Public Opinion

Becoming synonymous with inflated valuations and dotcom disasters hasn't done much for IPOs' reputation. How long before we can start to talk about going public again without snickering?
Magazine Contributor
11 min read

This story appears in the October 2002 issue of Entrepreneur. Subscribe »

When San Diego-based biotechnology firm MitoKor filed for an IPO in March 2002, the market for new issues was looking downright abysmal. Gone were the heady days when "concept companies" with no revenue to speak of--let alone profits--debuted to great fanfare and triple-digit first-day returns. Instead, "newcos," or prospective new issuers like MitoKor faced a marketplace still reeling from the demise of the dotcom frenzy, the trauma of terrorism and investors disillusioned by the Enron debacle--all of which upped the ante for IPO--bound firms.

"To go public today, you will have to show eight quarters of solid revenue growth, an organization where costs are controlled and probably at least four quarters of profitability," asserts Mark Jensen, partner and national director of venture services at Deloitte & Touche.

"There's also a tremendous push from investors for greater transparency with financials," adds Steven Barnes, principal and CFO at Wayne, Pennsylvania-based venture capital firm PA Early Stage. "The public market is demanding not just the numbers, but that you show how they were derived."

Tried and True
With IPO hopefuls facing that tall order, small wonder that the first quarter of 2002 saw just 15 make the private-to-public leap, compared with 126 in the first quarter of 2000. So what prompted MitoKor, which posted a net loss of $21 million in 2000, to brave the plunge? Paradoxically, it's among a handful of companies that are finding an upside to the IPO market's new outlook. "In the heady dotcom days, investment bankers were telling us that no one was interested in biotech because technology was taking over the world," recounts 40-year-old MitoKor CFO and management team member Craig Johnson. "We're not hearing that argument anymore."

"In the IPO craze two years ago, the median age of companies going public was three years; today it's 15."

Too true. Technology firms, which accounted for 70 percent of public offerings in 1999 and 2000, constituted less than a third of new offerings in the first quarter of 2002. Instead, the IPO pipeline spat out more traditional businesses, from spinoffs like Citigroup's Travelers Property Casualty and Nestle's Alcon to new entries from mature industries, like air travel's JetBlue and health care's Medical Staffing Network.

In the current climate, a company's IPO prospects depend heavily on its market sector's performance, says Rick Bartlett, co-head of U.S. equity capital markets at investment bank Salomon Smith Barney. "The IPO market is very sector-specific," says Bartlett, who advises companies considering IPOs to gauge their potential by observing peers in the open market. "If your company is in a hot growth sector, it can go public."

Proven staying power also factors into the equation. In the IPO craze two years ago, says Jay R. Ritter, a professor of finance at the University of Florida at Gainsville who maintains a database on new offerings, the median age of companies going public was three years; today it's 15.

On the plus side, those who make the grade are faring relatively well compared to the overall market. First-day returns for 2002 new issues after the first half of 2002 are averaging 9.9 percent, according to Greenwich, Connecticut-based IPO research and investment firm Renaissance Capital (see "Times Are a-Changin'"). Even the half-yearly average total return for 2002 IPO stocks (8.6 percent) starts to look downright rosy when stacked against today's market figures, points out William Smith, president and portfolio manager of Renaissance Capital's IPO Plus Fund. "The performance of 2002 IPOs is far below the double- and triple-digit jumps we saw in 1999 and 2000," he says, "but compared with the NASDAQ, down 34.3 percent this year, that's not bad at all."

Wait and See

Still, just because a good company can successfully go public in a bad market doesn't necessarily mean it should. When demand for new issues is uncertain, offerings often tend to be priced more conservatively--making the deal less attractive for both the company and its founders. "I would wait it out," advises Jensen. "Any company that goes public in this market is going to leave a lot of money on the table."

New issues are usually priced at a 15 percent discount to comparable public companies. The dotcom frenzy sent discounts into the single digits, but now that demand for new issues is sketchy, they can soar to 50 percent. "Discounts have widened because of the market we're in," concedes Tim Gould, head of the global equity syndicate at Lehman Brothers investment bank. He blames low pricing for a recent spike in the number of delayed or withdrawn offerings. "Companies aren't willing to go based on the valuation they've gotten."

Unfortunately, postponing an offering can be traumatic for even the healthiest of companies. Once the IPO process has begun, the reputation of a company's management--internally and externally--rides on its fruition. "When you come back, it's harder because you're now a failed deal," says Bartlett. "It also crushes morale because you have to go back to all those employees you gave options to and tell them 'Well, we're still private.' "

Worse is the prospect of outright failure--weathering the IPO process only to have your stock price sink. Such a botched offering can scar a company forever. "The risk of failure is huge," says Bartlett. "If you launch priced at $20 a share and six weeks later your stock is at $10, you have less access to capital than you had if you had stayed private. You have no access to VC money [and] public money."

Those who are experiencing the IPO process counsel patience and preparation in guarding against such outcomes. "If somebody came to me early in our life cycle and said 'Let's take you public,' I would have said no," says F. Scott Moody, co-founder, president and CEO of Melbourne, Florida-based AuthenTec. Early in the semiconductor technology company's life cycle, quarterly revenues were too unpredictable for the short-term-oriented public market. "You don't want to go public on a good quarter, then have a bad next quarter."

