What’s in an IPO? My experiences through GrubHub’s offering from start to finish
GrubHub had it’s Initial Public Offering on April 4, 2014. In many important ways, this was the start line for a new phase of the company. For me personally, it was the finish line after eleven years of hard work. Now, ten months later, I’m far enough from the events that I’m able to speak about them. This then is an attempt to share the IPO experience from the founder’s perspective.
The process itself is very opaque to those outside it. As a first-timer, I had little understanding of it relative to the bankers, lawyers, and investors that had gone through it many times before. This relative difference in experience combines negatively with the reality that every player in the process is optimizing for their own interests. I needed to educate myself rapidly. So then, here is a post that describes the process for those interested. I’ll try to keep the editorial content to a minimum because the nuts and bolts are quite interesting to a lot of people. Not to mention, I need to be careful about what I disclose…
And that’s the big highlight of the IPO process. It is very secretive. This secrecy is inherent in the structure of the process. By convention and SEC rules it is covered by a “quiet period” from the filing of the initial registration statement with the SEC all the way to the “pricing”, which is the night before the first public trade (more on defining the steps in just a bit). For traditional filers the start of the quiet period is very clear: the filing of the registration statement (also called the S-1). This traditional quiet period has been extended with the passing of the JOBS act, which allows emerging growth companies to file their initial registration confidentially. For confidential filers there is a lot of ambiguity as to where the quiet period should start. The bankers and lawyers, who are by their very nature conservative, address the ambiguity by arguing that the quiet period then extends all the way back as early as the “org meeting” (again, I’ll define these steps in just a moment).
So, on to the process itself. The ‘formal’ IPO process is quite long: taking about nine months from soup to nuts. Informally, the process is even longer. Countless prep elements must be addressed in the years leading up to the beginning of the formal process. Then, at the end, tack on another six months for “lock ups” and yet another six months for “secondaries”. A smooth IPO can be 21 months from “org meeting” the start to the day a founder can sell their first share on the public markets.
For GrubHub, the process was even longer because we prepped twice. We started the process once, only to halt it when we reached an agreement to merge with a competitor, Seamless Inc. Because of this, I had a unique opportunity to see several of these steps twice, with different players involved. In fact, my role in the company changed from the 1st time through to the 2nd. Seeing the same events repeat, but from a different seat was an interesting experience… and sometimes challenging as well.
What is an IPO?
Fundamentally, the IPO is a transaction. The transaction happens in two parts: the pricing and the opening trade.
In the pricing, an investment bank buys a set of shares from the company at a pre-agreed price and then sells them to a syndicate of institutional investors. It happens on the night before the IPO, typically just after the markets close.
The next morning, those institutional investors begin selling shares to the general public on a particular exchange. This opening trade is what most think of when they envision the IPO.
The amount of the shares to be sold in this transaction have a practical minimum. It doesn’t make sense to sell less than $100 million-ish worth of shares during this initial transaction. It would be too hard to get one of the big investment banks to rally their sales and underwriting teams. They carefully guard their relationships with institutional investors, so they aren’t going to let just any small potatoes company go pitch to them. If they did flood the investors with small deals, they would lose their access. To avoid correction in the comments, I hasten to point out that there are exceptions to this minimum.
The % of the company sold, and therefore subsequently available for public trades, is called the float. Basic macroeconomics suggests that the size of the float (supply) and the amount of interest investors have in the company (demand) will determine the price of the stock. Too much float and the price will be depressed. Too little float and the stock will be highly volatile. The investment bank gives the company lots of advice on what this number should be. But keep in mind, since they get 7% of the transaction, they have an conflicted interest in wanting this number to be as big as possible. Further, brokers are in the moving business, not the storage business, so the more float out there, the more opportunity they have to make trades. No float is ever big enough to satisfy the investment bank. They always push for more. Caveat Emptor.
The IPO Timeline
So now that we know what an IPO is, how does it work? Here’s the basic timeline. Key elements are in bold with ideal timing.
Initial conversations with investment banks
Board approval to start the bake-off process
Organizational meeting (6 months prior to pricing)
Drafting the initial S-1
Employee/Shareholder agreements finalized.
