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— Cover Story —
Seven initial public offers began trading that week in late September after a long nuclear winter in new public issues, to mix seasonal metaphors. Suddenly, America's frozen IPO market appeared to be thawing and, to judge from the hoopla, about to flow again. (See related story) Well, it would be wise to keep your mittens on. True, more and more companies are apparently beginning to at least discuss the possibility of going public, say a number of investment bankers, who have every reason to talk up a moribund business. Pitch books have been fine-tuned, they say. Bakeoffs are being scheduled. S-1s are being prepared. Maria Pinelli, Americas director, strategic growth markets, for Ernst & Young LLP, says 600 companies "have identified themselves as IPO candidates over the next 18 to 24 months." Who are they? Mostly, these are relatively mature companies that have weathered the economic storms and come out intact. "There's a huge backlog of companies wanting to go public," concurs Richard Kramlich, longtime venture capitalist and co-founder of venture capital firm New Enterprise Associates Inc. "In our case, there are 20 to 30 companies really qualified for the public markets." However, even for those companies and their financial sponsors that are ready and willing, getting them to market isn't simple or anywhere near guaranteed. Large and vexing hurdles will continue to impede the frequency, size and composition of new issues. Problems range from the consolidation of investment banks, dissolution of a large IPO-related infrastructure and the demise of the industry's Four Horsemen to Sarbanes-Oxley, a far more risk-adverse institutional investment base and the unquiet ghost of Eliot Spitzer. "I think the backlog is real," says Jeff Bussgang, general partner of the venture capital firm Flybridge Capital Partners, who remains skeptical about an IPO market explosion. "The question is how the system works through the backlog." Jay Ritter, a University of Florida finance professor who has studied IPOs for years, believes 2009 will be "a carbon copy of 2003. The first half was pretty much dead. The second half came back to life." He puts any notions of recovery in historic perspective: "It wouldn't surprise me if we go for a few more years before we get to what in the 1990s was a pretty average year." Just about everyone agrees that this past decade wreaked havoc on the IPO ecosystem. On Wall Street trading floors, money management offices and in the board rooms of hundreds of high-growth companies, from Palo Alto, Calif.'s Sand Hill Road in California, to Cambridge, Mass., cafés and occasionally to the corridors of Washington, the debate these days is a lot messier and far more forward looking: What do the changes of the past decade mean to possible new public issues in the months and years ahead? How will this altered terrain affect not only the ease of getting to market, but also the nature of what new issues are likely to squeeze through? Few of those in the venture capital industry or those advising it buy into the popular notion that the IPO market is simply cyclical and thus is scheduled for a monumental recovery. "A number of players on the Street are out there looking for IPOs. But conditions have dramatically reduced what the market will be, compared to what it was," says Gregory Moore, a Boston-based partner at Ropes & Gray LLP and the co-head of the firm's venture capital practice. "What we've experienced over the last several years is not cyclicality, but more of a structural change." The need for a regular flow of IPOs can come off looking like a minor sidebar in the grand debate on economic recovery. To its advocates, however, a healthy IPO market is a vital ingredient of the capital markets and a market-based economy in general. "[It's] necessary to support economic growth," maintains David Weild, a senior adviser to Grant Thornton LLP's capital markets group and a former vice chairman of Nasdaq. Gus Tai, general partner of venture capital firm Trinity Ventures, puts it another way: "A healthy IPO market is very important as an indicator of a vibrant economy, of vibrant businesses innovating in fast-growing ways." Tai suggests that the altered state of the IPO market reflects fundamental changes in the economy as a whole. "Ten years ago, startups could find capital, build a company with predictable avenues to financing and then grow," he says. "Today there's a hyper-nimbleism of financial markets, businesses and even consumers" that most young companies find hard to manage, let alone take to public markets. "It's a much more complicated dynamic today than 10 years ago." Even those new public issues that launched that week in late September show the premium these days is on size, age, stability and profitability, not frisky growth. Of the seven that went public, two were real estate investment trusts, one was a hospital operator, one an asset manager, one a Chinese computer-gaming concern and one an online purveyor of vitamins. Only A123Systems Inc., which manufactures rechargeable car batteries, qualifies as the typical high-technology, venture-backed concern that once formed the backbone of the high-growth public market. The lineage and size of those issues is also instructive. Both REITs are private equity backed, as is Select Medical Holdings Corp. Everything from Securities and Exchange Commission filings to conversations with advisers indicates that private equity, smothered in debt and cut off from secondary buyouts, now view the public markets as the best, perhaps the only, exit strategy. And some investment bankers and lawyers believe private equity-backed companies will form the bulk of IPOs for some time to come. "The PE world invested so much in the last 10 years. They're