What is the role of an Initial Public Offering (IPO) in a venture capital deal?

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Before I go into details, it’s appropriate to define what an IPO is. An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors.

The transition from a private to a public company can be an important time for private investors to fully realize gains from their investment as it typically includes share premiums for current private investors. Meanwhile, it also allows public investors to participate in the offering.

In Uganda, our IPOs are governed by the Capital Markets Authority Act, especially the 2011 amendment that deals with offering shares to the public.  In some jurisdictions, depending on the regulatory framework, it’s only companies with a high growth potential that could be allowed to go IPO on the securities Exchange.

Most notably, in the United states, since the passing of the Jump Start Our Businesses (Startup Act), many tech startups incorporated in any jurisdiction in the world with a reputation of good corporate governance practices, can list in the U.S. Sadly, this can’t be the case everywhere especially in Uganda.

In Uganda, we have the growth enterprise market segment (GEMS) rules at the Uganda Securities Exchange (USE) for small businesses to list. The reason investors can’t make what venture capitalists call an exit on this segment, is that in Uganda our financial and capital markets aren’t liquid enough, so they choose to go to more established stock markets.

Recently, the Uganda Securities Exchange launched an online platform to purchase shares but I doubt it will remedy this. Low market capitalization on the USE is one reason that drives investors away, coupled with incompetent regulators at Capital Markets Authority.

Jumia is one such tech startup that went IPO on the New York securities Exchange (NYSE) as a way of raising money to pay early investors like MTN to exit the company. MTN didn’t not sell its entire shareholding in Jumia, but reduced its stake significantly. This is a common exit strategy in venture capital investments. Jumia went IPO on NYSE in March 2019.

An IPO isn’t done by an early tech start up. It is done when a company reaches a stage in its growth process where it believes it is mature enough for the rigors of regulations of the authority depending on the jurisdiction along with the benefits and responsibilities to public shareholders. It will begin to advertise its interest in going public. Typically, in the U.S this stage of growth will occur when a company has reached a private valuation of approximately $1 billion, also known as unicorn status.

However, private companies at various valuations with strong fundamentals and proven profitability potential can also qualify for an IPO, depending on the market competition and their ability to meet listing requirements. After launching its IPO at $14.50 per share, the mid-point of its initial share price range, Jumia’s shares reached an all-time low of $14.02 before recovering to close at $14.57 on Monday Aug. 5 2019, but the share price is still doing badly.

During its first quarterly earnings call following the IPO, Jumia stood by its prospectus and transparency. The call did reveal however that the company’s operating loss widened year on year with a $51 million (€45.5 million) operating loss recorded in the first quarter of 2019 meaning that Jumia had accumulated over $1 billion in losses since inception in 2012.

But the company’s stock has not been able to shake off speculation with at least two law firms issuing press releases claiming Jumia is under investigation and trying to organize class action lawsuits. Neither Jumia, nor the SEC has disclosed any investigation in this period.


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A common legal mistake venture capitalists going IPO on NYSE (Wall Street) & NASDAQ make is they think of an Initial Public Offering (IPO) as a liquidity event, and thus as a scenario where the early investors should get their proceeds.

After the Uber IPOs in 2019, there will continue to be a debate on whether Initial Public Offerings (IPOs) are a “liquidity event” for venture capitalists. An IPO is simply another funding event for the company, not a liquidation of the company. In fact, legally in almost all IPO scenarios, the VC’s preferred stock is converted to “common stock” or (ordinary shares) as part of the IPO, eliminating the issue around a liquidity event in the first place.

Only that in certain IPOs, an investment banker who would be willing to take the tech company public might commit himself through something called an over allotment agreement. In this agreement, the investment bank/underwriter commits himself to buy the shares from the early VC investors if the shares of that company will trade substantially above its IPO price and sell it into the market.

In Uber’s IPO scenario, instead of this agreement enabling the early venture capital investors to cash out,  it will be used to support the share price that has been trading below IPO. But it’s not automatic that an IPO by itself is a liquidity event. Uber’s IPO period has been extended to 5 months.

What is a liquidation event?

Entrepreneurs think of a liquidation event as a bad thing, such as a bankruptcy or a winding down of the company. In venture capital speak, a liquidation is actually tied to a liquidity event in which the shareholders receive proceeds for their equity in a company and includes mergers, acquisitions, or a change of control of the company.

As a result, the liquidation preference section determines the allocation of proceeds in both good times and bad. Standard language defining a liquidation event looks like this:

Liquidation Event: A merger, acquisition, sale of voting control in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation or sale of all or substantially all of the assets of the Company shall be deemed to be a liquidation. Any acquisition agreement that provides for escrowed or other contingent consideration will provide
that the allocation of such contingent amounts properly accounts for the liquidation preference of the Preferred Stock.

Ironically, lawyers don’t necessarily agree on a standard definition of a liquidation event. One at the University of Michigan teaching a venture class said that an initial public offering (IPO) should be considered a liquidation event. His theory was that an IPO was the same as a merger, that the company was going away, and thus the investors should get their proceeds.

Even if such a theory were accepted by an investment banker who would be willing to take the company public (there’s not a chance, in my opinion), it makes no sense, as an IPO is simply another funding event for the company, not a liquidation of the company. In fact, in almost all IPO scenarios, the VC’s preferred stock is converted to common stock as part of the IPO, eliminating the issue around a liquidity event in the first place.

In an IPO of a venture-backed company, the investment bankers will almost always want to see everyone convert into common stock at the time of the IPO. It is rare for a venture-backed company to go public with multiple classes of stock, although occasionally you will see dual classes of shares in an IPO as Google had. The thresholds for the automatic conversion are critical to negotiate.


 

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