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How the IPO arket Works
It should come as no surprise that New York City was home to the first hot U. S. initial public offering (IPO). In the spring of 1791, the first Bank of the United States (BUS), which was the young American government's new central bank, began plans for a stock subscription to raise $10 million. When the stock subscription--what Wall Street brokers called IPOs back then--was launched in July, it sold out in an hour.
The lucky purchasers of BUS stock were the U. S. government itself, buying $2 million worth of shares, and the powerful, London-based Barings Bank, which scooped up the rest. The shares, priced at $100 each, quickly shot up to $185 before dropping back to $130 that September. Until BUS was forced to go out of business by the federal government in 1811, its shares were a popular speculative stock for New York's stock market participants, who traded shares at the Merchants Coffee House at the corner of Wall and Water streets.
The great success of the BUS offering spurred other entrepreneurs to organize banks and raise money. Following a pattern that would be repeated many times over the next three centuries, the first companies to go public in a particular business sector are usually the strongest, and they are quickly followed by weaker and weaker fry. The Bank of New York, today a staid New York institution, became the first company to trade on the new New York Stock Exchange (NYSE) in 1792. It became a favorite of the sharp-elbowed speculators who made up the majority of NYSE participants. The ease of raising money drew in hustlers, who launched issues of the Million Bank of the State of New York, Tammany Bank, and others. The frenzy to buy bank shares was so high that some of the banks were able to attract shareholders even though they had no customers, branches, or deposits. The Internet phenomenon of profitless and revenueless companies isn't so new after all!
Alexander Hamilton, who was serving then as the first Secretary of the Treasury and who had been instrumental in the creation of the Bank of the United States and of the Bank of New York, worried about "unprincipled Gamblers," much as Alan Greenspan would later fret about "irrational exuberance."
Prices of the bank stocks soared. During the 1790s, over 290 companies were formed, mostly banks and insurance companies. Inundated by the flood of issues, suddenly people realized that many of these banks were complete frauds. Investors panicked and tried to dump their shares. When the dust settled, only the Bank of the United States and the Bank of New York survived.
This scenario of greed followed by fear would be repeated time after time on Wall Street. In 1817 it was canal companies. The Erie Canal Company was the first to offer shares to the public. At the time, canals were a major revolution in travel and commerce, dramatically reducing the time it took to get goods to markets and allowing more products to be transported. The Erie Canal, which was completed in 1825, connected New York harbor, at the mouth of the Hudson River, to what would later become Buffalo on the shores of Lake Erie. The canal vastly reduced the cost of shipping goods from the west to the east, made New York the major East Coast port, and spurred westward migration. These developments captured the imaginations of investors, and they scooped up shares.
Just like the Internet revolution almost two hundred years later, the success of the Erie Canal created a frenzy for other canal stocks. Offerings for the Blackstone Canal in Rhode Island and the Morris Canal in New Jersey were vastly oversubscribed, with many more investors than there were securities to give out. Investors didn't bother to look closely at the business, its management, or its finances. Investors gave the Chesapeake and Ohio Canal Company $22 million to build a canal that was never completed. Within 10 years, the stocks of most of these companies were worthless.
It is worth examining this bit of history because IPOs have always been at the cutting edge of the economy. The Internet infrastructure companies of today are the railroads of the 1840s, the mining companies that came out of the craze that marked the 1848 California Gold Rush, the telegraph companies of the 1850s, and the electric companies of the 1870s.
Every public company started life as an IPO. Companies that would later become stock market behemoths were launched during these heady times. American Express and Wells Fargo, later to become giant financial institutions, came into existence as couriers delivering stock certificates and cash to and from the increasingly busy brokerage houses. The business evolutions of both those companies help put the public's fascination with Amazon. com and eBay in perspective. Companies that are long-term winners evolve over time, changing as technology changes. As a unique sector of the equity market, IPOs are situated in terms of risk and potential return between the high-risk venture capital companies and older, established companies. Exhibit 1.1, "IPOs--A Unique Asset Class," shows this risk/return profile.
It is also worth pointing out that the first to try to exploit a new opportunity are not always the first to claim success. The now defunct Internet retailers, who were the first to try to commercialize the World Wide Web, have predecessors in history. Most of the men who sieved muddy water in the streams of Northern California never really benefited from the California Gold Rush. Rather, it was the Bavarian immigrant who began selling them work clothes made of blue denim in 1853 who created wealth that has endured. Levi Strauss, in fact, did its IPO in 1971, over a century after its founding.
