Rethinking an IPO in a seller’s market
By Kevin Burke,
Founder and managing partner of Trinity Capital LLC
For many years now, the dream of an initial public offering has generally meant wealth, prestige and success for the lucky few restaurant concepts. While 2013 was the biggest year in terms of dollar volume for IPOs in more than a decade, 2014 is on pace to double that mark (Papa Murphy's, the fifth largest pizza concept in the U.S., is a great example of this year's IPO activity).
Recent IPOs have received higher valuation multiples, often reaching 12- to- 14x, relative to the 8- to- 10x achieved in an M&A process. It’s no surprise, then, that restaurant owners are looking to an IPO as a sale option or to fund growth.
We believe, however, the restaurant IPO story frequently starts well, but does not always end well. Restaurant business owners need to carefully evaluate their business objectives to determine the best course of action. When contemplating a company sale through M&A versus an IPO the first question to ask is: Will this be a growth funding strategy or an exit (liquidation) for the existing equity owners?
Multiples and full monetization
While the potential for a higher multiple is attractive, it is important to understand that the stock market uses discounted cash flow models to value equities, which means significant, consistent unit and same-store sales growth is a prerequisite. When growth slows, the stock market will usually punish companies.
Through an IPO sellers on average receive a 25 percent monetization. Companies have to market a series of follow-on equity offerings to realize the value of the 75 percent of unsold shares, a process that often requires a period of several years. If the stock market is not cooperative, sellers could find themselves in a position where follow-on equity offerings are not feasible or not attractively priced. This makes the value of remaining shares subject to the vagaries of the economy, stock market, restaurant sector, geography, concept and, finally, the operating performance of the restaurants. With the exception of perhaps the last two, these items are beyond the control of the management team.
IPOs are time-consuming, expensive and require lots of regulatory compliance. This commonly means a company may need to change its auditor, upgrade its legal counsel, engage one or two more C-suite executives and prepare for much greater transparency and accountability in business operations. Frequently, a company’s operating agreements, supply contracts and other principal documents will need to be filed and disclosed, and therefore be accessible by friend and foe alike. Similarly, loan documents and other information associated with a company’s capitalization, such as shareholder loans, insider stock holdings and compensation, will become public as well. In essence, once the IPO is completed, management’s life will change dramatically as the steward of an SEC-regulated public company.
The successful IPO vs. those that have struggled
IPOs make sense for a concept that is profitable, growing rapidly and will require significant debt and equity capital to fund future expansion initiatives. A concept that meets these criteria will generally be rewarded by the stock market, the most evident example of this being Chipotle Mexican Grill. Chipotle was adding approximately 100 new units per year when it decided an IPO in 2006 was the best strategy to fund ongoing growth. Chipotle continues to achieve meteoric growth with new unit and system-wide sales increases of more than 12 and 17 percent, respectively, in 2013. Needless to say, Chipotle not only completed a successful IPO, but has also enjoyed exponential growth in share price since then.
At the same time of Chipotle’s IPO, there were other less fortunate concepts engaged in IPOs. Carrols Restaurant Group’s share price declined roughly 25 percent from its IPO price within the first eight months and continued to decline until it lost approximately 90 percent in value. Carrols' share price today is almost 50 percent below its IPO price. Morton’s Restaurant Group’s share price declined nearly 20 percent from its IPO price within the first five months and settled about 70 percent below the IPO price before being acquired. Lastly, Einstein Noah Restaurant Group’s share price has remained below its IPO price for all but approximately three months out of its nearly seven year history on the public exchange.
There are a number of factors that may have contributed to the poor stock performance following the IPOs of these three companies, not the least of which is the Great Recession. Regardless of their monetization goal, these companies speculated on the future performance of the stock market and paid the price.
IPO vs. M&A
For restaurant companies looking for growth funding, IPOs will generally provide better outcomes, assuming the company’s performance meets expectations and the market cooperates. For those seeking an exit strategy, a private sale provides sellers with fully monetized, simpler, lower cost, less time-consuming process and most importantly, a more immediate payout, which also means less ongoing uncertainty and risk.
If the level of uncertainty is greater than that of the level of certainty, we advise to get paid up front through an outright sale and not speculate on a series of secondary stock offerings.
Kevin Burke is the founder and managing partner of Trinity Capital LLC, a boutique investment banking firm with deep restaurant, consumer/retail, and food & beverage experience.
Photo provided by Wikipedia.