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So You Want to Go Public?

“So You Want to Go Public?”

This seven-step outline of the process of Initial Public Offerings is based on the book Going Public, by Frederick D. Lipman. It is accompanied by commentary from three CEOs who have accomplished IPOs: Al Scheid, Scheid Vineyards; Brenda Hall, Hall, Kinion & Associates; and Sky Dalton, Earthlinkt

YHOO, CYMI, SIPX. What are these strange acronyms? If you guessed that they are part of some jumbled word puzzle, guess again. These are stock market ticker symbols for three companies (Yahoo!, Cymer Inc., and Sipex Corp., respectively) that are leading the hottest business trend in the past several years: going public. These are just a few businesses in a fast-growing group that made the jump in 1996 from privately held to publicly owned, and prospered in the process.

The rewards of an initial public offering (IPO), when done correctly, are many: money, prestige, power, and publicity. In fact, many history-making public offerings have turned some entrepreneurs into instantly wealthy individuals. Take for example, the story of Netscape Communications. The evening before the high-tech communication company’s public offering, its founders, Marc Andreessen and Jim Clark, each went to bed owning a portion of a software development company that had yet to turn a profit. When the men awoke the following morning, both were millionaires.

As a result of IPO success stories like this, the business community, the press, and the public at large have become infatuated with Wall Street. The stock market has never been more closely watched nor more heavily invested in; business owners are clamoring to file for offerings; and investors are always on the lookout for the next darling of the public market. It seems that businesses in every industry are catching the fever to go public: Internet service providers, communications companies, software developers, restaurateurs, employment agencies, and so on.

Not only are more companies filing public offerings, they’re making more money in the process. According to Boston law firm Hale and Dorr LLP’s 1996 New England IPO Report, the total number of IPOs issued in 1996 increased 50 percent from 1995 — 768 compared to 512 — and they yielded 46 percent greater proceeds — $38.8 billion in 1996 and $26.6 billion in 1995. In the introduction to the report, senior partner Paul P. Brountas states that many factors contributed to the substantial growth in the IPO market between 1995 and 1996, including the colossal rise in the overall stock market, the more than $200 billion that was invested in stock mutual funds, and the huge success of venture capital-backed IPOs. Another factor, he stated, was the positive business-oriented attitude that has evolved in Washington, D.C., sustained by a high governmental priority for deficit reduction. Brountas continues, "It appears that capital spending is being dominated by outlays for technology. Because the life span of new technology is considerably shorter than the life span of traditional capital goods, the demand for new replacement technology has escalated. All of these factors, combined with continuing low inflation and moderate growth, created an ideal investment environment in 1996."

If you are considering jumping on the going-public bandwagon, there are many other factors to weigh. While the monetary and other benefits of a public offering can be very tempting to entrepreneurs who want to raise capital and grow their businesses, there are some serious hurdles that must be considered.

Culture Shock

First and foremost, after going public, your company will undergo some marked changes. Many CEOs agree that the most important issue to manage after an IPO is preventing employees and managers from becoming fixated on stock performance. Often, the stock becomes an obsession and a distraction from the key aspects of running a successful company. Therefore, the key is to keep the entire staff focused on what is really important — running the company.

"Too many companies run their business just for the stock, and that’s just wrong," says Sky Dayton, the founder of EarthLink, a Pasadena, Calif.-based Internet access provider that went public in January 1997. "The stock is an arbitrary measurement that on a day-to-day basis is totally neurotic. You have to look at it over the long term. We really got this when we went public, and it was the source of lots of staff e-mails and talking to folks saying, ‘Look, let’s just hunker down and run our business. Let’s turn out a great product. If we do that over the long haul, the stock will take care of itself.’"

To keep their attention focused where it should be, some CEOs choose not to check their stock on a daily basis. Instead, they reason, if something drastic happens, an advisor will let them know. "I never look at it," says Al Scheid, the CEO of Scheid Vineyards in Marina del Rey, Calif., which went public in July 1997. "Why bother? It’s not relevant to my daily activities. I can tell you one thing: If it goes up someone’s going to call me, and if it goes down someone’s going to call me. I’ve got hundreds of people out there watching it. Why should I?"