very eager to get liquidity," says Donald Keller, who heads the corporate group at Orrick, Herrington & Sutcliffe LLP. Private equity is not the only source, however. Artio Global Investors Inc. and Shanda Games Ltd. are large spinoffs of much larger established companies. Vitacost.com Inc. was started 15 years ago as a catalog retailer. Shanda is noteworthy for another reason: its Chinese pedigree. In this environment, Chinese companies are proving relatively easy to take public, both in terms of persuading investors to buy and issuers to handle the offering. "The simple answer is growth -- and scale," says Mitchell Nussbaum, a New York partner with Loeb & Loeb LLP. Nussbaum says he's helped list "40 to 50 Chinese companies" in the U.S. Nussbaum adds these companies can grow 30% to 50% year after year, still be profitable and be willing to come to market at what he terms a "fairly reasonable valuation." From the perspective of the company itself, the lawyer continues, a listing on the New York Stock Exchange or Nasdaq gives the company prestige, which helps attract talent, gain customers, keep suppliers, even acquire others. In terms of issue size, Shanda eclipsed $1 billion. Artio tipped $600 million. A123 almost hit $400 million. The smallest of the issues was Vitacost.com. It still topped $100 million. "The trend is toward larger IPOs," says Navid Mahmoodzadegan, a managing director at New York investment bank Moelis & Co LLC. "If you're a smaller company, typically an IPO is not going to be an exit event." Compared with what the market has been through, any IPO activity constitutes good news. Last year, just 21 companies went public, and the number of venture capital-backed IPOs totaled a mere six. In the fourth quarter of 2008, the IPO market flatlined. Just three companies went public in a six-month period from Oct. 1, 2008, to March 31, 2009. Even worse, in the full year that began March 31, 2008, only one company that was venture backed, Rackspace Hosting Inc., conducted an IPO. "Six months ago, markets were so fragile, no one was looking at an IPO. Everyone thought it was Armageddon," says Jonathan Biele, who heads capital markets at middle-market investment bank Cowen and Co. LLC. Now "we're having conversations about IPOs across the board." Look at the historic data, however, and it's obvious the recent stasis isn't just about last year's market freeze. In 1999 and 2000, a total of 859 companies came to market, according to data from the University of Florida's Ritter's. That's almost as many, 881, offered during the entire period from 2001 to 2008. No one advocates a return to the kind of mass investing insanity that characterized the late 1990s with the Internet and telecom stocks. That subsequent collapse was partly responsible for the damage that followed. Investment banks launched public companies as fast as they could print prospectuses. Recently hatched startups had little or no chance of profitability and long-term prosperity. The most outrageous made a mockery of sound business practices. Think Pets.com, which shipped 50-pound bags of dog food for free and spent millions on ads featuring a crudely designed puppet. Its trajectory was telling. Pets.com launched in August 1998 and was taken public a scant 18 months later in early 2000. It went bust before the millennium year ended. Giddy investors wolfed down even the most far-fetched of these issues, at least for a while, before massive indigestion set in. When public investors stopped buying, private investors stopped funding. That left all sorts of startups -- good and bad -- hung out to dry. "Many companies went public way too early," says Orrick's Keller. In the aftermath of the dot-com crash, he says, "a lot of young [privately funded] companies went out of business as well." The IPO market may have reached the heights of absurdity in 1999 and early 2000, but it had a surreal quality for much of the second half of the '90s. The biggest number of IPOs, according to Ritter's statistics, actually came in 1996, when 675 companies went public. Bussgang talks about his days as an executive of an Internet commerce software company called Open Market Inc. It went public in 1996 with a $1.2 billion market capitalization. Yet the company wasn't profitable. Its revenue in 1995 totaled just $1.8 million. (Open Market merged with Divine Inc. in September 2001. Divine went bankrupt 1-1/2 years later.) Florida's Ritter, for one, attributes continued investor wariness to the memory of being burned in years past. "There was a poor track record of companies that went public when they were young and small," he says. "That has made institutions less than enthusiastic." Bussgang adds: "The time when a highly unprofitable, two-year-old company goes public is long gone. We'll never return to that. The late '90s was a massive aberration. The new normal will feel a lot more like the 1980s and early '90s." The problem COMPANIES now face is that "the pendulum has swung horribly the other way," Bussgang says. Now, he says, "you could have a company with well more than $100 million in revenue and $15 [million] to $20 million in Ebitda and still not be able to go public." For that, the blame can be widely apportioned. The bleak IPOs market reflects all sorts of factors, some specific to the process of going public, some more general, some possible to reverse, others extremely difficult. Sarbanes-Oxley is the most obvious target. With its strict reporting requirement for public companies, the law "costs a company $2 million to $3 million a year," Bussang says, not to mention the time and stress factors it imposes on management. "It's crazy." For companies on the cusp, the additional time and money spent may simply not be worth it. Few in the investment industry, however, believe the law is the most important