How Non-Executive Directors can help de-risk IPOs
fdu’s guest blogger, David Tilston is a Chartered Accountant, a Fellow of The Association of Corporate Treasurers and a member of The Institute for Turnaround. He has held CFO roles in both listed PLC and PE-backed companies and has significant experience of managing turnaround situations.
IPOs are hugely challenging for management teams. The day before the IPO they are usually working for a major shareholder trying to get the transaction over the line. The day after the IPO they are overjoyed that the deal is done but have new owners.
The executive management team are often in unfamiliar territory faced with Stock Exchange regulatory requirements and trying to meet the aspirations of an entirely new group of investors who have no history with the business. How can Non-Executive Directors (“NEDs”) help de-risk the IPO process?
NEDs can coach CEOs and CFOs on key areas relevant to PLC obligations
NEDs can coach CEOs and CFOs on key areas where they may not have experience but which are required in the PLC environment.
Test the Strategy
At the IPO the management team will be articulating a medium term strategy to potential new investors as to how the business is expected to develop over the next few years. It is important that the strategy is:
- Balanced (ie not unduly optimistic)
- Easily and simply communicated to potential investors
NEDs can constructively challenge the strategy ahead of the IPO to ensure it is soundly constructed, based on data and assumptions that can be validated, and can be articulated clearly and simply. This challenge will largely reflect the questions the team can expect to get from potential investors.
Major risks need to be discussed and various scenarios assessed (if not necessarily communicated during the IPO) so there is confidence that downside risks can be managed and upside opportunities exploited.
Forecasting accuracy and the management of market expectations
Stock Exchanges typically require an announcement without delay of any developments not in the public arena which relate to a change in a company’s financial condition or business performance which, if made public, would be likely to lead to a substantial movement in the company’s share price.
This puts a much greater emphasis on the accuracy of forecasts and keeping them up to date. For privately owned companies a material change in outlook would not result in external visibility or comment. Unfortunately in the listed PLC sphere public visibility will occur and external comment may be difficult to control. Profit shortfalls are typically dealt with more severely with share price falls than profit upgrades (with more modest price increases).
Obviously market expectations will need to be confirmed or updated at each results announcement and so forecasting is an important ongoing discipline.
NEDs (and particularly former CFOs) will be able to coach the CFOs in particular around forecast accuracy and how to frame messaging to manage external profit expectations, and will have their own anecdotes and experiences to draw on to provide colour.
“Coach the CFOs in particular around forecast accuracy”
Some Potential Conflicts of Interest that can arise with IPOs
Overly ambitious growth expectations
NEDs should encourage that a balanced picture of prospects is communicated at the IPO launch in order to mitigate the risks of failing to hit targets or milestones and the share price potentially falling below the IPO price.
This approach could however conflict with selling shareholder interests. Exiting shareholders may want to communicate more ambitious growth prospects in order to achieve a higher IPO price. The financial advisors in an IPO may similarly be incentivised in their fee arrangements to achieve the highest possible price.
“Conflict with selling shareholder interests”
This can put the executive management team in an invidious position. They may be seeking to realise cash through selling some of their own shareholding in an IPO and so would favour a higher price. However the day after the IPO they are now responsible to new shareholders to deliver the expectations communicated at the time of the IPO, and if these expectations are too ambitious they are likely to fail. The CEO and CFO could see the share price subsequently falling below the IPO price, and even being replaced in their roles.
Dislocation of director remuneration arrangements with the broader market
NEDs, particularly those who chair Remuneration Committees, will want to see that at IPO the executive team remuneration arrangements are broadly benchmarked to peer companies. If not, this can store up problems for the future.
In PE-backed companies it is not unusual for executive team members to accept salary and remuneration arrangements which are low relative to the broader market as these are offset by equity incentives which can be very significant. The executive team members will quite often realise some of these equity incentives at the point of the IPO.
The question of what salaries should be paid immediately post IPO can be emotive. The selling investor will not wish salaries to be raised significantly on the argument that (a) if salaries are increased then the expected profitability will be reduced and the value of the business will reduced by the price/earnings multiple applied at the time of the IPO and (b) the executive team are already realising significant value from their equity incentive arrangements.
“Salaries … paid immediately post IPO can be emotive”
For listed companies there is great focus by investors to ensure that salary increases paid to Executive Directors do not increase at a rate which diverges significantly from increases achieved by the broader workforce. In the current low inflation environment this means that director salary increases are likely to be modest at best.
Consequently executive management team members could subsequently become disenchanted as they are not being paid a market rate (which should not take account of gains made under a previous ownership structure). Alternatively institutional investors will be upset with significant pay rises for the management team if market rate salaries are subsequently implemented (and may vote against the reappointment of Remuneration Committee members at the next AGM). Furthermore if members of the management team choose to leave it is likely that they will need to be replaced by new directors who are paid the market rate for the role.
NEDs can help ensure IPOs are successful by assessing the risks around growth aspirations and executive remuneration and ensuring appropriate expectations are set which will be valid for a period of at least 2-3 years post IPO whilst the company establishes its credibility in the PLC environment.