Public affairs

Taking a company public is always risky, but the stock market’s blanket disapproval for new issues in the past few months makes the prospect even scarier. Twenty-five percent of the IPOs filed between Jan. 1 and Dec. 15, 2000, were withdrawn, according to IPO.com. And the long-term picture isn’t much brighter: IPO companies have underperformed their peers in the aftermarket by 30% to 50% over a three- to five-year period.

So why would a company subject itself to the regulatory acrobatics of going public? Numerous tangible reasons, detailed below, but intangibles count also. Basically, an IPO says a company has arrived.

"I think it’s the best and the worst of what running a company is about," says Hugh Martin, president and CEO of optical vendor ONI Systems. "It’s a validation that you’ve achieved something, it’s exciting and it provides access and capital. And it’s incredibly stressful."

But telecom upstarts aren’t likely to be scared off. Many telecom companies will go public in the next few years. And knowing the ins and outs of the IPO process and preparing diligently can mean the difference between a sweet and sour stock market debut.

Most companies go public to raise capital, whether that money is needed to expand the business, erase debt, buy other companies or to keep operations running. And equity financing is a relatively cheap form of raising capital, says Charles Kaplan, president of IPO advisory firm Equity Analytics and assistant professor of economics at Long Island University. "The marginal cost of going public is very low—besides the investment banking fees, actual costs are somewhere around $1 million to $1.5 million to raise $100 million," he says.

An IPO also provides existing stakeholders a liquidity event or even an exit strategy—a chance to cash out on some of their interest in the venture. Venture capitalists generally fund companies with the expectation that they will go public. Company founders want the opportunity to realize some of the paper value they’ve built up in the business. And for employees, a public share price can make it easy for the company to give them a formal stake in the business. (This also can be a powerful recruiting tool.)

There are downsides to going public, however: the potential loss of control, the fishbowl environment public companies operate in and the numerous financial and information reporting responsibilities required by the Securities and Exchange Commission.

"One of the negatives of going public is you have a new party sitting at the table: public investors," says Stephen Nill, chief financial officer of Sonus Networks. But the allure of a big stock market windfall usually overrides those concerns.

Shifting standards

But when a company is ready to go public is another matter.

Venture capitalists, investment bankers and executives use their own yardsticks to measure whether a company is "grown up" enough to wear the public company mantle, and those measuring tools have changed over time.

Ten years ago, companies had to demonstrate consistent revenue and earnings growth to be considered worthy. The rule of thumb was at least three quarters of profitability, says Barry Eggers, general partner at Lightspeed Venture Partners.

But around the time of Netscape Communications’ IPO in 1995 that changed. "In some cases, very young companies with untested business plans, no assurance of revenue growth and absolutely no assurance of positive income were able to go public," Kaplan says. "It shifted the risk of funding a start-up company from where it had been historically—VC firms—to the general investor."

The recent depression in tech and telecom stocks means the pendulum now has swung back a little. Companies that go public in 2001 must be much more ready to withstand the scrutiny of their business plans, underlying market fundamentals and management team by public investors.

"Now the public market will look for companies with two to four quarters of sustained revenue growth and a broader set of customers—more than three," Eggers says. "The bar has just been raised."

Softswitch developer Sonus waited for a "predictable business model" before going public in March 2000. For Sonus, a predictable business model meant a strong customer profile that would allow the company to accurately forecast how quickly its revenues would expand, Nill says. "We wanted to have at least two ‘anchor tenants’ in our customer base—large carrier contracts in which we could see a predictable rollout of our product in their networks," he adds. "And we wanted a number of smaller customers to round out the picture."

The importance of predictability of revenues (and earnings, if the company has any) cannot be understated. A company should have "crystal-clear visibility" into its financial performance at least six months out, says Sean Dalton, general partner at Highland Capital Partners. That’s because once a company makes its public debut, the worst thing it can do is disappoint Wall Street with a rotten quarter.

"It will very hard to capture their attention again," Nill says.

Part of building a predictable business is a capable, seasoned management team that can grow with the company as it goes public and can handle Wall Street with aplomb.

"Good managers can make a lousy company profitable, and bad managers can make Microsoft a losing proposition," Kaplan says. Because of the allure of stock options, a privately held company’s ability to

attract talent can be at its highest level just before its IPO. Therefore, it can be an opportune time to fill holes in the executive and technical ranks.

Another important checklist item is ensuring the company’s policies, procedures and systems are set up to accurately report quarterly results and give management a view into daily performance. A high premium is placed on "no surprises," Nill says. "The rubber band is stretched pretty tight with valuations [now], and there’s zero tolerance for error."