The greed-and-fear cycle of the stock market, with its booms and busts, is played out with much more intensity with IPOs. The feeding frenzy over Internet stocks in 1999 was just another chapter in the normal cycle of the IPO market. Hysteria develops over IPOs because of the known investment rewards of getting in early on new technologies. Demand is strong because the supply of shares is limited. At the beginning, the investment potential seems limitless. Investors see IPOs as a way to buy a ticket to the future. Weak, copycat IPOs force investors to look closely for flaws. And when they do, reality sets in. Then, just as bad money drives out good money, investors see flaws in every IPO and frantically dump them all.
This cycle happened with Internet retailing in 1998 and 1999. At first, companies that sold goods over the Internet were driven up to impossibly high valuations, as was the case with Amazon. com and eBay. And then Christmas of 1999 happened. Investors who owned the "e-tailing" stocks bought things from the companies and quickly realized that prices were high and fulfillment was dreadful. Investors watching television or listening to radio were barraged by commercials on no-name dot. coms. They realized they couldn't remember which ads were for what IPOs. The twin problems of poor execution and over-spending with too little results caused investors to rethink their infatuation with e-tailers. And down, down, down, the stocks came. The pattern was exactly the same as it was for the bank stocks of the 1790s--when the dust settles, only the sound companies are viable.
This doesn't happen only to Internet retailers. In the early 1990s, the federal and state governments allowed Indian tribes to open casinos. Grand Casinos, which operated two Las Vegas-style casinos for the Ojibwe Indian tribe, was one of the first to take advantage of this new ruling in 1991. Then state governments up and down the Mississippi River relaxed gaming laws, spawning a new industry--riverboat gaming. In 1992, Casino Magic, which ran one Gulf Coast casino, went public with great fanfare. It was followed by President Riverboat Casino, which claimed to have the largest riverboat casino in the United States, operating out of Davenport, Ohio. Even tennis great Jimmy Connors was an investor. The floodgates really opened in 1993, when it seemed like anyone with a seaworthy barge, a few packs of cards, and a gambling license could go public.
Faced with an oversupply of small gaming operations, investors took a close look at what they had bought and didn't like what they saw. Mounting an IPO on the business model of having a single, small gambling barge was pretty risky. What about hurricanes? Ooops! Bad weather along the Mississippi and disaffected investors practically drove the smaller players out of business. Since 1993, the IPO market has not seen another gaming IPO from a legitimate underwriter.
IPOs are often cast by the media as the whipping boys of the stock market because of these experiences. However, speculation and frenzies over IPOs are created by people who participate in the stock market without knowing what the companies are doing, without studying them, without learning lessons from the past, and by letting greed overcome common sense.
Investors today have a much better chance of getting in on the IPO action. Years ago, the stock markets were rife with fraud. Luckily, ordinary people simply didn't have the money to buy even one share of stock. Incomes were low, and share prices were high. Information about companies was available only to groups of insiders. As recently as the mid-1930s, publicly traded companies routinely withheld critical financial and business information from shareholders. Today, the process of an IPO is more open and the Securities and Exchange Commission (SEC) is more vigilant against fraud than it was in the "bad old days."
The starting place to getting smart about IPOs is understanding the process of going public. An IPO is a privately held company that issues shares in a public stock market. In the United States that means the New York Stock Exchange (NYSE) or the Nasdaq. The NYSE is an auction market, where members of the exchange meet five days a week to buy and sell stocks that are "listed" on the exchange. To be listed, a company must meet NYSE minimum requirements for revenue, market capitalization, and profitability. Because of these standards, most IPOs are offered on the Nasdaq, which is a dealers' market. There is no established physical place where dealers gather to buy and sell over-the-counter (OTC) securities. Rather, individual dealers at brokerage houses make markets in particular stocks and post their prices electronically.
Although the U. S. equity market is the biggest stock market in the world, other stock markets are developing worldwide, specifically for emerging growth companies. Germany's Neuer Markt is one of the fastest growing. IPOs are becoming an even more important part of Wall Street as their numbers climb and the number of dollars raised grows. As seen in Exhibit 1.2, "Number of IPOs Has Boomed," and Exhibit 1.3, "Increasing Capital Raised by IPOs," these trends have been building for years.
