Pre-IPO Acquisitions

By September 26, 2019Other
Business Acquisition Deal

As your company prepares for an IPO, you may wish to pursue an acquisition-based growth strategy. Although acquisitions are more common after an IPO1, pre-IPO acquisitions can also offer significant benefits. This article examines the advantages and disadvantages of pre-IPO acquisitions, including how they may impact your upcoming IPO. Knowing the potential benefits and costs of engaging in acquisitions prior to going public will give you confidence as you plan for and carry out your IPO.

Advantages of Pre-IPO Acquisitions

Market Consolidation

One key reason that executives engage in pre-IPO acquisitions is to consolidate a particular market. By consolidating the market, executives increase market share, reduce competition, and broaden service offerings. Each of these improvements can increase a company’s appeal to investors and contribute to a higher stock price on the day of the company’s IPO.

Market share. Harvard Business Review calls market share “one of the main determinants of business profitability2.” Reasons for such profitability include increased efficiency from economies of scale, higher purchasing power from suppliers, and better management from experienced executives.

Reduced competition. Well-known economist Michael Porter created the Five Forces model to analyze competitive forces in an industry. As part of his model, Porter asserts that as the number of companies in an industry decreases, the intensity of rivalry also decreases, which increases the overall attractiveness of the industry in terms of profitability. Such a conclusion is logical when one considers the cost of price wars, employee poaching, and disruptive innovation often initiated by competitors.

Broadened service offerings. Increasing the number of services offered by a company diversifies its revenue streams and reduces the cyclicality of its performance. As performance becomes less volatile, executives can plan an IPO with less concern for market timing because their company’s stock price is more resistant to market changes.

Aaron Skonnard, CEO of Pluralsight, cited market consolidation as one reason for a series of acquisitions prior to Pluralsight’s 2018 IPO: “We saw an opportunity to create value for the enterprise customer by consolidating the content on the market under one SKU, one price point3.” Acquiring these companies enabled Pluralsight to offer a more comprehensive set of technology learning courses to its clients, which likely contributed to the 34% jump in share price on the day of Pluralsight’s IPO.

Fundraising Maximization

One of the major goals of an IPO is to raise as much capital as possible. To meet this goal, executives spend significant time convincing investors to pay more for their company’s stock. Therefore, executives may find pre-IPO acquisitions advantageous because they can enhance the perceived value of the company and reduce the possibility of underpricing4.

Pre-IPO acquisitions reduce underpricing because they provide investors with evidence of the acquirer’s quality. Beyond demonstrating the strategic vision held by company executives, these acquisitions may also confirm the company’s superior quality relative to the firm being acquired. This conclusion is supported by a study conducted at the University of Minnesota5, which found that companies with pre-IPO acquisitions experienced significantly less underpricing on the day of their IPO. With the additional information provided by acquisitions, investors more accurately valued these companies pre-IPO.

By limiting underpricing, a company can potentially capture millions of dollars in additional value that would otherwise be transferred to investors. For instance, Beyond Meat recently suffered severe underpricing earlier this year when its stock price rose from $25 to $65.75 on the day of its IPO. With an offering size of 9.5 million shares, Beyond Meat lost out on over $380 million that would have been captured if analysts had correctly valued the company prior to the start of trading.

Competitive Advantage

Another benefit of pre-IPO acquisitions is privacy: information regarding pre-IPO acquisitions can be kept confidential until the roadshow. As private entities, pre-IPO companies do not have to make the same disclosures required of public companies. Upon becoming public, however, companies are required to disclose considerable detail relating to material acquisitions. Some of these disclosures include (1) the purchase price, broken up into cash and noncash amounts; (2) the primary reason for the acquisition; and (3) the amount of gain on the sale or a qualitative analysis of the expected synergies comprising the value of goodwill. These disclosures can give valuable information to competitors who may be looking for strategic moves to mimic or weaknesses to exploit. Therefore, pre-IPO acquisitions can help companies maintain a competitive advantage over their competitors.

In planning for pre-IPO acquisitions, companies should remember the SEC requires the filing of a Form S-1 prior to the IPO date. The S-1 will include financial statements prepared according to U.S. GAAP, including the above-mentioned disclosure requirements. However, since 2017, the SEC has allowed S-1 filings to be kept confidential until 15 days before the start of a company’s roadshow. This change means that pre-IPO companies now have a longer window in which to carry out acquisition, integration, and restructuring activities without giving competitors key information that public company disclosures might otherwise reveal.

Disadvantages of Pre-IPO Acquisitions

Although pre-IPO acquisitions can provide a number of important benefits, you should also be aware of their disadvantages and the potential for unintended consequences leading up to your IPO.