Filing the S-1 confidentially (4 months prior to pricing)
SEC comment period
Final audit of S-1 numbers
Publicly file the S-1 (4 weeks prior to pricing)
Roadshow & end of quiet period
Opening trade (Morning after the pricing)
End of employee lockup
End of secondary lockup
Prep Work The longest lead time item for prep work is hiring an auditor. Most companies go with one of the big four accounting firms (Deloitte, PWC, Ernst & Young, KPMG). However, in recent years many companies have chosen to select from a larger list (GrubHub used Crowe Horwath). The process of going through an audit takes time for a young company to understand. So, this should happening years before a public offering occurs.
Another important element is having the right law firm engaged well before the offering occurs. There are lots of details to sort out that have the potential to be costly if they aren’t addressed early. Everything from articles of incorporation, to state registrations, to option agreements need to be in order well before an IPO is contemplated.
A CFO is hired who has been a part of an IPO previously. This person should have been highly placed in the finance organization of a company that has gone through an IPO, though not necessarily in charge as CFO at the time.
Finally, a board needs to be composed to be appropriate for a public company. There are specific SEC regulations here. The most obvious of which are that a compensation committee and audit committee. The audit committe should be chaired by a CPA who had previously been the CFO of a public company. I can’t remember if this is a legal requirement or an optics issue. The compensation committee is important to get right in light of all of the attention on executive compensation since the banking crisis.
Initial Conversations with Investment Banks The interested investment banks have initial conversations with management to see if the company is one they want to help go public. They gather information about the company to be able to present a “pitch” later about why they should get the business. Also, they do some research to understand if any conflicts of interest exist with other clients.
Most companies want to work with one or two of the big five as “lead underwriter” (Citi, Morgan Stanley, Goldman Sachs, JP Morgan, BoA Merryl Lynch). The lead underwriter manages the entire project and drives things forward. They coordinate the creation of the S-1, get the lawyers, accountants, and bankers to agree.
In addition to the project management, they have two very important functional roles. First, they underwrite the actual offering. That means that they buy the offered shares from the company, and then sell them to the interested investors the night before the public offering (this is called the “pricing”) Second, they employ a sales team that collects orders from investors prior to the pricing.
In addition to the lead underwriter, anywhere from one to six co-managers are selected. The co-managers are smaller investment banks that offer experience in certain niche areas to round out a total team of investment banks. Well, that’s the official line anyway, but the secret that the entire industry knows is that there is an extremely high (above 95%) correlation between the co-managers of an IPO and the investment banks that initiate research on a newly public company.
Board Approval to start the bake-off process Once the initial conversations with banks are done and the company is ready to make things official the board votes to start the IPO process by giving management approval to begin receiving pitches from investment banks who want to bring the company public. This vote is one of the ‘bright white lines’ that matter for certain legal matters, so it is pretty important. Also, it isn’t a great idea for a management team to start the IPO process without board approval, so we’ll just file this under “good governance”
Bake-Off This where both the lead investment banks, and the co-managers pitch the company on why they should be selected for the process. What shocked me most about this was the extremely wide variance in quality of the presentations.
The best banks had company on-brand presentations that showed they understood the drivers and culture of the business. They had done lots of research including calling our customers to ask about why they liked the product. They even had video of customer perspectives on the business. I should specifically call out that Citi was head and shoulders above the rest, and clearly wanted our business. It proved to be a good choice because they worked very hard.
The worst banks were apathetic about this part of the process. They had no clear grasp of our business fundamentals. Obviously, these are not the banks we chose. The worst presentations were the banks that acted like their shit didn’t smell. The entitlement that you’d expect from wall street came through strongly in these meetings.
At the end of this process, the banks and co-managers are picked. Things can shuffle around after this point in the co-manager slots, but the primary decisions have been made. Two banks really stood out during this process and beyond: Citi and Allen & Company.
Organizational Meeting This is the official start of the IPO process once all of the banks have been picked. All the key people get in a room and management takes a few hours to explain the fundamentals, history, and financials of the business. The mission statement and core values are discussed. Then there are some lengthy Q&A sessions. The key people in the meeting are:
A couple of things to notice in this meeting. One, the underwriter’s counsel is trying to find holes in the story. Their job is to protect the liability of the underwriters. So, their questions get answered thoroughly. Two, the youngest person in the room from the lead underwriter isn’t going to sleep for the next five months. They are the one doing most of the actual work. They are not the one getting all the pay. Be nice to this person.
