Start-Ups

Startups: How to know when it's time to IPO

For startups, the IPO is an exit option that is used and abused and can be hard to understand. Here's how to know whether an IPO should be the goal for your startup.

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 Image: iStockphoto/Andrea Rode

Startups are often glorified as a dream job where anyone with an idea can set out to save the world. Once a startup has achieved success, it comes to an end as an IPO--one final moment where the heavens open up and cash rains down on founders.

In reality, an IPO is intensely complicated--in making the choice to go public and in the process it takes to get there. In fact, going public without real operating metrics can be downright painful. A company doesn't just naturally grow toward a point where an IPO will happen without a hitch, it requires founders who are ready to defend their company and it requires a plan to make it work as a public company.

In the past the IPO was traditionally used as a financing vehicle. While that is still the case in rare instances today, according to Draper Fisher Jurvetson managing director Andreas Stavropoulos, the IPO now exists for two primary reasons.

First, it provides liquidity to both investors and employees. The second reason is "to create valuable currency that you can use in the market to buy other companies or provide incentives for others to merge with you."

Margins and growth: The numbers

You have to have your numbers tightly buttoned up before you even consider going public. Wall Street needs to trust your ability to make money and keep making money. You have to build rhythm and predictability.

While preparing for an IPO, you should focus on two things: gross margins and growth. Gross margin is calculated as revenue minus cost. For example, if it costs you $50 to make product and you sell it for $100, your gross margin is 50 percent. It is basically the amount of money you make selling a product or service after you account for the cost of that product or service to you. It's the money you make after all is said and done, and to be a public company you need strong margins.

Let's consider the state of your gross margins. According to Matthew Howard, a managing partner at Norwest Venture Partners, Wall Street likes predictability. "They would like the gross margins to be steady to slightly improving," Howard said. The main thing to consider is that Wall Street wants to trust you before you IPO; they don't like to be surprised.

If your margins are in good health, the second thing to consider if whether or not they are high enough for you to warrant a go as a public company. Let's consider some common startups company types. Howard asserts that If you are a hosted SaaS, you better be at 70 to 80 percent margins and if you are a systems company you should have gross margins of 60 to 70 percent. And, bear in mind that these numbers only work if they are combined with steady growth.

Growth will be defined differently for different types of companies. It can include increased revenue, customer acquisition, better customer retention, and lowering costs, among other things. You have to prove that you are not stagnant, that you have a plan for the future. You have to be able to tell your story.

Telling your story

When asked what he looks for, outside of the numbers, in a company that wants to IPO, Howard responds, "Being a reformed product manager, I look for the road map."

This concept of a road map is the story you tell as a company. It's how you explain how you got to where you are now but, more importantly, it's an explanation of where you are going. This is your plan of response to market changes and trends. A quality story must exist in conjunction with a quality firm behind you, a quality legal team behind you, and quality auditors behind you.

"Going public involves selling your vision and future results." Andreas Stavropoulos

When you consider the years of ideas you have thought up for your company, you have to decide if they are empty promises or something you can sink your teeth into. These plans should enhance a product, not just polish it by making it faster or cheaper. As you consider this roadmap, your customers should be the driving force behind each idea you come up with.

When Andreas Stavropoulos is evaluating a company he considers how much visibility and predictability they have in their business model and metrics. Confidence in your business is important, he said, because: "Going public involves selling your vision and future results."

Part of that vision is the part of your business you do better than the competition. It's like KFC's 11 secret herbs and spices. It is something you have to truly believe gives you leg up on potential imitators or current competitors. Something that is definitively yours.

"You have to really believe that you've got something that is a sustainable competitive advantage," said Stavropoulos.

You also have to believe that you can keep building that advantage even after you have taken a megaphone and told the world how great your company is. This cannot be a single, tightly-guarded secret that could undo your company if your competitors got ahold of it.

Your competitive advantage also has to scale with your company as you grow. It has to be spread across different parts of your company's DNA. Often, it also has to be able to scale across markets.

You can't build promises of future success on the strength of your team alone. A rockstar management team is often labeled as competitive advantage, but a good management team is actually standard fare for a successful company.

Making the decision

If you are eying an IPO, here are some questions to consider:

  • Have you created a scale or network effects advantage in your business or product?
  • Think about your sales and marketing team, how do you handle customer acquisition costs and growth?
  • Do you have processes built into your business plan that define a path for growth while accounting for possible change?

An IPO can be a great strategy for a business to grow, but it's not for everyone. There are some disadvantages to going public:

  • Going public is expensive. An IPO can cost hundreds of thousands of dollars with no guarantee that it will go through.
  • Subjecting your company to new rules and regulations. By going public, you are now subject to governing bodies like the SEC.
  • Risk of takeover. Once your company is publicly traded, anyone can buy shares--even your competitors.

Stavropoulos typically begins the conversation with the question "What are you trying to achieve?" Your goal cannot solely be to make money. You have to have a vision for where you are taking your customers. While IPOs are necessary for some companies to pay back investors, they are also a resource to better serve your customers.

As Mark Zuckerberg wrote in his letter to investors when Facebook filed for its IPO:

"We don't build services to make money; we make money to build better services."

Be ready for the consequences

According to Howard, when you are a startup there is much more understanding if you miss a benchmark. People know your story when you are a startup, but when you go public there is much less sympathy.

"There is very little understanding of why, there is just punishment," Howard said.

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About

Conner Forrest is a Staff Writer for TechRepublic. He covers Google and startups and is passionate about the convergence of technology and culture.

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