Lack of Capital

The first and most obvious disadvantage of making acquisitions as a private company is the lack of available capital. In some cases, the lack of capital may make acquisitions impossible, while in others, it may lead to excessive debt. For example, prior to carrying out the largest healthcare IPO in U.S. history, Avantor Inc. purchased the much larger VWR International for over $6 billion, most of which was financed with debt. Many investors were skeptical that such a high level of debt would be sustainable6.

In such cases, company owners should be aware that investors will likely discount the value of highly leveraged companies due to the increased risk of financial distress. If this discounted valuation persists, the proceeds of a subsequent IPO may be greatly reduced. Thus, as pre-IPO companies consider taking out debt to finance an acquisition, they should weigh the depreciating effect of excessive debt against the potential appreciation that will come if acquisition synergies are fully realized.

If the risk of taking on debt is too high, executives should remember that, after a successful IPO, they will likely be in a much better financial position to make acquisitions. Initially, their company will receive significant proceeds from the IPO itself, and perhaps more importantly, the company’s stock can be used as a form of currency. In fact, one survey found that the number one reason CFOs choose to go public is to create shares to use as acquisition currency7. Consequently, pre-IPO companies considering an acquisition should use careful judgement, especially if a significant amount of debt will be involved.

Unforeseen Dis-synergies

Although executives often justify an acquisition by the value of its potential synergies, many either fail to recognize or downplay the impact of possible dis-synergies8. One dis-synergy that executives often overlook is customer losses. A study performed by McKinsey found that most post-merger companies lose between 2 and 5 percent of their combined customer base, with some companies losing more than 30 percent9. The article cites an example where a large U.S. bank acquired another bank that served a similar geographic area. As redundant branches were closed, many customers were lost to competitors.

Because pre-IPO acquisitions will be highly scrutinized by investors, executives should carefully weigh the risk of dis-synergies and the impact they may have on the company’s image. If investors discover significant dis-synergies leading up to a company’s IPO, they may lose confidence in the company’s ability to perform as expected, and the company’s stock price may consequently be discounted on the day of its IPO.

Integration and Reorganization

Just as many executives tend to misjudge the impact of dis-synergies, they also underestimate the time required to integrate an acquisition and reorganize their company structure. One study showed that executives underestimated the time required for implementation in 43 percent of organizational redesigns10. When integration takes longer than expected, companies may experience unanticipated costs and executives may even be forced to delay a scheduled IPO.

Delaying an IPO can cause significant harm, especially if a company is depending on the inflow of capital from the IPO. At the very least, executives will need to explain such a delay to investors, who may fault management for poor planning. Therefore, if executives are considering an acquisition close to a planned IPO, they should commit adequate time to finishing integration activities before releasing the company’s S-1 to the public and beginning the company’s roadshow.

Conclusion

Although many executives successfully utilize acquisitions to enhance their company’s appeal to investors, others are surprised by unforeseen disadvantages that acquisitions may bring. As you plan an acquisition around your IPO, be sure to evaluate how the issues discussed in this article may impact your company. Careful planning and thorough evaluation are the keys to making successful acquisitions that will positively impact your IPO.



 

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Footnotes

  1. According to one study, only 19% of IPO firms made an acquisition in the five years leading up to their IPO, but 74% completed an acquisition in their first five years as a public company. The average number of acquisitions increased from .43 to 4.00 over the same time frame.
  2. Market Share—a Key to Profitability
  3. Pluralsight Continues Its Acquisition Spree
  4. Underpricing is when a company’s stock is priced below its market value. Underpricing may be done intentionally to reward investors, who benefit from the subsequent rise in stock price, or it may be done unintentionally due to erroneous valuation models.
  5. The Race of Unicorns: A Signaling Story of Private Acquisitions
  6. As reported by Reuters, creditors began increasing the rate on bonds due to the riskiness of the endeavor, and one portfolio manager stated, “Avantor is simply pushing the leverage limits of comfort.”
  7. Based on a survey of 336 chief financial officers conducted by Brau and Fawcett in “Initial Public Offerings: An Analysis of Theory and Practice.”
  8. Dis-synergies may include any number of factors that increase costs or decrease revenues following an acquisition, such as increased bureaucracy that decreases operational efficiency.
  9. In the article “Where mergers go wrong,” McKinsey reported that the 25th- and 75th-percentiles of customer losses were 2 and 5 percent, respectively, in an analysis of 124 mergers.
  10. Based on a study performed by McKinsey & Company in “Taking organizational redesigns from plan to practice.”
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Author Josh Mortensen

Josh grew up in Eagle Mountain, Utah, where he regularly participated in piano competitions and gained a passion for classical music. Josh loves the challenge of simplifying technical accounting problems so that non-accountants (like his wife) can understand them. In his free time, Josh enjoys mountain biking, hiking, and brushing up on his Hungarian.

More posts by Josh Mortensen

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