Drafting the initial S-1. There are a bunch of sections to the S-1. The part I was involved with drafting was the “Business” section. Basically, that’s where we discuss the “Business” in plain prose. There is a lot of debate on individual words here. Since this is a legal document, and the SEC is very strict on every statement being provable, every word needs to be carefully considered. We had to be very careful about making claims about how we benefit our customers… such claims need to be provable and backed up by data. The lawyers are very picky about this stuff. And, when you get it all done, the SEC basically pulls an 8th grade English teacher’s red pen out, marks the whole thing up, and says, “do it again, Johnny”
Employee/Shareholder Agreements Finalized. The underwriter won’t move forward unless they get a very high percentage (99-100%) of employees/shareholders to sign a lock-up. Basically, this is an agreement not to sell for six months post IPO. This is because institutional investors wouldn’t buy a stock if management/employees/shareholders had a chance to dump it shortly after the pricing.
Filing the S-1 Confidentially (4 months prior to pricing)Because of the JOBS act, emerging growth companies can file the S-1 confidentially. This allows the SEC to make comments and suggestions on the S-1 filing in private to the company.
While the SEC conversations stay confidential, the fact that the filing has occurred always leaks to the press. Apparently everyone thinks it is perfectly OK. Suspicion usually goes to the banks that weren’t picked during the bake off process. Though, I suspect that leaking this info is someone’s job on the actual banking team. But maybe this is just sour grapes that I was under the strictest of secrecy, but somebody was having a great time blabbing to the press.
SEC Comment Period The SEC takes out a big red pen and challenges the company on statements within the document. Some examples include asking for more proof to substantiate claims, suggesting different wording for clarity, suggesting further risk factors, etc. Most of the comments are right on, and get quickly resolved. Some derive from misconceptions or and require further…. explanation. Everything is done with the utmost respect by the company as the SEC can really drop the hammer on the whole process here. Stuff like “The company respectfully submits that the examiner refer to section… of … to which elucidates that blah blah blah blah”
This process feels like it takes forever to the company. I can’t remember exactly, but I think there were six rounds of back and forth here total; each round having fewer and fewer outstanding comments. The first back and forth takes about a month. The last one was less than a full week.
In case you couldn’t tell, the pace is teeth-grindingly frustrating for the company. It is all just so…. slow and bureaucratic compared to the pace at which a startup moves. Welcome to being a public company.
Final Audit of S-1 numbers Since the comment period can take anywhere from 6-14 weeks, odds are the company has traversed another quarter, or maybe even a fiscal or calendar year end. The S-1 is updated with the latest quarter and the firms auditors must audit and approve those numbers, supplying the company with a letter with the opinion that the financials and company have no material weaknesses. The auditor’s “national office” investigates and applies its seal of approval if appropriate. This is an independent group that has oversight over the local auditors to make sure that personal relationships between the company and the individuals within the audit firm don’t compromise the legitimacy of the audit. This part of the process is extremely serious
Publicly file the S-1 (4 weeks prior to pricing) The company “flips” the S-1 filing public. This announces to the world of the company’s intention to have an IPO. A mandated waiting period of 21 days from this date is required before the pricing can occur to give the markets time to absorb the information in the S-1 before public trading. During this period, the company can be “marketed”, but with very strict rules. That’s called the roadshow.
This is the point of no return. Once this happens, either the company goes through with the IPO in short order or has a big black mark on it that makes a future IPO much harder to pull off. Timing is important. If the company can’t get the attention of investors during this time, than it can’t pull off a successful IPO. This has obvious implications such as not having any holidays like Thanksgiving, Christmas or New Years between the flip and the pricing.
Fun fact: A non-obvious timing conflict is the private school holiday schedule in New York City. Which is important to take into account since NYC is home to about half the investors in most IPOs. To avoid having the school holiday fall between the “flip” and the “pricing”, we actually delayed our “flip” by a couple of weeks. This delay allowed us time to negotiate an initial agreement to merge with Seamless. This pretty much ended my first IPO process. We started again just under a year later as a combined entity.
Roadshow & end of quiet period During this timeframe the CEO and CFO hop from city to city (with extra time for NYC) talking with investors of large institutions about the company. Getting to 8 cities in 5 days during business hours requires the use of a private jet. Sweet! At the same time a public facing roadshow presentation and video are presented for the general public.