factor on whether or not to launch an IPO. "Not a single company failed to go public because of Sarbanes-Oxley," maintains Jeff Horing, managing director of Insight Venture Partners. "Sarbanes-Oxley is a bit of a red herring," adds Grant Thorton's Weild. "Sarbanes-Oxley didn't come into effect until 2002, and the small IPO had already gone away like a dodo bird. If you just got rid of Sarbanes-Oxley, you're not going to fix the market." More germane is the dramatic decline in the number of investment bank underwriters. Lehman Brothers Holdings Inc. and Bear Stearns Cos. have effectively disappeared. So, too, are the four technology-focused investment banks that led many of the new issues of the previous decade, the so-called Four Horsemen: Robertson Stephens, Hambrecht & Quist, Montgomery Securities and Alex. Brown & Sons. All four fell prey to much larger banks and were either absorbed or closed. Robertson Stephens, for example, was sold first to Bank of America Corp., then to BankBoston Corp., which was in turn acquired by Fleet Financial Group Inc., which unsuccessfully attempted to sell it off, only to liquidate it in July 2002. These days, bulge-bracket banks -- notably Goldman, Sachs & Co. and Morgan Stanley -- pretty much have a lock on underwriting new issues. (Goldman Sachs, for example, was co-lead manager on five of the seven IPOs that late-September week, and only Vitacost.com turned to bookrunners who weren't bulge-bracket banks.) Not only does their "brand" dominate, but they've done a good job of convincing pre-IPO companies of their worth. "The common joke is that no CEO gets fired for hiring Goldman Sachs," says Cowen's Biele. Domination means that these larger banks can pretty much dictate IPO terms. With very few exceptions, they demand IPOs of $100 million or more "to make it worth their while," one venture capitalist says. That translates into a minimum valuation of $400 million to $500 million, which excludes a whole universe of high-growth, middle-market concerns. "Private equity and venture capital are saying 'we're going to wait for the big guys to handle the $500 million market cap,' " says Benjamin Howe, CEO of America's Growth Capital, a Boston boutique investment bank focused on growth companies. Companies themselves "have felt that the risk of going public earlier with a smaller name player is too overwhelming to be worth it." Adding to the squeeze, lead banks demand a much larger percentage of the shares on offer. That's typically 80%, as opposed to the 40% to 60% range common during the heyday of the IPO market. If they can get any cut at all, boutique investment banks must be satisfied with perhaps 10% of a shares allotment. Those scraps aren't nearly enough to make selling an IPO profitable for those banks, a further constraint on their own growth. The sharp decline in the IPO market, the consolidation of investment banks and the financial meltdown all combined to decimate the infrastructure that surrounds new issues, including sales, marketing and investment research. In some bulge-bracket banks, entire floors lay deserted where armies of sales representatives once roamed. Sell-side research has been particularly hard hit. In 2002, then-New York Attorney General Eliot Spitzer, in return for dropping a series of lawsuits, pressured banks to settle on reforms designed to rebuild or reinforce the Chinese Wall that separates investment bankers, securities marketers and research analysts. Under the agreement, research and marketing of a public issue were decoupled. Linking the two was widespread and led to a common form of institutional boosterism, which companies expected from their investment banks in return for taking them public. While the linkages created a system suspect at best, practically speaking, it meant that investment bank operations underwrote research through a kind of soft money subsidy. Separating these functions to eliminate conflicts rendered research unprofitable. As the decade progressed, banks saw margins squeezed. They needed to reduce head count, and research was an easy target. Two investment bankers estimate that it costs $500,000 for every company covered. "It's very expensive," says Mike Bauer, managing director of equity capital markets at Jefferies & Co., who quickly adds his bank has gone to great lengths to keep research. "I think we have as many, if not more, research analysts as before the Bear Stearns debacle. Research is incredibly important both to buy side and public companies themselves." Academic studies indicate dropped research coverage isn't a new problem. A 2009 study by Ajay Khorana, Simona Mola and Raghavendra Rau, "Is There Life after Loss of Analyst Coverage?" reveals that in the two decades from 1983 until 2004, hundreds of companies each year found themselves bereft of coverage, that is, research orphans. Most of these were small issues, but 15% of the sample firms analyzed showed market capitalizations of more than $100 million, many in excess of $500 million. If anything, it appears to be getting far worse in the years after the study was completed. Data suggests some of the most prominent bulge-bracket banks, including Goldman Sachs and Morgan Stanley, dropped on average of one company for every four they took to the market over the past two years. Other factors have led to a crisis in coverage. Institutional investors and hedge funds do more research in-house and have poached staff from the sell side. Investment bank consolidation, including the demise of Bear Stearns and Lehman and the merger of Merrill Lynch & Co. with Bank of America, means simply fewer institutions have the ability to mount research. As times got tough, many bulge-bracket investment banks that survived moved upstream. They've increasingly targeted both coverage and sales support on their larger-cap