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INITIAL PUBLIC OFFERINGS
A WAY TO SURVIVE IN TODAY'S MARKETPLACE

by Bob Brooke

Studying the Stock PageAn increasing number of small and medium-sized companies are choosing to create initial public offerings (IPOs) as a way to survive in today's competitive marketplace. When carefully planned and executed, they can often provide an effective way to raise needed capital. However, nothing comes easy and a lot of advanced planning is necessary for a successful IPO in today's market.

"IPOs enable business owners to diversify their investments without selling or losing control of their companies," said Fred D. Lipman, of the Philadelphia law firm of Blank, Rome, Comisky & McCauley and author of Going Public: Everything You Need to Know to successfully turn a Private Enterprise into a Publicly Traded Company. "Any privately-held business with growth potential can go public."

If that last statement is true, then there must be a lot of companies with growth potential since over 15 companies per week went public in 1995, compared to just 15 per quarter in 1980. According to Lipman, over 150 IPOs were executed by companies with gross annual earnings of less than $10 million. "We had a company with no revenue and no earnings that raised $15 million," he said, "but they initially had $5 million in preferred stock."

While that example may put stars in the eyes of business owners strapped for funds, the reality of IPOs is a bit more disconcerting. "With so many companies going public, it's hard to get investors' attention," said Patrick Hurley, general partner with Howard, Lawson & Co. and editor of The IPO Reporter until it was sold to Dow Jones. "The trick is for a company to distinguish itself from the pack."

"Growing a business is like a food chain," said George M. Jenkins, a venture capitalist with the P/A Fund in Radnor who has invested in a number of companies that have later gone public. "At first entrepreneurs take their ideas and seek out business angels to get the capital to get started. Then later they need greater amounts of money to keep going and venture capitalists, like myself, invest in their companies. Finally, they're self-sustaining and need capital to expand. That's where IPOs come in."

Raising Capital from an IPO is First and Foremost
I
f a company's valuation in the public market is high, it often can seek capital in both the public and private sectors. IPOs are a way for business owners to achieve liquidity--a way to sell stock. They also help to motivate and attract key employees and provide another form of payment for acquisitions, trading stock instead of cash. "The market determines which companies should go public," said Howard Ross, consultant with Arthur Andersen & Co., who works with emerging companies that have later gone public. "There's no boilerplate answer."

What is the rationale behind why a company asks the public for money. For a large company, critical mass is enough of a reason. The IPO provides liquidity and currency for acquisition. But for a small company, access to capital is the single most important item.

"A small company needing $10 million or more will get a better price publicly than privately," said Hurley. "A public company sells common stock, while private investors require convertible preferred stock or redeemable convertible preferred stock."

"If a company receives $5 million in venture capital, it puts that money into preferred stock," he added. "Private investors holding preferred stock always expect that the business will either go public or that it will be sold. The structure of venture capital investment provides the return of the investor's capital first, as well as participation in company operations. These investors must seek a way out, either from the sale of the company or through a public offering."

A company that executes a public offering is in much more control of its destiny and offers more value. However, this control comes at a high price. It costs $200,000-300,000 per year to go public--with no benefits. That's a high price to pay for what may amount to private investing.

"There are always reasons why people hold stock," Hurley said. "They may want to sell it, but it's the business owner's job to create the demand. After going public, the owner now finds he's in two businesses--his original one and the security business--trying to sell stock in company."

A business owner has to have a good reason for taking his company public. He has to be able to access large amounts of capital to accomplish his long-term business strategy. Otherwise, it's not worth the cost. If his public costs are too high, then he might as well take his company back private. He has to make a decision which is best in the long-term.

"The most difficult challenge in going public is getting the attention of institutional investors," added Hurley. "IPOs are traditionally traded at 10-15 percent below what a company's stock is expected to trade at. This is intended to create an early reward for those who buy unseasoned stock."

Most companies going public immediately go to the NASDAQ national market list, the only one published in newspapers across the country. Otherwise, investors won't know a company is there.

An institution's minimum liquidity requirement is 100,000 shares of trading per week per company. Some refuse to buy shares unless an analyst follows a company and publicly researches it. It's the job of the analyst to attract investors to do business with the firm. In fact, institutions see the analyst as someone who can ferret out returns over time, acting as the company's front man.

What Does an Emerging Company Need to Do to Initiate an IPO?
A company has to show evidence that it's on a growth curve. The more growth potential in its industry sector, the greater potential for success of the company's IPO. It must show a minimum 15-20 percent annual return. "The less a company's track record, the greater its growth potential," said Lipman. "I believe a company's size is unimportant. Its earnings must give credibility to its growth projections. If it's projecting 20 percent growth, better have a record to back it up."

Lipman also recommends that business owners establish management credibility by making a chief financial officer part of their management team. The company should also adopt a stock option plan, as well as a thorough business plan. It should also have prestigious names on its board of directors and be incorporated as a Sub-Chapter S corporation.

"But one of the most important things is for a company to have a track record," said Lipman. "Its owner should follow the marketplace, comparing private and public capital sources and decide which is right for his company before preparing to go public."

George Jenkins believes a company should create a minimum of a $10 million offering, before which a company would have an equity of $20 million, thus giving the public one third ownership.

"Purchases of IPOs are 90 percent institutional," said Hurley. "These investors need to feel they have liquidity in stock, as well as in subsequent public offerings. The company needs to put the money received from its IPO to work, to show the investing public that their money to being put to good use."

Research the Market
A business owner also has to look at other companies in his category in the IPO market. If there are a lot, he may not be able to sell his stock due to competition, If there are no other companies in his category, he has a chance.

If a company has the growth required and has done its homework as to marketing its IPO, how does it position itself to initiate one? A company planning to go public should develop an impressive management and professional team. Its owner should grow his business with an eye to the public marketplace. He should obtain audited or auditable financial statements. He should also establish two classes of stock or other anti-takeover defenses and create insider bail-out opportunities, select his own independent board of directors, and take advantage of IPO windows, fads and IPOs of similar companies. But most importantly, he should clean up his act.

"Early on, a business owner should get to know Wall Street underwriters," said Jenkins. He recommends working with a venture capitalist firm like the P/A Fund. "We pick the right management teams and scan the marketplace for operating companies as if they had already gone public. We look at their boards of directors, reporting systems, general operating procedures--and make recommendations.

"We add value to strategic companies by helping them think through diversification and expansion," he added. "We help them think these things through and help them determine when the timing is right to go public."

Venture capitalists like Jenkins know underwriters. They're involved with hundreds of companies, and by being involved with them, a company is given referenceability in the marketplace.

How Long Does this Whole Process Take?
It can take from four weeks to six months to convince underwriters on Wall Street to help a company go public. Once an underwriter is selected, it's basically a predictable mechanical process, taking from nine to twelve weeks. This involves preparing the prospectus, filing with the FCC, and advertising.

"Some companies in the early stages cultivate underwriters to cut down on the time required to initiate an IPO," said Ross. But most important: Owners should have a complete management team, know their five-year strategy, and surround themselves with advisors who know the pitfalls."

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