Common IPO Pitfalls

An initial public offering (IPO) brings a host of pressures, challenges, and regulatory issues that many founders and executives may be unfamiliar with or unprepared for. The complexity of these issues creates many pitfalls that can jeopardize an IPO’s success. To help navigate the IPO process, this article provides an overview of the more common IPO pitfalls and offers guidance on how to avoid them.

1.  Inadequate Preparation

Inadequate preparation is a major reason for problems during an IPO. Although some executives may think preparation begins with an organizational meeting six months prior to an IPO, initial preparations should actually begin as far as 18 to 24 months earlier, depending on the scope and complexity of necessary organizational changes. Emerging growth companies under the JOBS Act or mature companies with already well-designed processes and infrastructure might successfully shorten this timeline, but even established companies should be careful not to underestimate the time needed to prepare for an IPO.

For example, Palantir—a company with over $1 billion in revenue and a 16+ year history—was expected to go public in 2019. However, Palantir announced that its IPO would be delayed because “it still only has one independent board member, has yet to build out its nascent sales team, and will need to find enough seasoned finance employees to handle a public debut,” as reported by Bloomberg. Because it was unprepared to go public, Palantir now exposes itself to several risks, including reputational damage and investor disenchantment.

Without careful preparation, companies are far more likely to experience significant challenges on the road to an IPO. The following sections focus on aspects of IPO preparation that, when properly executed, will best help a pre-IPO company carry out a successful IPO:

Building a Team. Preparation for an IPO should begin with building a qualified team of both external and internal professionals. The following chart provides an overview of the major personnel required during an IPO.

When hiring new team members for an IPO, current board members and executives should be upfront and honest about the state of the company, expectations for future performance, and the planned IPO timeline. Where possible, team members should have prior IPO experience. For more information on building a team, including a more detailed description of the personnel categories listed above, see the IPOhub article Preparing for High Growth and an IPO: Building Your Team.

Preparing Financial Statements. One of the most time-consuming IPO requirements is issuing financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) and audited in accordance with PCAOB¹ standards. The following steps can help management avoid delays in financial reporting:

1. Long before the anticipated IPO date, select an external auditor that is registered with the PCAOB and experienced with the IPO process.
2. Work with the external auditor to produce two to three years of audited annual financial statements and reviewed interim (i.e., quarterly) financial statements. The exact requirements mandated by the SEC will depend on the company’s age and qualification as an emerging growth company.
3. Develop accounting policies and technical accounting memos for significant accounts and complex topics. These topics may include revenue, leases, debt, stock-based compensation, cheap stock, segment reporting, and business combinations, among others.

By following these steps and working closely with the external auditor, management can ensure that all required financial statements and disclosures are ready for inclusion in the company’s S-1.

The following articles provide further details about various aspects of financial reporting:

• See Audit Prep for the Big Leagues for information on becoming GAAP compliant
• See SOX Readiness for information on the creation and maintenance of internal controls
• See Common Financial Reporting Pitfalls in an S-1 for information on avoiding mistakes in your S-1

Drafting the S-1. Management should plan plenty of time to draft the S-1. Time invested in preparing a robust S-1 should be viewed as a long-term investment because the S-1 can be used as a template for future 10-Qs and 10-Ks,² which will facilitate more efficient quarterly and annual reporting. For more information, see the IPOhub article Drafting an S-1.

Closing the Books. Public companies rely heavily on the closing processes of their respective accounting departments. Monthly closes are standard, although only quarterly and annual financial statements must be filed with the SEC. Fortunately, technological advancements have greatly improved the efficiency of closing the books, reducing the strain on new public companies to stay current on financial reporting requirements. Nevertheless, executives should assemble the necessary people, processes, and systems long before going public to ensure financial reporting success. Accounting personnel should also carry out several quarterly closes before going public to prove the timeliness of the implemented processes. As a point of reference, PricewaterhouseCoopers LLP found that in 2017, companies with a median revenue of $2.5 billion could usually conduct their quarterly close in 4.5 days.

2.  Weak Corporate Governance

Strong corporate governance is critical to an IPO’s success, while weak corporate governance can destroy value and call into question a company’s reliability. The role of corporate governance may be defined as ensuring that “businesses have appropriate decision-making processes and controls in place so that the interests of all stakeholders are balanced.”³ Stakeholders for a startup may initially include only founders, employees, suppliers, and customers, but the list quickly grows to include angel investors, venture capitalists, creditors, and, with the advent of an IPO, public-market investors. Establishing a proper governance structure can contribute to long-term success in the eyes of all stakeholders by emphasizing long-term value, aligning incentives with long-term objectives, and improving oversight and compliance.

