What to Know When Your Company Goes Public
Whether it’s an IPO, Direct Listing, or SPAC can make a difference. Here’s the rundown on this and other questions.
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As the financial markets and economy have recovered from the coronavirus-driven downturn in 2020, more private companies have been turning public. For employees at these companies, this can be a big financial windfall, but it also raises lots of questions for those not familiar with the process.
Complicating manners is that there isn't just one way for a company to go public: There are traditional initial public offerings, direct listings, and vehicles that have been in the headlines lately--special-purpose acquisition companies, otherwise known as SPACs. Each of these different avenues comes with a different set of dynamics around managing the shares of your company.
In this article I'll provide an overview of the different paths to becoming a company with publicly traded stock and the main questions you'll need to be aware of.
First the basics:IPOs
An initial public offering, or IPO, is a process in which a private company offers its shares of stock to public investors for the first time. Prior to an IPO, the company may have a smaller number of shareholders, usually limited to accredited investors such as angel investors, venture capitalists, friends, family, and employees. This is why when a company goes through an IPO, we often say it is going public.
While it's been the norm for companies to choose an IPO, there has been an increasing trend of companies electing for the direct-listing process, and for good reason.
When a company goes public through the IPO process, new shares of the company are created and brought to market by an investment bank. There's a ton that occurs behind the scenes before the first day of trading in the public market. Underwriters help decide the initial offer price of the company's shares, commit to buying a specific number of shares from the company, and sell those shares to institutional investors within their networks. This process of garnering interest from the investment community and raising capital is often referred to as the IPO roadshow. This is important because being able to gauge interest received from their network helps underwriters set a realistic IPO price for the stock.
Direct listings is an alternative to an IPO in which a company does not work with an investment bank to underwrite the issuing of stock. Instead of raising new outside capital like in an IPO, no new shares are created, there is no roadshow, and employees can sell their shares directly to the general public--hence making the process faster and less costly. Spotify (SPOT), Slack (WORK), Asana (ASAN), and Coinbase (COIN) are all recent examples of companies that have opted to skip the traditional IPO process and go public via a direct listing.
While forgoing an underwriter provides a company with a quicker, less expensive method to raise capital and enter the public market, there are certain risks that affect both investors and employees. For instance, there is no support or guarantee for the share sale, no institutional marketing, and no safe long-term investors--all things that affect the price of your shares when they initially hit the public market.
Special-purpose acquisition companies have been around for decades but have been in the spotlight recently. A SPAC is a company that raises money from its own IPO with the sole purpose of acquiring another--generally privately held--company. That privately held company then essentially turns into a publicly traded company.
Before announcing the deal, the SPAC and the target company usually negotiate a fixed valuation. This initial price stability is good for shareholders such as employees because there will likely be less volatility once the shares begin trading in the public market. Not only that, but you will likely have a faster cash payout since the SPAC will typically purchase a percentage of the company stock from existing shareholders. It is worth mentioning that while the terms of IPOs are relatively consistent, they can vary significantly in SPAC deals as the acquiring company generally determines the terms.
In a traditional IPO, existing company shareholders agree to a lockup period, usually 180 days from the date of the IPO pricing, when they are restricted from selling or hedging their shares.
One important difference between an IPO and a direct listing is that the latter does not have a lockup period. Since no new shares are issued, transactions will only occur if existing shareholders are seeking to cash out and choose to sell some or all of their shares. Because the share price isn't negotiated beforehand as with an IPO, the stock price in a direct listing will depend solely on supply and demand. In turn, there is often more initial volatility because the price range in which the stock is trading is less predictable.
An important variable for employees is whether they are granted restricted stock units, or RSUs; incentive stock options, or ISOs; nonqualified stock options, or NSOs; or a combination of the three. Because these vehicles have varying advantages and disadvantages, particularly around tax consequences, the strategies you can deploy will also vary. For instance, a common strategy I have recommended to clients is to exercise options six months before the IPO, which will start the clock for your stock holding period. Assuming a six-month lockup period, any stock you sell will be taxed as a long-term gain, being that you've held the stock for one year. Ultimately, this approach gives you the flexibility to sell your shares at the lower capital gains rate as well as the earliest calendar date possible if you need liquidity or have concerns about concentration risk.
If you are strapped for cash and can't afford to exercise your options, another practical approach is to sell your RSUs at vesting and use the proceeds to exercise your options. By doing so, you can mitigate and perhaps avoid capital gains taxes while exercising your options without directly affecting your cash flow and budget. However, it's worth noting that these strategies are dependent on your company's lockup period, or lack thereof. Companies may also enforce certain restrictions around when and how much company stock you can actually sell. It is for these reasons that it's best to work with a financial advisor who specializes in stock-based compensation, tax planning, and liquidity events.
What happens after an IPO, direct listing, or SPAC acquisition is unpredictable. Sometimes things work out the way we hoped, and sometimes they don't.
It can be easy to become enthusiastic or even anxious about the possibility of your company successfully going through an IPO or direct listing. Not only may a successful entrance into the public market lead to increased liquidity for your employee shares, but an appreciation of the stock price might also lead to the generation of considerable wealth.
The biggest mistakes I see made with equity compensation are getting caught up in the emotions of the event and a lack of understanding around how to optimize stock decisions. To help you avoid some of those pitfalls there are three broad critical planning areas to be on top of:
Samuel Deane is a financial advisor and CEO of Deane Wealth Management, an independent investment advisory firm for millennials in technology. He specializes in comprehensive financial planning, equity compensation, and tax planning. The views expressed in this article do not necessarily reflect the views of Morningstar.