CEOs warn that, following an offering, most companies experience one or two low-performance quarters. The reason for this is that the preparation process for going public dominates the attention of top management members during the months prior to the offering. As a result, the rest of the company usually suffers from the lack of attention, and it takes several months to get the company back up to speed and the directors reacclimated to their roles in the company.

"It’s such an exhausting effort that nothing else happens," says Scheid. "I mean, literally, the store doesn’t keep. It is sort of like closing shop. Decisions get delayed, customers don’t get talked to, things just don’t happen."

In addition to managing the transitions for customers and employees, going public puts a company and its directors under intense scrutiny by investors, competitors, and market analysts. On a quarterly basis, public companies are legally obligated to disclose information such as executive salaries, sales figures, profits, competitive edge, and contracts with major customers. It is important to note that investors put considerable pressure on the directors to maintain a steady growth rate. If sales or earnings begin to level off, investors may get nervous and sell their stock, driving down its price, and the directors may not have the necessary capital to buy back the stock at the depressed prices. As a result, stockholders may become disgruntled.

Because investors will evaluate public companies every three months instead of 12, as is the case with private companies, the pressure on the management team is more intense and it significantly shortens the company’s planning and operations schedule. The pressure may tempt you to make short-term decisions that could have a harmful, long-term impact on the company.

Furthermore, public companies and their directors, officers, and controllers are at risk of being sued by shareholders if there is a sharp drop in the price of the company’s stock caused by negative news about the company. Shareholders can claim that management knew or should have known about the news and should have disclosed it earlier. Public companies can win or prevent such lawsuits from being filed by carefully disclosing adverse news and by avoiding overly optimistic or exaggerated comments in shareholder reports and press releases. To protect against such shareholder lawsuits, you can obtain liability insurance for your directors and officers for between $15,000 and $100,000 per year.

This new dimension of account
ability will add more layers of responsibility to your job if you choose the role of CEO, and it will take more of the sparse time you had before you went public. Some business owners handle this transition with finesse, while others are traumatized by it. Brenda Hall, who took her San Jose, Calif., technology employment firm, Hall Kinion & Associates, public in August 1997, explains, "When you go public, you bare your soul to the world. You tell everybody everything you can about your company. You invite literally hundreds of people to put money into your company and to care about how your company runs and to vote daily by leaving their stock with you or moving their stock. It’s a big step."

In addition to culture changes and the potential for litigation, it is possible to lose control of a public company by selling too many shares of stock. After a company is publicly held, additional public offerings and acquisitions can further diminish control. This risk can be minimized by carefully drafting anti-takeover provisions in the charter or by creating two classes of stock with unequal voting rights. Although there are few, if any, anti-takeover defenses that are completely and legally watertight, an attorney can assist you in developing some that are effective. Keep in mind, however, that such defenses may also make it more difficult to attract certain investors.

Finally, going public will not only effect major changes within your company, it will also make an impact on your personal life because the process requires enormous quantities of your time. For at least three months leading up to the opening day, you will eat, sleep, and drink your IPO. You will be required to put in many long hours and will likely not have much time for any semblance of a personal life until after the opening day. "I tell everybody, ‘Don’t plan on traveling; don’t plan on company dinners; don’t plan on family dinners; don’t plan on taking your kids to the beach; don’t plan on anything,’" says Scheid. "If you don’t want to give up three months of your life, don’t do it."

If, after careful consideration, you still want to take your company public, the following is an outline of the process.

Step 1: Choosing An Underwriter

The first thing you have to do to get the ball rolling is to attract an underwriter, or investment banker, who will bankroll your offering. The company that underwrites your story (industry jargon for your company’s case) will walk you through the entire process from start to finish and will purchase a predetermined number of shares of your stock at a discount and then resell it to the public market, making a profit in the process. There are many national underwriting firms that range widely in size and prestige that you can locate by looking in the Yellow Pages. Merrill Lynch & Co., Dean Witter Reynolds Inc., and Prudential Securities Inc. are among the most well-known national underwriters.

You must sell the underwriter on your story by proving that the public market will have a desire to purchase stock in your company. Believe it or not, if you can show that your company has unusually high appeal to the public market, you can go public before you even have one dollar in revenue.