Simultaneously the investment banks are having their sales team, also known as the capital markets team, pitching investors on the company and answering questions. This sales team does a lot of the heavy lifting on getting investors excited about buying the stock.
Pricing In the final days, hours, and even minutes before the pricing various investors declare their interest at where they’d like to buy and at what price. If everything goes perfectly and the company has created a lot of buzz and momentum, there is interest to buy at a price above what has been printed on the S-1. As the pricing approaches, the company responds to this interest by increasing the price. Then the investors respond to the new price. This cycle repeats two to three times as the date approaches.
If everything has gone well, even at this new higher price, there will be orders for more shares than are up for sale. This is called oversubscribed. At some point, the final decision needs to be made about who gets to buy what. That decision is carried out by the board’s “pricing committee” on the night of the pricing. This committee is taking into account a lot of interests and strategies in allocating the shares:
One possible process would be to allocate a pro-rata share to all the investors who registered interest. Another would be: sell shares to the highest bidder. Another would be: sell shares to the most stable buyers who are likely to hold the shares for a long time. Another would be to sell shares to the clients the investment bank likes best.. though obviously this would put the investment bank in conflict with the company.
Our pricing landed at $26 dollars, up from $18 at the “flip” just 4 weeks before. To put it bluntly, I was thrilled. I had just made… what’s the technical term… I think it’s “a metric shit ton of money”.
Opening Trade (Morning after the pricing) On the morning of the pricing, I showed up at the NYSE at the corner of Wall and Broad streets. There’s a big GrubHub banner on front of the building and actors in food costumes running around the place. We rang the bell and Cramer interviewed Matt. Good Times.
Also exciting was the opening trade.
The first public trade of a stock is between the group that had been allocated shares during the pricing and … well… the public.On the floor of the exchange, a guy called the market maker is collecting interest and matching up buyers and sellers. It takes about 15-25 minutes as the various orders come in. They aggregate them to make the first trade a big one rather than letting the volatility bounce it all over the place in the first half hour.
The first trade was 15% of all of the shares offered during the pricing. It was composed of many sub-orders. It was at $40, a 53% premium over the pricing. I was standing on the floor at the time just behind the market makers I turned to a coworker, Mike, who had founded Campusfood, a company we had acquired two years previously. On the verge of saying something colossally stupid like: “HOLY SHIT!” He looked at me with wide eyes and held a finger up to his lips, glancing knowingly at the reporters with pads out that were surrounding me. I swallowed my comments and hummed contentedly.
Lockup Period In the 11 years between founding GrubHub and the IPO, my stock had been illiquid. As is typical with startup founders I’d been prevented from finding buyers for my stock by covenants with our investors. With the IPO, I was one step closer to getting some cash, but still had a significant hurdle: the lockup.
As I mentioned earlier, the company carefully controls the float, or the amount of stock available to trade. They’re optimizing for the highest possible stable price. The lockup is their tool to do that as it keeps a large portion of the shares illiquid for six months.
If I’d been really keen to sell before the employee lockup, I had the option of selling a pre-set % of my shares at the IPO. Personally, I decided that would be a terrible deal. Many companies experience a jump from the pricing to the first trade. I didn’t want to sell at a discount. Further, selling during the IPO would have subjected those shares to the % commission that the investment banks take, typically 7%. Arguably I should have done it for diversification reasons, but I decided to roll the dice.
Secondary Offering The lockup expiring presents a big problem form a volatility perspective. Between that moment and the IPO, only 15% of the company is trading on the open market (the float). After the expiration, that jumps to 100%. Obviously a 7x increase in supply can depress the price.
To prevent this glut of shares on the market, the bankers go to the largest shareholders and offer to sell a % of their shares directly to buyers in a private transaction. In exchange, these new sellers sign an additional six month lockup agreement. This makes for a smoother deployment of the liquid shares on the market.
An unintended, but predictable, consequence of the secondary offering is that in engenders a lot of frustration and feelings of betrayal in the rank and file employees. They can see that all the big wigs and investors get an opportunity to sell before the primary lockup expiration. If the stock price drops between the secondary offering and the expiration of the lockup, that looks like the people on top looking out for themselves.