Corporate governance typically starts with a board of directors. Board members of most pre-IPO companies include preferred shareholders, such as venture capitalists, who are closely tied to the company. However, once a company goes public, the requirement for independent directors forces a reorganization of the board. Current board members can facilitate this transition by establishing a succession plan that will be well received once the plan comes under public scrutiny during an IPO. For instance, investors are often wary of founders with too much control,⁴ so retaining founders as board members may be unwise. In addition, stakeholders are increasingly interested in maintaining diverse boards, with Goldman Sachs going as far as refusing to take companies public unless their board of directors includes at least one diverse member.

WeWork provides an insightful case study into the importance of corporate governance. Leading up to WeWork’s IPO, investors displayed unease with the company’s apparently weak corporate governance structure. Reports emerged that the CEO, Adam Neumann, owned many of the buildings leased by WeWork, received millions in loans from the company, and encouraged a culture of partying and drug use. As investors became increasingly concerned about the extent of Neuman’s control and the apparent lack of oversight, WeWork’s valuation plummeted from $47 billion to $10 billion. WeWork was forced to lay off thousands of employees, Neumann stepped down as CEO, and the company cancelled its IPO. Although WeWork suffered from additional problems beyond corporate governance, proper oversight could certainly have helped WeWork avoid many of its IPO pitfalls.

3.  A Misunderstood Business Model

Helping investors understand the potential of a pre-IPO company’s business model is critical to IPO success; misunderstandings can reduce investor interest and generate negative publicity. Unfortunately, when presenting to public market investors, executives may unintentionally cause confusion just when maximizing investor interest becomes most important. Misunderstandings may begin with or be exacerbated by unprepared responses to investor questions, an overly complex story, or the nature of a company’s business model.

Unprepared Responses. A company is particularly vulnerable to public speculation prior to an IPO because investors are seeking assurance about the sustainability of the company’s competitive advantage. Consequently, unprepared and unpracticed responses by executives, particularly during a roadshow, can derail an IPO. For example, during Google’s roadshow, Google executives were unable to adequately respond to questions about Google’s strategy in dealing with competitors.⁵ These poor responses likely contributed to Yahoo’s immediate jump in share price and Google’s subsequent reduction to its IPO price.⁶

A Complex Story. Founders can get away with a complex story prior to an IPO because venture capitalists tend to invest significant time into understanding a company’s potential for profitability. However, when facing public market investors, founders must adapt to shorter attention spans brought on by the need to monitor more companies. Furthermore, public markets tend to move more quickly than the private markets. One method of quickly engaging investors is to focus on unique intangible assets. Intangibles—which now make up over 80 percent of the S&P’s market value⁷—may include a talented workforce, intellectual capital (patents, trademarks, copyrights, etc.), or brand reputation, among others. By focusing on their company’s most important intangible assets, executives can simplify their story and differentiate their company from competitors.

Questionable Business Model. Sometimes the nature of a company’s business model can lead to negative publicity. Negative publicity may result from severe unprofitability leading up to an IPO, an apparent lack of social responsibility, or a potentially unsustainable competitive advantage, as demonstrated by the following examples:

• Uber’s lackluster IPO could be attributed in part to investor concern over the profitability of Uber’s business model, which lost over $1 billion in the quarter prior to Uber’s IPO. This concern deepened when Uber lost an astounding $5.2 billion in the quarter after its IPO.
• Airbnb, which has made plans to go public, was criticized for lacking social responsibility after studies revealed Airbnb’s negative impact on the housing market. The Economic Policy Institute went so far as to claim that the economic costs of Airbnb likely outweigh its benefits.⁸
• Prior to WeWork’s failed IPO, investors were questioning whether the company even had a sustainable competitive advantage. This concern came in part because competitors could easily copy WeWork’s business model, after which WeWork would not be able to easily differentiate itself.⁹

Executives should seek to proactively respond to questions about their company’s business model. Through proactive efforts, executives can often limit negative publicity while also increasing investor confidence.

4.  Regulatory Violations

Regulatory compliance can be overwhelming for companies looking to go public. However, most litigation and noncompliance can be prevented simply by engaging a reputable legal firm early in the IPO process. Still, reliance on legal professionals does not eliminate the need for executives to understand common regulatory violations and how to avoid them. Due to the number of potential regulatory violations, this article focuses only on two regulatory violations around communication that are particularly relevant to executives: (1) gun jumping, which is a violation of the US Securities Act of 1933, and (2) violations of Regulation Fair Disclosure (Reg FD).

Gun Jumping. Gun jumping refers to any communication or publicity before, during, or after an IPO that violates restrictions outlined by the Securities Act. The SEC defines three distinct periods with varying restrictions: the pre-filing period, the waiting period, and the post-effective period.