Your industry will largely determine the amount of attraction your stock will have for investors. Currently, the investment community considers the Internet, software, communications, health care, biotechnology, semiconductors, information technology, and networks among the hottest industries for public offerings.

Beyond being in an attractive industry, developing an engaging and credible presentation is the most important step you can take to spark an underwriter’s interest. The pitch that you prepare for your company must include a business plan and a growth plan that are thorough and impressive (a growth rate of 20 percent or more a year is expected). These plans should contain descriptions of the business (including its birth and development), management’s background, and detailed growth projections. The presentation should highlight the assumptions behind projections, identify the risk areas, and describe ways that the company can hedge those risks.

From the underwriter’s point of view, an experienced management team is the most important attribute of your potential as an IPO candidate. In fact, the underwriter’s judgment of your executive talents and those of your management team is crucial in the underwriting decision. Although there is no standard amount of time that management is required to remain at your company, investment bankers will be turned off if any of the directors intend to bail out after the IPO by selling all of their stock. Underwriters will want management to assume the same risks that the new investors will be making.

The underwriter will conduct intense one-on-one interviews in which they will ask questions to determine your aptitude as a CEO. The importance of demonstrating a thorough grasp of your business and its problems cannot be overemphasized. If you appear not to have the answer to an obvious question, the underwriter will question your competency as the leader of the company. Reputable underwriters will thoroughly investigate every aspect of your story in a process called due diligence. They may question your employees, customers, suppliers, bankers, and competitors about the information you have provided to them. You must be prepared to answer any questions that arise from this investigation.

Many entrepreneurs who have never attempted a public offering before are concerned that they won’t be able to find an underwriter who will back them, especially if their companies are small or relatively new. Rest assured that if you have taken the right steps in planning your IPO, you will have little difficulty in attracting an underwriter. "Remember that underwriters are in the business of taking people public, so they’re looking for these opportunities," explains Scheid. "They’re anxious to do it if they can justify it."

In fact, if your company is considered a good growth opportunity, you may have to choose from several investment firms vying for your deal.

"I had always heard that you go out to 10 underwriters, and five of them will say yes," recalls Hall. "We went out to five of them, and all five said, ‘Please, can we do your deal?’ It was a hot time in the market, and the underwriters considered us an excellent growth opportunity. We’ve had exceptional compound annual growth rates of over 70 percent over the last four years."

Although Hall had a positive experience shopping her IPO to several underwriters, some industry players warn against this practice because it might give the impression of desperation. In other words, your story may appear to lack interest in the investment community. If you get turned down by more than one underwriter, Scheid warns, word will spread among investment industry acquaintances, and you will have difficulty closing a deal.

If you’re interested in testing the waters of the financial community to see if there is any interest in your story before you take the plunge, Scheid recommends doing it subtly. Keeping a poker face while speaking to potential investors worked well for him when he was contemplating taking his company public earlier this year. "We investigated a few underwriters without showing our cards," Scheid explains. "We checked them out informally: Were they interested in doing this kind of deal? Would they like to talk? We made it very clear that we were investigating the interest on the street — not shopping for an underwriter. It’s sort of a mating dance. You don’t go rushing in and say, ‘Here are my financial statements. Take me public.’"

The cost of going public is substantial, both initially and over the long run. Initial expenses include the underwriter’s discount, or commission, which can equal 6 percent to 10 percent of the total offering (even more in some cases). That means that for a $10 million public offering, the underwriter’s discount might
be $600,000. In other words, the underwriter purchases your stock for $9,400,000 and resells it to the public for $10 million.

Additionally, you can expect out-of-pocket expenses that typically range from $150,000 to $500,000 for even a small offering. It is important to know that if your IPO is canceled at the last minute because of adverse market conditions or other reasons, you will be liable for a portion of the costs.

Ongoing regulatory reporting requirements, stockholders’ meetings, investor relations, and other expenses can run from $25,000 to $100,000 or more annually. In addition, you may need to hire more financial and accounting personnel to help prepare your company’s financial disclosures. There are ways to minimize the ongoing costs of owning a public company, including minimizing the use of outside professionals, sending bare-bones annual and quarterly reports to shareholders, and using inexpensive methods to reproduce and mail reports.

