raj. He too had received the email. In an urgent tone, she said "Let's call for an emergency meeting. I think.....I think we might have to put the IPO plans on hold. Or maybe even call it off."

<insert suspense music>


Read Part 2

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