• The pre-filing period starts when a company decides to pursue an IPO and ends when its registration statement is filed with the SEC. During this time, the SEC generally prohibits anything that could be construed as an “offer”¹⁰ of securities, except when “testing the waters”¹¹ with certain qualified investors.
• The waiting period begins upon filing a registration statement and ends when the statement is deemed effective by the SEC. During this time, any sale of securities is prohibited, but the SEC allows companies to make limited oral and written offers.
• The post-effective period begins when a company’s registration statement is deemed effective by the SEC and extends over a 25-day “prospectus delivery period.” Even though a company becomes public when its registration statement is deemed effective, the SEC prohibits the disclosure of information beyond what is in the company’s final prospectus. Once the 25-day window has passed, the Securities Act no longer restricts communication.

Violating gun-jumping laws can result in fines, reputational loss, and a delayed IPO, among other consequences. For example, Groupon Inc. filed its registration statement with the SEC in June of 2011 in anticipation of going public in September. However, during the waiting period and in response to negative publicity, the CEO sent an email to all Groupon employees expressing his confidence in Groupon’s future success. Unsurprisingly, the email leaked to the public, and Groupon found itself in violation of gun-jumping laws. The violation forced Groupon to delay its IPO until November, and the SEC required that Groupon include the email in an amended Form S-1¹² and assume liability for the email’s contents.

Reg FD. As soon as a company’s stock starts trading, the company becomes subject to Regulation Fair Disclosure. To prevent insider trading, Reg FD prohibits company executives from selectively disclosing material non-public information to outside parties. Because violations of Reg FD can result in significant personal liability for the offending party, all senior officers should be knowledgeable about the restrictions imposed by Reg FD prior to going public. Common methods of mitigating Reg FD violations include preparing detailed scripts for quarterly earnings calls, conducting regular trainings on disclosure policies, and making all analyst calls public. For more information, see the IPOhub article Regulation Fair Disclosure.

Executives should remember that even implied or unintentional violations of gun-jumping laws or Reg FD can result in significant penalties. For example, in 2010, Office Depot executives conducted several one-on-one calls with analysts in which the executives implied that Office Depot would not meet its earnings forecast. Even though the executives did not explicitly convey non-public information, the SEC determined that the signals sent by Office Depot executives constituted a violation of Reg FD. Office Depot was fined $1 million, and the executives were each required to pay a $50,000 penalty.¹³

5.  False Expectations

Setting false expectations is a major pitfall before, during, and after an IPO that can ultimately damage a company’s credibility and destroy shareholder value. Although executives may set false expectations to intentionally mislead investors, false expectations are more often created by over-optimism or in response to pressure.¹⁴ Regardless of the reason, setting false expectations is especially harmful during the IPO process because investors and analysts have little historical information on which to rely, forcing greater reliance on assurances made by management. This greater level of reliance leads to greater consequences when expectations are unmet.

For example, in the quarters immediately following a company’s IPO, analysts fully expect the company to meet all forecasts as outlined during its roadshow.¹⁵ Any negative deviation usually results in a plunging stock price, such as when the stock prices of Pinterest and Uber dropped by 14 and 12 percent, respectively, after they missed their first quarterly earnings targets. Therefore, when pressured to set unreasonable expectations in response to external pressures, executives should remember that (1) the magnitude of demands and the seriousness of consequences only increase when a company goes public, and (2) providing stakeholders with an accurate picture of company performance is ultimately more likely to create long-term success.

In addition to overpromising, executives may be tempted disclose positive information that does not truly align with their long-term strategy. For example, companies commonly include key performance indicators (KPIs) in their Form S-1 to increase investor confidence regarding company performance. Investors value the information provided by KPIs and expect them to be reported in the future. Therefore, if executives are unwilling to consistently report these KPIs in future quarterly and annual reports, the harm from setting false expectations for investors may exceed the short-term boost to investor confidence. Lyft fell into this trap when, in its first quarterly earnings call as a public company, management did not report gross bookings and take rate—two metrics they had showcased in their IPO filing. Lyft’s CFO justified the omission by explaining that the metrics were misleading given Lyft’s recent investments in new services. Nevertheless, investors remained skeptical, and Lyft’s stock price dropped by 10 percent soon after the earnings call.

Conclusion

The complexity of the IPO process can easily lead to a variety of pitfalls. Although the room for error may feel overwhelming, executives can greatly improve their company’s chance for a successful IPO by simply being aware of the common pitfalls mentioned in this article. As executives recognize potential pitfalls during the IPO process, they will be better equipped to anticipate and avoid many of the serious mistakes that can delay or even prevent their company from going public.

Resources Consulted

• Latham & Watkins LLP, US IPO Guide: 2019 Edition
• PwC, Roadmap for an IPO
• Skadden Discusses Jumping the Gun: Social Media and IPO Communication Issues