Furthermore, you must provide the underwriter with an out-of-pocket expense allowance.

Step 2: Valuation

Although the official valuation of your company will not occur until after a registration statement is filed, you will have several preliminary discussions with the underwriter about the value of your company. An underwriter will compare your company to similar public companies in your industry to determine its market value and an approximate stock price. Usually the value of a company is placed a bit lower as an incentive for investors to buy your stock rather than the stock of veteran industry players.

You can eliminate any surprises in the valuation process by doing your own thorough investigation of comparable public companies in your industry or by hiring a professional to do it for you. If your company is valued lower than you expected, but it is a fair assessment of the market value at that point in time, you may want to consider temporarily postponing your offering until the market rebounds. That’s what Hall did, and it paid off for her company.

"We chose our investment bankers in December of last year, and at that time, the valuations looked very, very high," Hall recalls. "Then when we got ready to go public in March of this year, suddenly valuations had gone way, way down. There was a little hiccup in the market during that time frame, so we stopped. We said, ‘OK. We’re not going to do the filing today.’ We waited 60 days, and the valuation came in very, very strong. Then we went out." According to Hall, learning that the valuation is a constantly moving target, rather than an inflexible judgment, was an important lesson. She says that a good investment banker will be able to offer assistance in choosing the best time for an IPO.

Step 3: The Letter of Intent

Signing a letter of intent basically signifies that you agree with the conditions of the IPO, including the expected price per share; the underwriter’s discount; overallotment option; who is responsible for paying for expenses, such as lawyers, accountants, printers, filing fees; any board members who will be designated by the underwriter; and preferential rights on future financings by your company.

The letter of intent also restricts you from issuing press releases or other publicity about the offering without your underwriter’s approval. It does not, however, bind the underwriter to purchase your IPO, so you should make it clear at this point that you will not reimburse their firm for legal fees or other expenses if it arbitrarily withdraws from your IPO.

Step 4: Registration

The first step of the registration process for an IPO involves writing a prospectus, which is a statement that describes the company and forecasts as accurately as possible its future performance within its industry. You, along with your directors, attorneys, and accountants, will be responsible for drafting the prospectus for submission and approval by the Securities and Exchange Commission (SEC), the Federal watchdog that governs the sale of securities in this country. Although you can hire someone to draft this document, it is expensive and anyone you hire will not be as familiar with your business as your in-house management team.

Although writing a prospectus for the SEC can seem like a difficult undertaking, the good news is that all prospectuses contain the same general topics, including a business description, a management discussion, and analysis section, and a use of proceeds section. Therefore, by requesting the prospectuses of other public companies in your industry, you can get an idea of what type of information you should include in your own. After you have completed a working draft of the document, your underwriter and his or her attorney will request an opportunity to "wordsmith" it until it tells a convincing story to potential investors.

Be forewarned: Writing a prospectus is a long and arduous process. Scheid explains, "Under the best of circumstances, it has to be something in the neighborhood of a 45- to 60-day exercise. That includes the time you spend writing the first draft, then several weeks of meetings with lawyers and so forth called ‘all-hands’ meetings. Then finally comes the all-nighter, which invariably comes up because you’ve got a date that you’re shooting for."

The second part of your registration statement contains other information, which although filed with the SEC, is not distributed to investors, such as a breakdown of the costs of the offering, indemnification rights of directors and officers, and certain financial statement schedules.

After you file your registration statement with the SEC, there will most likely be a quiet period until they issue their comments, which usually happens within 30 days. The SEC’s comment letter itemizes the revisions that are required before they will accept your registration. The SEC may actually require several rounds of revisions before they declare your registration statement effective. In most cases, if you’ve prepared a sound prospectus, the changes the commission requests will be minor and will only take a few days to make.

Step 5: The "Road Show"

At some point between the time you file your registration and the time it is accepted, your underwriter will schedule a road show, which is a meeting extravaganza that allows you to promote your IPO to investors in various cities around the world. During this presentation tour, you and your management team will meet with other potential underwriters, portfolio managers, securities analysts, brokers, and institutional investors, to try to entice them to purchase your company’s stock after it goes on sale. Each meeting will last about 20 minutes and may include a slide show or a flip-chart presentation, with which you must be intimately familiar.