WHAT KIND OF IPO?
IPOs come in a number of different flavors. First, there is the plain vanilla IPO--a company is privately held and mostly owned by management. The company has probably been in business for several years and is going public because management needs more money for expansion than they can raise privately. Until recently, the median IPO had been in business seven years.
Many IPOs are venture capital-backed deals--management has sold shares of the company to one or more groups of private investors in return for funding and advice. It used to be that a venture capital firm would let a company germinate in its portfolio for several years, get on the cusp of profitability, and then go public. Not so any more. Some IPOs are hurried through the process in months, which doesn't create the environment for a successful company. The supposed advantage to buying venture-backed IPOs is that experienced venture capitalists have vetted the company and have good contacts with major underwriters. It is regrettable that with the dramatic amounts of money flowing into venture capital coffers, decisions on funding are now more likely to be made by a stressed out, inexperienced young MBA.
Another type of IPO is a reverse leveraged buyout (LBO)--management uses the proceeds of the IPO to pay off the debt accumulated when the company was bought out, or LBO'd, as they say on the Street. Reverse LBOs were common in the early 1990s as debt-ridden companies unburdened themselves of the high interest debt accumulated in the late 1980s. Reverse LBOs are examples of companies that need to recapitalize to pay off debt (to change the proportions of the underlying debt and equity on the balance sheet). During the 1980s, when interest rates were relatively high, companies like Revlon, Maybelline, and Playtex were acquired by takeover specialists who bet that they could chop expenses and refinance in a couple of years when interest rates went down. Gagging with high coupon debt, Revlon, Maybelline, and Playtex used the proceeds from the IPO to pay off the high-priced debt and to put in place lower priced debt. Reverse LBOs are generally disappointing investments to all but the creditors who are being paid off with the proceeds from the IPO.
Sometimes, a large corporation will "spin off" a noncore business to the public. A spin-off is created when a large company carves out a distinct, stand-alone part of its business and offers all or part of it to the public. A well-known spin-off was Lucent, which was the telecommunications equipment business of AT& T. The reason for the spin-off was that other telecommunications companies would be more likely to buy Lucent's products if it wasn't wholly owned by AT& T. By doing a spin-off, the parent company is able to shine light on what may have been a relatively small but profitable division. Sometimes the stock market's valuation of the spin-off increases the valuation of the parent, which usually retains some stock. Spin-offs have often times been excellent IPO investments. Though lacking huge first-day pops due to the large number of shares offered and the relative maturity of their business, the management of the spin-off is highly motivated to do well.
Tracking stocks have come back into favor. Unlike a spin-off, in which the parent company is actually selling a particular business to share-holders, tracking IPOs do not carry any of the actual assets of the business nor do the tracking shares have the right to vote. The tracking IPO is meant to "track," or to follow, the results of the business. A parent company may choose to issue a tracking stock if it wants to highlight the results of a particular division but retain ownership of the assets. A tracking stock IPO route may be the chosen structure also because the assets of a division are not easily separated from the parent company. AT& T Wireless is a tracking stock, as are Sprint PCS and GM Hughes Electronic. Tracking stocks have been far less successful than spin-offs, largely due to the ownership issue. Often, tracking stocks have built-in conflicts with their parents, due to ongoing ties, the lack of asset separation, brand control, or competition.
An IPO can be a privatization of a government-owned company. For example, Deutsche Telekom and France Telecom were the IPOs done by the German and the French governments of their telecommunications operations. Most privatizations are non-U.S. However, if the U. S. government ever decided to sell the U.S. Postal Service, that would probably be a record IPO. When non-U.S. companies list in the United States, they do so by issuing American depository receipts (ADRs). ADRs are not the direct shares of the non-U. S. issuer but rather receipts issued by a U. S. bank and backed by the actual shares.
As the investing public has recently learned, IPOs can be developmental stage companies, lacking not only profits but products. Most of the developmental stage companies that investors will encounter are biotech operations with a drug or drugs that are still in advanced stages of clinical testing but close to winning government approval. The companies need additional capital for the final and most expensive stages of testing the drug before commercialization. The mapping of the human genome brought a new wave of less knowledgeable investors to this group, simply because of the huge opportunity genomics and its branches represent. These "scientifically challenged" investors are likely to dump the stocks at the first sign of disappointing results.
WHY GO PUBLIC?