Other questions the company must ask itself include basic benchmarks that it probably encountered at the venture investing level:

• Is the company in a growth industry?

• Are the firm’s underlying fundamentals strong enough to sell the deal?

• Is the current product stable and is the company developing a next generation product?

• Is the product or service proprietary?

Finally, management must ask itself if an IPO the best thing for the company from a capital perspective, Dalton says. "Once you’re out, you’re out. If there’s a hiccup along the way, it’s very hard to recover."

Whom to bank on

There are many interim steps involved in preparing a company to go public, including finding a credible board of directors, restating financial results, if needed, to comply with SEC regulations (audited financial statements for the last three years are required) and clearing up any property and contractual agreements between insiders and outside parties such as customers and suppliers.

But the next major step to going public for most firms is finding the right investment bank to underwrite the IPO and, to a lesser degree, the right auditor and legal advisers.

"You want to go with the finest underwriter that is willing to take you on and the most prestigious accounting firm you can afford," Kaplan says. Currently, the top firms underwriting telecom deals include Goldman Sachs, Morgan Stanley Dean Witter and Merrill Lynch. A big-name underwriter can increase the offering’s legitimacy to investors and reduce the perceived risk, Kaplan says.

At the same time, mid-size deals can get overlooked at larger firms, so sometimes a second-tier bank makes sense. Wireless carrier Dobson Communications, which raised $550 million last February, was wary. "We wanted underwriters respected in the telecom community, underwriters with a good track record in IPOs and underwriters that would focus on our business—we didn’t want to be lost among our lead underwriters," says Bruce Knooihuizen, chief financial officer of Dobson.

In many instances, investment banks will come calling to pitch their services, and the "bake-off," or selection process, can start with as many as a dozen firms.

The company should have a checklist of criteria by which to screen underwriters. Those criteria include the underwriter’s experience in other telecom IPOs, its willingness to make a market in the stock, its aftermarket support of the share price, the quality of the bank’s research team and the quality of the overall banking team.

The reputation of the firm’s sell-side analysts is paramount, Nill says. "They are going to be the ones front and center with institutional investors on a daily basis. How big a push is the investment bank placing on your particular part of the industry?" Nill asks. The team’s overall quality will come into play when the company needs merger and acquisition advice or wants to hold a secondary offering.

At Sonus, Nill modified a request for proposal used in a previous job to select the company’s underwriting team. Sonus wanted to separate its IPO from the pack by having the best possible syndicate.

"When the IPO market is very busy, fund managers have hundreds of prospectuses stacking up on their desks—they distinguish deals by their experience with the underwriters," Nill says. Nill’s sampling of fund managers led him to narrow the choice for lead underwriter to Morgan Stanley and Goldman Sachs. Goldman Sachs won.

ONI had a similar experience, although it went public in a more difficult market in June 2000. "We picked Goldman because we were looking for an investment bank that had the retail strength to drive sales," ONI’s Martin says.

One way to distinguish investment banks, Nill suggests, is by the valuation analysis they present. The quality of thinking behind the analysis—not the numbers—is a good indicator of how well the bankers understand the company’s market and the company itself and how to put it in the best possible light for investors.

Aftermarket support, including the amount of trading activity that the investment banks accomplish in the security, is another consideration. A portion of sell-side analysts’ compensation is based on the amount of trading activity they spawn, Nill says. If an analyst is "noisy" on a stock, that will promote trading. Nill suggests asking the bank for its trading statistics for the periods of six months, one year and two years after it has taken companies public.

It’s not necessary to have just one lead underwriter on an offering. To add to its deal’s exposure, Dobson hired Lehman Brothers and Banc of America Securities as its two bookrunners.

"We are seeing more IPOs with joint bookrunners," Knooihuizen says. "Investment banks are more accepting of that role."

The choice of auditor is important because it can lower the perceived risk for the investor, Kaplan says. "If you go with one of the Big Five, it tells the investor that he can rely to a higher degree on the financial statements," Kaplan says. "Ultimately, they may turn out the same product, but the perception is that the big firm’s numbers will be more accurate and stand up to more rigorous scrutiny." That also means investors may be willing to pay more for the deal.

On the road

After the company files its registration statement ("S1") with the SEC, and the SEC determines that the company has made a full disclosure of financial and competitive information, the investment bank distributes a preliminary prospectus, or "red herring," to potential investors.

