Pre-IPO Imperative: Know Your Customer

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Editor’s note: Glenn Solomon is a Partner with GGV Capital. Some of his recent investments include Pandora, Successfactors, Nimble Storage, Isilon, Domo, Square, Zendesk, Quinstreet and AlienVault. His personal blog, goinglongblog.com, focuses on growth-stage entrepreneurs who are thinking big. 

The IPO window is currently wide open. Riding the wave of strong IPO performance over the past few years (the classes of ‘12 and ‘13 IPOs have on average returned 234 percent and 78 percent, respectively, according to Deutsche Bank data), a growing number of high-growth, venture-backed companies are filing for IPOs. In fact, five venture-backed IPOs have been completed already this year, and 13 more are now publicly on file.

The most forward-thinking of these IPO aspirants are preparing diligently for their big days – hiring experienced CFOs, building detailed financial models, homing in on metrics that help measure progress and raising plenty of private capital to fuel growth leading into their public offerings. These steps all make good sense. But there is a missing ingredient from today’s standard IPO-preparation recipe that is critical to keep in mind – “know your customer.”

The motivations and priorities of the typical public fund manager are very different than those of VCs – attempting to see the world from the public fund manager perspective can help prepare a company for success in the public markets.

To put yourself in the shoes of the public fund manager, there are three key things to keep in mind:

  1. Public investors don’t know you or your company nearly as well as they know public companies.
  2. Early trades of a stock at IPO may not dictate much.
  3. Illiquidity presents real challenges to public investors.

Getting the first-impression rose

The typical public investor has spent considerable time studying her universe of companies – meeting management teams, competitors, customers, partners, etc. The best public investors know when someone sneezes at one of the companies in which they hold a stake. Over time, they gain confidence that they won’t be surprised and possible risks are well understood.

For private companies, the reverse is true. Most forward-thinking private companies conduct Non-Deal Roadshows (NDRs) nowadays to meet public investors and give them a taste of the story in advance of an IPO. This is good, but it still leaves public investors wanting for more information relative to the public companies they track. These investors follow lots of stocks, so earning their attention and serious consideration is no small task.

The good news is that you get a chance to make a first impression, and you can do so by telling a compelling story, complete with your numbers and outlook, and delivering on this story as time progresses. The best advice I’ve heard on this point is to set yourself up to exceed the expectations of public investors and, to the extent possible, leave some good news in the tank to help build excitement for once you’re public.

Being a “hot” deal can be a double-edged sword

The ultimate goal of the IPO process is to attract great public investors who will get behind your vision and support you in both good and tough times. It’s certainly exhilarating on the day of your IPO to have a big pop in your stock. A pop can serve to attract and reward the investors you seek, but if the deal is too hot, and the price runs up too much, the smart money sometimes exits to seek shelter elsewhere.

In hot IPOs, companies may end up attracting less convicted investors, and in that case, the slightest hint of possible bad news can cause a stock price dislocation. Similarly, it can feel really bad if you have a “cold” IPO, where no one wants to buy the deal, for reasons that may or may not be in your control. Investors, for example, may have a concern with your industry or macroeconomic conditions. If you encounter this, don’t despair — the same rules apply for cold deals. If you gain the confidence of investors by delivering good results and good news over time, you might see pretty heroic aftermarket performance. Investors love to catch a good story early where they can run with it for a long time. As proof, four of the top-five-performing IPOs from the classes of ’12 and ’13 were cold deals, pricing at or below the bottom end of their filing ranges (VIP Shop, Solar City, Wageworks and YY, a GGV Capital portfolio company).

The illiquidity minefield

The best public investors, whether from long only funds or hedge funds, typically end up managing relatively large pools of capital. Therefore in order to move the needle on their own performance, they need to be able to take meaningful positions in your stock.

To do this, fund managers need comfort they can sell out of your stock when they need or want to. The fewer shares you sell in an IPO (or, conversely, the more that are closely held by you and your venture capital investors), the less liquidity in your stock, making for a more difficult trading environment for public investors. If your VCs don’t want to sell any stock at IPO, this is a good thing, but it does work against deal size. Don’t be afraid to get your bankers to allocate bigger stakes in your IPO to investors with deep pockets, who have done their homework, and convincingly seem to want to go long with you.

Additionally, it’s wise to think about a secondary offering, to get more stock from your executive team and VCs into public hands, as you’re completing your IPO. Make sure you have plenty of slack in your underlying operation versus your Wall Street plan so you have good momentum to do a secondary offering.

Conclusion

If you’re part of the leadership team at a high-growth, private tech company and you want to go public, either this year or in the near future, you undoubtedly recognize that it’s an exciting and time-intensive process. But, similar to the importance of product/market fit to your business, the more you recognize that public investors are another set of end customers, for whom you need to tailor and customize your offering, the better off you’ll be through your IPO and life as a public company.