The sound I heard at the end of 1998 was a grinding halt," says Jeffery Adduci, president of the Regional Investment Bankers Association. Announcing what is probably bad but predictable news for entrepreneurs, Adduci is referring to the market for initial public offerings (IPOs).
Investment bankers that handle IPOs were primarily spooked by two events, according to Adduci. The first was the volatility in the stock markets. "Investment bankers can't underwrite IPOs in an environment where the market may drop 200 points the day before or the day after they come out," Adduci says.
What's worse, the prognosis for the market is questionable at best. "We're not economists," says Adduci, "but nonetheless, the economic slowdown in Asia, as well as the near collapse of the Russian economy, all complemented by hedge funds that could lose trillions, would lead prudent investors to conclude that there's a chance the markets will [continue to] seriously decline." With odds like that, investors, as well as the investment bankers who serve them, are reluctant to place their bets on new companies via IPOs.
The numbers tell the story. According to Securities Data Co., the IPO tally for the first eight months of 1998 was just 340 deals--a number that on an annualized basis is way off from the 1997 and 1996 tallies of 636 and 874, respectively. And what the numbers don't show is that the market's 1,500-point slide from mid-July to the end of August 1998 virtually turned off the IPO spigot altogether, with just four IPOs squeaking out in September.
Adduci's remarks about IPOs are all the more painful because his trade organization's membership consists of the boutique brokerage firms that underwrite initial public offerings of $5 million to $15 million--a size that is generally too small for national and regional firms but which constitutes a vital resource for many small and growing companies.
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The Gathering Storm
According to Adduci, the outlook for smaller IPOs looks challenging. "Unfortunately, there have been several structural changes in the public equity markets that are making them unreceptive to smaller public companies," he says.
The first of these is the growing dominance of institutional investors in the marketplace--the mutual funds, pension funds and hedge funds through which individuals now routinely invest. "When a portfolio manager has $1 billion to invest," Adduci says, "it's no longer feasible for him or her to make investments in small companies whose total market value may be only $25 million."
The problem, Adduci says, is that the portfolio managers would have to buy the entire company--which of course they don't want to do--for it to make any impact on their portfolios. "The institutionalization of the market has taken many individual investors out of the market altogether," says Adduci, "leaving far fewer buyers of smaller initial public offerings."
Adduci says what's exacerbating this problem is that the Nasdaq stock markets--specifically the SmallCap market and the National Market System--appear to be accommodating this trend with new regulations, the most visible of which are tough new listing standards. "The new listing requirements which took effect in February substantially raised the bar on the share price, size, required equity and number of shareholders that companies must have before they can trade on that stock market," Adduci says.
The net effect of these new listing standards was that Nasdaq sought to de-list some 309 companies from the SmallCap market and 443 companies from the National Market System that didn't meet the new requirements. "To put the numbers into perspective," says Adduci, "the 309 companies that were told they would have to trade elsewhere represented 24 percent of all the stocks traded on the SmallCap market."
Changes like these mean IPOs for small businesses are getting more difficult to negotiate. To alleviate the problem, Adduci has proposed the formation of a stock market to accommodate emerging growth companies. "Clearly, there's a need for a marketplace where emerging growth companies can access growth capital," says Adduci, "and where investors are protected."
Zigging & Zagging
For entrepreneurs living in the here and now, a challenging IPO market means that one of the trends for 1999 will be an intensified focus on private equity capital, according to Ric Klass, a managing director of Harmonic Research LLC, an investment banking and brokerage firm in New York City that focuses on emerging growth companies.
Klass says that IPOs are not out of the picture altogether, but the screen is so fine, only a few firms will make it through the process in the coming year. The real opportunities for entrepreneurs, and to a degree for investors, he says, "will be in the market for private capital from individual and institutional investors."
Happily, the former group, known as angel investors, is emerging in abundance, with more formal paths to their doors than ever before. Perhaps one of the most promising avenues of approach is the growing momentum of ACE-Net, the Internet-based matching service that puts companies seeking capital in touch with accredited investors looking for deals.
One of the benefits of ACE-Net, as well as the other electronic matching services that are proliferating on the Net, is that, like the public stock markets, they have the power to put buyers in front of sellers. "One of the historical challenges of raising money privately," says Klass, "was that the buyers and sellers didn't know where each other were. The market was very inefficient. But now that's changing."
One example of how the private equity markets are getting more user-friendly was the 1998 unveiling of what is known as the ACE-Net short form. This is a streamlined version of the Small Company Offering Registration (SCOR) short form that was once required for a company to list its investment deal on ACE-Net. According to Greg Dean, assistant chief counsel in the SBA's Office of Advocacy, the new filing makes the use of ACE-Net a feasible alternative for any company raising money. "With the short form and the nominal fee to post an offering, entrepreneurs have absolutely nothing to lose through ACE-Net, but perhaps very much to gain," says Dean.
Klass says another twist to look for in the coming year is perhaps an increasing number of reverse merger transactions, in which small, private companies become acquired by more or less dormant public ones and, in the process, go public. "A reverse merger does not raise capital per se," says Klass. "But a public company, even one that doesn't actively trade, can much more readily raise capital from investors than a purely private one can."
The reason for this seeming contradiction is quite simple. More than outright failure, many private investors fear that once they've invested in a company, there will be no way to get their money back again unless the company goes public or is acquired. Therefore, says Klass, there's a preference among investors to choose companies that have already crossed the divide into public ownership in some fashion. "These investors know that even if the company succeeds, it's still difficult to go public. If a company has already gone public, however, success means there's a greater likelihood it will be able to create the kind of active trading market that will provide an exit for investors."
But Klass says reverse mergers also have a cost. "They don't guarantee an active trading market, and sometimes these kinds of transactions are looked at askance by sophisticated investment and brokerage firms," he says.
Another trend that may emerge this year as a result of the stumbling IPO market is a focus on direct public offerings (DPOs), according to Drew Field, a San Francisco securities attorney and consultant. So-called DPOs are just like conventional initial public offerings, but instead of orchestrating the deal through an investment banking firm, in a DPO, the company sells the deal directly to clients, members of the community, vendors or any other constituency that has a stake in the company and its success.
Drew speculates that the market volatility and the downturn in equities in general may have left many individual investors suspicious of traditional Wall Street fare. "I think that during the coming year, companies and investors will both be looking inward and will begin to rely more on their own instincts and judgment rather than on that of others."
When thinking about the public equity markets, it's important to remember they're not unidirectional, but cyclical. "In 1975, there were only 15 initial public offerings done," recalls Adduci. "But six years earlier, there were more than 1,000. Markets come and go. When it comes to raising money, successful entrepreneurs simply learn how to roll with the punches."
Next Step
Visit ace-Net at http://www.sba.gov/ADVO , and learn more about how you can raise capital from private equity investors.
Contact Sources
Drew Field/Direct Public Offerings, (415) 296-7820
Harmonic Research LLC, fax: (914) 967-5907, rlk1@idt.net
Regional Investment Bankers Association, 171 Church St., #266, Charleston, SC 29401, (843) 577-2000
Small Business Administration, see listing in MONEY section.
This story appears in the January 1999 issue of Entrepreneur. Subscribe »