But the real selling comes when the company goes on the "road show," which usually occurs about one month before the day the company actually goes public. The road show—which by all accounts can make or break an IPO—is a series of face-to-face meetings nationwide with brokers and analysts in the syndication group (the co-underwriters of the offering) as well as with institutional traders and portfolio managers.

The road show is notoriously grueling, consisting of more than two weeks of presentations 10 hours a day for five or six days a week. "You have 25 minutes to convince people to invest millions of dollars in your vision," says ONI’s Martin. ONI gave its presentation 83 times in two-and-a-half weeks. "Janus wasn’t even seeing any road shows, they were so down on the IPO market," Martin says.

Flexibility during the road show is important because the stock markets can shift gears quickly in a short period. During Dobson’s road show, the wireless company’s public peer group lost 30% of its valuation, Knooihuizen says. The drop was spurred by a negative announcement from U.S. Cellular about the growth potential for roaming revenues. Dobson had to quickly change its presentation to explain how its approach to roaming was different.

During the road show, the underwriter closely monitors the demand for the stock, which is measured in how many purchase requests the bank receives. If the demand exceeds the supply—that is, the order book is full and no more shares are available—the deal is said to be "oversubscribed."

"IPOs that are 15 to 20 times oversubscribed are usually very successful," Eggers says. The amount of oversubscription also helps the underwriter make decisions on where the deal should be priced.

In the early stages of the IPO process, the company determines how much money it needs to raise and what the company’s valuation is. Valuation is determined by a number of factors, including comparable public companies, multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) and discounting of cash flows.

Valuation is more often an art than a science, Kaplan says. "If [the] deal calls for giving up 20% to the public and the company wants to raise $20 million, that valuation has to come in at $100 million. Quite often we work backwards," he says. Still, the valuation has to have some reasonable basis, because the underwriter has to provide a valuation in the S1 and justify it to the satisfaction of the SEC.

The IPO’s initial price range, which is usually filed in an amended S1 statement, is based on the company’s valuation and determines the amount of shares to be sold to the public. One million shares is the lowest a company can go, Kaplan says, because less than that doesn’t provide enough liquidity to stabilize the share price. In addition, mutual funds, pension funds and other institutional investors need good liquidity to purchase the stock. That’s because their policies usually prohibit them from owning more than 5% of a company.

IPO prices are usually between $10 and $20 per share but can fluctuate with demand, Kaplan says.

"The underwriters will tell you that there is a certain theory behind the optimal stock price to give [the stock] the broadest coverage," Knooihuizen says. "It should be cheap enough that an individual can afford to buy some but not [be] a penny stock."

Within a day or two of the deal, if demand is high, the pricing committee meets with the bankers to see if raising a price is justified. Then the syndicate manager gets on the phone to the investors who have ordered stock and asks how many shares they want to buy at the new price. The best bankers usually give the company the option of going with a lower price and filling the book 10 times over or going with a higher price and losing some investors, Dalton says. Underwriters normally underprice a deal somewhat to give the people who buy at the "inside" price a premium for supplying liquidity, Kaplan says.

Cold reality

In the current market for telecom stocks, of course, many IPOs die short of the pricing stage. "The IPO window is much more closed now than it has been in the past 10 to 12 months," Eggers says. "For service providers, it may be totally shut. For equipment providers, it may be virtually shut."

The macroeconomy has a large effect on the IPO markets, Kaplan says. "When the macroeconomy catches a cold, the IPO market catches pneumonia."

Cidera, a satellite multicast delivery company, canceled its plans to go public last December and instead raised a $75 million round of Series D private financing. The company had filed to go public in March but found venture investors much more receptive to its story, says Ram Viswanathan, vice president of corporate development and strategy for Cidera.

"We wanted to ensure that our funding would give us enough runway to grow our business," Viswanathan says. "It also allows us to shutter out some of the vagaries of the financial markets."

Another advantage to private equity financing is that the quality and depth of investor involvement supercedes that of public equity, Viswanathan says. Cidera’s Series D round brought in new international investors Trans Cosmos of Japan and Grupo Pegaso of Mexico—partners that will help the provider expand into Asia and Latin America.

Companies that do go public successfully often find that the hard work has just begun. As mentioned, the stocks of newly public companies often underperform the market. That’s usually because after three or four quarters of public financial statements analysts have a better handle on the company, Kaplan says. "Everybody’s an optimist pre-IPO, but ultimately reality sets in, and that reality comes in the form of quarterly earnings reports. And you can’t hide it."

Although companies could scale back earnings projections once their IPO is completed, ground-floor investors would not be happy, Kaplan says. "The venture capitalist might shoot you."