There's a deafening silence in the public markets lately. Why? Because small and midsize businesses are looking elsewhere for capital."There have been incremental changes that, when you stack them up on each other, have altered the IPO scene and the IPO as an option for small businesses," says Dennis Sullivan, who works in Palo Alto, California, as the co-chair of the capital markets practice at securities law firm DLA Piper.
Take, for instance, the emergence of viable foreign markets. "Because of technology and the maturity and number of foreign markets, U.S. investors are more comfortable making investments abroad," says Sullivan. Not far behind are growing U.S. companies following the money trail to places like The London Stock Exchange's AIM market. "Smaller deals can get done [on the AIM], they're cheaper, and there [are fewer] liquidity requirements," Sullivan says. "The deals I've seen there could not have gotten done here." (For more on the IM, see "London Calling.")
Of course, competition comes not only from across the pond, but also from right here at home. As interest rates rise, investors put their money into safer investments, such as CDs and bonds. "The IPO market is always, in part, a reflection of what's going on in all the other markets," says Sullivan. Some of the blame, however, clearly lies with the market's own regulatory bodies, according to Gregory Sichenzia, founding partner at Sichenzia Ross Friedman Ference LLP, a securities law and corporate finance firm in New York City. "If I'm a small company with $20 million in sales, I'd love to do an IPO, but there's no one there to do it," he says.
During the dotcom boom, there were more than 100 small investment banks that would underwrite small IPOs, but the National Association of Securities Dealers, the governing body for stock brokers and dealers, clamped down and put most of them out of business. "Where there were a hundred, now there are five," Sichenzia says. Selling stock to the public may be nearly impossible now, but Sichenzia says there are viable alternatives. In the first nine months of 2006, his firm represented 50 publicly traded companies that chose to raise funds through a Private Investment in Public Equities, or PIPE, rather than a traditional public offering. These PIPEs averaged just over $4 million each.
In an ironic twist, doing these "private" transactions still requires that a company have publicly registered stock. PIPE deals selling large blocks of stock to private institutional investors have largely replaced smaller IPOs, which involve selling shares directly to the public on the open market. As a result, in a deal known as a reverse merger, businesses are purchasing so-called shell companies as a way to become publicly listed. "What you're buying is the investor base," says Sichenzia. "Shells are the fastest way to go public and the fastest way to access the PIPE market."
Once considered fringe, merging into a shell is now entering the mainstream. "I'd say 90 percent of the small companies that were doing $5 million to $20 million IPOs in the past are now [going public] through a reverse merger process," says Sichenzia. Darryl Jackson, founder and CEO of Automotive Management Services in Charlotte, North Carolina, has firsthand experience with almost every aspect of the public markets. Last year, he tried to take his 14-year-old automotive finance company to the public markets but found only a few takers. "With only $5 million in revenue [in 2005], we knew it was going to be a hard undertaking," says Jackson, 46.
Eventually, Jackson got several offers, including a reverse merger with a capital group waiting to invest through a PIPE transaction. But he walked away. "We found that private equity can be the most expensive kind of financing," he says. "We just weren't able to put together the kind of deal that would be favorable to the company." For now, Jackson has decided to stick with debt. A commercial lender was able to structure a relatively inexpensive $5 million line of credit backed by the company's receivables. "I believe I'll be able to get back into the equity markets," he says, "but I'll have to grow my revenue a little more. Then I'll have more leverage."
At ROO Group, a multimillion-dollar online video broadcasting company in New York City, CEO Robert Petty made the opposite decision. ROO completed a reverse merger in December 2003. Petty says publicly listed stock offers two benefits: "First, it allowed us to raise smaller chunks of money, and we could do it every few months. Second, it gives you a currency for acquisitions, which was part of our strategy." Lately, he's parlayed his currency into much larger PIPE transactions, including a $5.5 million private equity investment that was completed in late August. Petty, 42, says the transition "from private business to public company" was not easy, and he warns other entrepreneurs that the transaction can change their lives. "From a CEO's point of view, 50 percent to 60 percent of your time will be spent running the company and not the business. "A CEO needs to be exceptionally tough, tenacious and determined," Petty advises. "If you haven't done it before, it will be the single hardest thing you do in your business life."