The road show can be extremely hectic for both you and your underwriter because it involves substantial travel during a compressed time period, usually ranging from six to 10 business days. "The road show really takes a lot out of you," says Dayton. "You go out to all the different funds, and it’s eight meetings a day: lunches, dinners, breakfasts, one-on-ones, big meetings with like 30 bankers all wearing suits in New York, Boston, Los Angeles — the whole deal. It’s logistical hell, and you do the same presentation over and over again. But I can tell you that if you didn’t understand it before, you really learn your business model because you’re saying it over and over again, and people are poking holes in it. Some really smart people get to analyze your business model eight or 10 times a day."

Despite the grueling schedule, these meetings are valuable because they offer you the chance to educate the financial community about your company and generate interest in your IPO. Hall says that her road show was actually an enjoyable experience, despite the frenzied schedule of presentations. "I had always heard everyone groan about the road show, ‘Oh, it’s so hard. It’s so awful,’" she explains. "What they forgot to mention is that
it’s just outrageously fun. Yeah, you have to traipse around to three different states in one day, and you’re dead tired because you’re getting up at 6 a.m., but you’re getting up to tell somebody about your company so they can buy millions of dollars worth of stock! It’s hard to hold a pity party about that."

Step 6: The Pricing Meeting And Closing

During the pricing meeting, which normally occurs within a few days after the effective date of the registration, your investment banker will establish the public offering price for your stock. At this point, however, you will have had many discussions regarding your IPO price, and there should be no surprises at the final pricing meeting.

Underwriters generally tend to price IPO stock at $10 to $20 per share, but occasionally the price is set higher than $20 to give it a sense of prestige. Underwriters are generally very cautious about setting the price too high because they do not want the after-market price to fall below the IPO price, which would turn off investors.

At this point, you and your underwriter will sign an agreement that legally binds them to purchase your securities at the closing, which is usually held five days later. In general, the underwriter will purchase at least 350,000 shares of your stock, but an even higher number will ensure that there is enough momentum to keep trading active after the IPO.

Step 7: Opening Day

If you make it through all the hurdles, long hours, and grueling meetings leading up to this point, you’ll be happy to learn that there is a big payoff at the end of this journey: You should be able to coast through the opening day of your IPO and watch the orders roll in. Because many of the orders for your stock are placed after your road show and well before the opening day of trading, you should not be anxiously pacing the floor wondering how your company will perform.

Although many CEOs have at least some angst about going public because it is a big step, most try to treat their opening day like any other normal business day. "It was kind of anti-climactic, to be honest," Dayton admits, although EarthLink’s IPO raised $26 million. "We had lots of work to do, and we did it. The only difference was at the end of the day, we looked to see what happened to our stock. Obviously, it was an important event for the company, but it didn’t really change what we did that day."

Scheid, whose vineyard company raised $20 million in its IPO, concurs with Dayton. "I just ignored the whole issue," says Scheid, who has taken several companies public. "My CFO [Scheid’s daughter, Heidi] got up at 5 a.m., and she was there when the trading opened. Of course, it was a swirl because it traded a couple of thousand shares the first day. While she was doing that, quite candidly, I was sleeping. I got up and did my normal exercise routine at my gym, worked at my home office until about 11:30, then went to the office and said, ‘Well, how was it?’"

Hall, on the other hand, was emotionally moved by the opening day of her company’s $47 million IPO. Plagued with sleeplessness the night before the offering, Hall was overwhelmed by the experience. "It was achieving a goal that seemed like such a remote possibility five years before," she says. "It was hard to imagine I could do it. You’re on the trading floor, and you’re watching this company that you built be embraced by the world’s markets and people that you’ve met clamoring to buy millions of dollars worth of shares, and you just cry."

Based on the book Going Public by Frederick D. Lipman. To obtain a copy, contact Prima Publishing at 800.632.8676 or visit http://www.primapublishing.com.

About the Writer: Lisa Rauck is a former editorial manager for Entrepreneurial Edge magazine. This article originally appeared in the Volume 1 1998 issue of Entrepreneurial Edge.

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