Instead, Moody, 45, who expects AuthenTec to enter the public market in two years, is readying the company to make the leap, bringing in a CFO with IPO experience and adopting the rigorous financial discipline required of public companies. A premature move? Not in today's market, where it's never too early to build a paper trail that documents relevant financials--or take on the onerous task of preparing SEC-compliant financial statements.

"The best thing you can do is start preparing your financial statements in an SEC-ready format long before you go public," advises MitoKor's Johnson. "Then you can focus on creating value instead of going through the angst of accumulating back records for an S1 filing."

Bartlett seconds that advice, urging companies to do quarterly budgets, monthly P&L statements and business forecasts as if they are already public. "You'll get used to the rigor of the discipline and the process of forecasting," he says. "Too many CEOs forecast their business models for the first time [while] standing in public--a recipe for disaster."

In fact, companies should do more than merely meet current SEC disclosure requirements. It's unlikely that proposals to tighten the deadline for quarterly filings and to improve the transparency of accounting estimates will take effect this year. But investors are already demanding more than the minimum SEC requirements. "The marketplace will make more changes than the SEC or the government ever will," asserts Jensen. "Investors are already looking for greater transparency in financial statements and more disclosure regarding what the company's business model is, as well as who its customers are and how it interacts with them."

Times Are a-Changin'
We all know that the golden days of the IPO market are dead. But how bad is it? Compare the first-half numbers over the past three years:
1H 2000 1H 2001 1H 2002
TOTAL RETURN 45.9% 18.6% 8.6%
FIRST-DAY RETURN 76.5% 15.2% 9.9%
AFTERMARKET RETURN -9.0% 2.5% -2.4%

Make Friends Now

IPO-bound firms should also communicate early and often with potential underwriters. Investment banks can offer invaluable feedback about issues that need to be resolved prior to an IPO launch, such as a customer base that is too concentrated or patents that need to be approved prior to registration. In addition to helpful counsel, opening a dialogue enables the company to build relationships with possible backers--and, when the time is right, choose the lead investor that's right for them. "We met with different underwriters to get to know them and keep them updated on our science," says Johnson, recounting 8-year-old MitoKor's path to IPO registration.

Meetings with investment banks should be viewed as a get-to-know-each-other first date rather than a deal-making opportunity. "Don't be afraid you'll screw up your chance to pitch, and don't think it's too early to talk to investment bankers," says Barnes. "Getting to know them now puts your company on their radar screen."

It also lets you ask tough questions, such as how the stock will be distributed, how it will be managed after the IPO, and what kind of analyst coverage you can expect--all of which figure significantly in a stock's performance. Prospective underwriters should have a rational distribution strategy, sector knowledge, and the ability to generate interest. "Beyond that, you're looking for chemistry," says Jensen, who counsels firms going through the process.

"Do what's right for your business, not what you think will get you to the market faster."

But powerhouse investment banks such as Lehman Brothers, Morgan Stanley and Salomon Smith Barney boast better access to investors and an inside track to analyst coverage. "A big bank brings big clients and big capital access," says Barnes, who went through an IPO as controller and director of investor relations at speech-recognition technology firm Voxware and now counsels PA Early Stage's portfolio companies on growth and exit strategies.

While big banks bring cachet, small banks deliver more personal attention. "The market is telling you something if the only one who will take you public is a small brokership," adds Barnes. While there are situations in which going public is imperative--such as when an IPO will facilitate international expansion or is a deal-breaker with potential clients--the move is likely to be off-strategy.

Yet once the possibility of an IPO is raised, many entrepreneurs become so embroiled in turning it into a reality that they lose sight of how the offering fits into the big picture. Often, new offerings are viewed more as exit events than the financing avenues they're meant to be--which is dangerous. "You want to make sure you're not becoming a chief 'going public' officer as opposed to a chief executive officer," warns Bartlett. "Do what's right for your business, not what you think will get you to the market faster."

After all, in the current climate, faster is not necessarily better. Given today's deeper discounts, skeptical investors and strict financial prerequisites, slow and steady sounds preferable. "The best thing you can do right now is to try managing your business so you are not at the mercy of a tough capital market," says Barnes. "If you're building a sound business and creating value, there will be opportunities to exit down the road, even though it seems awfully dark out there right now."

What About M&As?
Contrary to popular belief, not every entrepreneur is lusting after that elusive IPO. In fact, a growing number are opting out of the race, citing the headaches and expense of the process itself, not to mention sinking valuations and the pressures of the public sphere. "It's a lot easier to adapt your business model when you're not a public company," points out Don McMichael, a principal at Ali Ventures LLC, a New York City real estate and entertainment marketing firm. "You can explain what's going on and what you want to do to a small number of well-informed investors. If you're public, it's 'Oops, we had a bad earnings report; there goes 50 percent of the value.'"

A merger and acquisition (M&A) can deliver an infusion of capital without subjecting you to the hassles of the infamous three-ring-circus-like road show and pressures of Wall Street. The downside? The payoff may be lower, and acquiring companies often want you, the company's founder, gone. "In an M&A event, the buyer buys the company and does with it as [he or she] will," concedes PA Early Stage's Steven Barnes, who advises companies to give serious consideration to the M&A option. "That can range from buying your business and having no interest in you or your employees to giving you the autonomy to keep growing the business along with the upside of the parent company's stock price."

That doesn't scare AuthenTec's F. Scott Moody. "We're open to both exit strategies," says Moody. "In fact, I've told everyone in the company that they have immediate signature authority to sign an acquisition offer of $250 million and up. Don't even bring it back; just get the deal done."

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