clients. Institutional investors responded in kind, in part because of the lack of sell-side research and in part because of a diminished appetite for risk. "The T. Rowe Prices and Fidelities need to focus their own analysts on larger market-cap fare," says Weild. "Coverage is breaking down on the sell side. And the buy side stopped caring as well." Dropped coverage can spell the death of some smaller-cap companies. Institutional investors won't buy without independent research, and no company these days can survive only on the backs of retail investors. "In the commercial food chain, if it doesn't trade in the secondary market, demand falls off sharply," says a bulge-bracket bank executive. "It may be doing fine [in terms of its business], but if it's not trading, there's a real problem." The smaller-sized, high-growth companies are especially vulnerable to all these underlying changes. "No one can make an economic case to cover a small cap of $200 million," says Weild. Yet it's precisely these kind of technology companies that need "high-quality and sophisticated research," he says. "If there's no support, there's no trading," Moelis' Mahmoodzadegan adds. "That has to serve as a disincentive for others." Middle-market investment banks that survived consolidation, such as Cowen, Jefferies, Piper Jaffray & Co., William Blair & Co. LLC and Robert W. Baird & Co., as well as upstarts such as America's Growth Capital, make the case that they represent the new horsemen, that they're well positioned for underwriting smaller new issues, even "reinstitutionalizing," to use Biele's word, some of those companies orphaned by bulge-bracket firms. Jefferies' Bauer, for example, says that for his firm, "our universe begins as small as $60 [million], $75 million." As a rule of thumb, that equals 25% of pre-IPO valuation, which works out to a minimum $250 million to $300 million market cap. "There are 10 boutiques jumping up and down to do these," Howe says. Midmarket firms say they have maintained, even beefed up, research and kept sizable trading forces, adding that it's a myth only bulge-bracket firms are able to tap institutional investors. John Baumgartner, Baird's director of equity capital markets makes the pitch: Midmarket companies "don't have bulge firms to take them public. That's where our firm excels," he says. Bauer maintains that the real sticking point is that institutional buyers simply lack the desire for risky equities. However, Howe and others say persuading companies themselves to go with middle-market or investment-bank boutiques is easier said than done. The fact is, many prospective candidates for IPOs are running scared. They have yet to be convinced in any great numbers that the gamble of an IPO is worth it. "With all the negatives of being public, I don't think it even begins to make sense unless you have a market cap of [$500 million, $600 million, $700 million] and very clearly see a way to a billion-dollar market cap," says Brett Brewer, president of new Kansas City, Mo.-based media advertising network Adknowledge Inc., which is venture capital backed and still privately held. "There is no sense being public if you can't have top-tier analysts to tell your story," he adds. Brewer adds one more factor to the IPO equation: valuations. Right now, there's virtually no valuation premium for being publicly traded, he says. One of the arguments for going public is as a valuation counterweight to being acquired: Have the IPO exit and a company can demand a better multiple from potential acquirers. Financial sponsors call this "multiple avenues of liquidity." In this market, at least so far, that argument doesn't carry a lot of weight. "There's a huge amount of private capital. The last rounds [today] are easily the same size of IPOs in the late '90s," says Insight Venture's Horing. Companies "might as well enjoy life for a few more years," he says, adding, "We're not pushing [portfolio companies] to go public just to go public." Brewer's experience is instructive. Adknowledge has made six acquisitions, its latest the July purchase for an undisclosed amount of KITN Media, owner of virtual currency dealer Super Rewards. Brewer says the company is now busy integrating what it has acquired but remains on the lookout for a "couple more" acquisitions. Adknowledge now boasts revenue of $250 million and, says Brewer, is the recipient of "plenty of inbound interest from all the top-tier bankers" about taking the company public. But he doesn't think it's time. Brewer, who co-founded Intermix Media Inc., the publicly traded creator of MySpace that News Corp. acquired in 2005 for $580 million, says he's found similar sentiments in discussions with other Internet-related executives. He contrasts it to the time nine years back when he took Intermix public. "Now it's much more about building a long-term, sustainable business and less about the speed of getting money and going public," he believes. "Companies are going to be more patient," concludes Trinity Ventures' Tai, but he adds a venture capitalist's optimistic note: "Quality companies are going to go public every year."
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A very good in-depth article of the problems facing the most dynamic part of the economy.
One issue I'd like to see addressed is how private companies structure their compensation without triggering SEC scrutiny.
At about 400 shareholders or stock option holders, the SEC will look to classify a company as "public" and require full disclosure.
In the current economy I guess a job is all the motivation an employee needs, but I would think that in competing for talent a private company would be at a disadvantage, not being able to offer any kind of stock-based compensation and not having the cash-flow to support competitive cash compensation.