Burnt Offerings?

Public Peril

Consider the tale of Microleague Multimedia Inc., once a hotshot little company that traded on Nasdaq's SmallCap market, now a has-been that's left behind a trail of broken dreams, stilted careers and shareholder losses.

The company had a promising beginning; it was seemingly pulled out of thin air through a series of deals orchestrated by Neil Swartz, an able, engaging entrepreneur. By 1996, Swartz had built a company with $5 million in sales and four business units that developed multimedia software, primarily for the sports and entertainment markets. This momentum enabled Swartz to put together a $5 million IPO in May of 1996.

The bloom started to come off the rose just three months later, however. In its first earnings release as a public company, Microleague announced that its forthcoming title, Sports Illustrated Presents Microleague Baseball 6.0, upon which the IPO had been largely predicated, would be delayed. The product was delayed again in the fall. Meanwhile, Swartz was spending more and more time soothing ruffled investors and trying to put together deals that would help the company make up for lost time. By 1998, Microleague was headed toward Chapter 11.

"There's no doubt about it: I left the operations to others and spent a lot of my time with investors," says Swartz. "If I had concentrated my efforts on continuing to build the business, it might be a much different story today."

Swartz, who is now a principal with MCG Partners Inc., a merchant banking firm in Boca Raton, Florida, is drawing on his experience to help other companies avoid the pitfalls he ran into in the public equity markets. According to Swartz, "Some companies shouldn't attempt an IPO in the first place because they don't have the ingredients to succeed as a public entity." So the question remains: Should your company be on an IPO track, or will you make the most money by staying private? Here are some acid-test questions to help you find out:

  • Are you building a company that can run without you? Large companies hire financial professionals to structure deals and work with investors. In smaller companies, it's generally the CEO who rides herd on these duties. That's fine--unless the rest of the organization can't function without your leadership, input, vision, direction or whatever warm fuzzy you want to put on it. In retrospect, muses Swartz, this was his company's downfall. "I did deals, and I left the business to people who may not have had enough management skills and experience to pull off what I was selling to investors," he says.

    This doesn't mean that a nuts-and-bolts micromanaging entrepreneur can't take his or her company public. It simply means that if this is your personality type, you need to hire a CFO who has operated public companies and been through the IPO process before.

  • Can you get to a market capitalization of $100 million within three years of going public? Remember, the so-called market capitalization of a public company is the total number of shares outstanding--in other words, those shares held by the public and the founders, multiplied by the market price of the shares. For example, if a company has 10 million shares outstanding and the price is $10 per share, the market capitalization of the company is then $100 million. Why is this benchmark so important? Because it's at this level that a company begins to attract a wide enough following among brokers and institutional investors to ensure a vibrant liquid market for its shares. It's not that smaller IPOs aren't viable; it's just that they must grow rather quickly to succeed as a public entity. For instance, Swartz's Microleague started life as a public company with a market capitalization of approximately $22 million. This would have been fine if, within a short period of time, the company had developed the kind of sales and earnings to command a $100 million valuation.

    Your financial projections will show whether you can reach this level in the required period of time. Keep in mind that the value of a public company is generally a multiple of what it earns and that industries tend to have different multiples. Find out the average multiple for your industry by looking at the average price-earnings ratios for your publicly traded peer companies. Take this figure, and apply it to the earnings you project for three years after your company goes public. If it's not close to $100 million and shows no signs of getting there, your company isn't a good candidate for going public.

  • Are you building a company with high gross and operating margins? The gross margin is your sales less the cost of your sales (as a percentage of sales), and the operating margin is your gross income less your selling, general and administrative expenses (as a percentage of sales).

    Again, no rules are written in stone, but high margins are important because they keep companies out of the volume game. For a company to reach critical mass in earnings with low margins, it must generate enormous sales growth.

    To generate not only high sales volume but also growth in that volume, a company must meet two requirements. First, it must have access to tremendous amounts of funding to promote and finance sales. Second, it can't falter--missing on the top line can often cause a disproportionate loss on the bottom line. And nothing hurts a public company more than unanticipated losses.

    If you want some hard and fast evidence that low-margin companies should stay away from the public markets, check out the November 30, 1998, issue of Forbes magazine, which lists the 500 largest private companies in the United States. Note how many are supermarket companies, which are known for having razor-thin margins of 3 percent or less. The point is, if being public doesn't appear to be viable to many of these giants--who have annual revenues ranging from several hundred million to billions of dollars--you've got to question whether your low-margin $2 million business can make a serious go of things as a public company.

  • Can your business deliver double-digit sales and earnings growth year in, year out? This stipulation is more or less implicit in the requirement that a company reach a market capitalization of $100 million as soon as possible. After all, if you go public at considerably less than this level, you'll have to grow fast to catch up.

    But there's another reason why high-octane growth is de rigueur. The public equity markets will settle for nothing less. Remember, public companies compete with all other public companies, plus thousands of mutual funds, for the attention and capital of investors. So, in a world filled with Ciscos and Intels, to say nothing of a hot new breed of Internet stocks, what possible reasons would investors have to bet on a virtually unknown company that's growing at the speed of cold tar?

  • Are you building a family business? Mixing family business and public shareholders can work out just fine. After all, if the public owns two-thirds of the company and a manageable number of family members who work inside the business own the other one-third, then their interests are aligned in a positive symbiosis. However, while the family thinks generation to generation, public investors think quarter to quarter. If the business hits a few bumps, the shareholders, with their shorter-term views, will probably clamor for immediate change. Often, this change doesn't include the next generation of the family.

    Again, it's not that you can't have a successful family business that's also public. But be cautioned: If you absolutely, positively must turn over the reins to the next generation, don't go public because the business may very well not be there for your successors if you do.

  • Can the business be built inexpensively? Many public companies go public for the express purpose of creating what's known as a pipeline to capital markets. The pipeline concept rests on the theory that public companies can raise funds much more easily than private ones. For instance, once public, companies can raise additional money through a secondary offering or by selling shares privately. All of this thinking is cogent if the company delivers sales with the financing received during the first go-round, i.e. the IPO.

The sad fact is, except for biotechnology companies and, of course, Internet companies--which break all the rules of conventional finance--nobody wants to pump money into a company only to learn a year later that it needs still more to achieve the goals it claimed it could reach with the first infusion of money.

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This article was originally published in the July 1999 print edition of Entrepreneur with the headline: Burnt Offerings?.

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