A company's management decides to go public for a variety of reasons. The most obvious is raising capital to build its business. In the case of the Erie Canal or Motorola's ill-fated attempt to build a worldwide wireless satellite network called Iridium, the funds were used to build large, capital-intensive infrastructures. Many dot. coms, particularly retailers and business-to-business (B2B) companies, use the funds raised in the offering to publicize their brands through advertising and promotions. A private company may also go public to offer stock or options to motivate management. An IPO may be undertaken by a family-owned business to transition succession to professional managers.
There is always a certain urgency to go public. A company that is first to market in a particular sector has powerful ammunition its still-private competitors lack--cash and a publicly traded stock that can be used to grow the company by making acquisitions. Amazon. com, the first Internet bookstore, got a tremendous boost over its arch rival, Barnes and Noble, because it was the first to raise a significant amount of money. Even though barnesandnoble. com followed a year later with its IPO, barnesandnoble. com never caught up in terms of market share or publicity. Amazon. com was able to use its cash hoard to develop its business and its high stock price to acquire other e-tailers.
Sometimes companies have odd reasons for going public. When one CEO (chief executive officer) was asked why he was taking his regional bank public, he replied, "I'm getting a divorce and need the cash for the settlement." That type of candor is unusual.
The single worst reason a company goes public is to cash out insiders. This indicates that management and the owners have little faith in the future of their company. Insiders sometimes do it by selling stock directly in the offering. However, sometimes they cash out by paying themselves a big fat bonus right out of the proceeds of the IPO.
As one CEO summed it up in a survey conducted by the Investor Access Corporation: "Make sure you go public for the right reasons and at a realistic price."
THE BEAUTY CONTEST: PICKING AN UNDERWRITER
When a company decides to go public, management will meet with bankers from Wall Street brokerage houses to discuss how the IPO will be marketed to the public. This rite of passage is called a "beauty contest" because each of the bankers is competing for the business. (As you can see in Exhibit 1.4, "Key Dates in the Life of an IPO," this is the first step in the IPO time line.) The bankers will try to entice the management with promises of a high IPO price and ongoing research coverage. Sometimes the expertise of the underwriter's capital markets group, the people who will sell the deal to investors, wins the day. Sometimes the prospect of having a well-respected Wall Street analyst write research on the company after the IPO is the deal clincher. Remember, the companies know that an essential part of the deal is that the research is always positive.
Brokerage houses develop special strengths through their research analysts or a specialized banking team that seeks potential IPOs. Large brokerage houses like Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney, CS First Boston, UBS Warburg, and Merrill Lynch have deep benches. Because they have much experience taking companies public, they and other established firms usually apply certain standards of quality to the companies they are willing to underwrite. The operative word here is usually. Usually, the internal investment banking committees conduct due diligence (asking questions about the management and finances of the company). There are many on Wall Street who think that the Internet gold rush has led to a decline in standards.
Again, usually, the biggest, best-known underwriters get the best IPOs. Companies that are in the process of deciding who is going to do their IPO are concerned with how well the deal will be distributed, and they want to have ongoing research by the brokerage house's analyst. Every large brokerage house mans a research department with analysts who toil away issuing research and investment opinions on stocks. Brokerage houses compete for star analysts who are on the "II " team (an annual survey done by the industry rag, Institutional Investor, a magazine that ranks analysts in many industries). Mary Meeker, dubbed the "Internet Queen," is Morgan Stanley's lead Web analyst. It's every Web retailer's and B2B provider's dream to be followed by her.
It is a simple fact that underwriting IPOs is one of the most profitable businesses for Wall Street. On a $100 million technology IPO, an underwriter would gross about $8 million. The underwriters grossed over $400 million on the monster UPS offering. Faced with getting stock commissions of three to five cents a share on institutional trades and with the competitive pressure on the retail side from discount brokers, IPOs are critical to continued profitability and fat bonuses. Underwriting decisions are more influenced by what underwriters think they can sell to the public than by the quality of the company.
It used to be that when an IPO was launched, the lead manager (the underwriter running the deal) would invite other underwriters into a "syndicate" to help distribute the deal. These top managers would then bring lesser Wall Street firms in to be part of the selling group. Shares of the offering would be distributed among the firms, with the lead manager getting the most and the rest of the underwriters getting allocations according to their status. The syndicate would manage the offering, sometimes supporting the stock price in early trading.
That was the old days. Today, with profits paramount, oftentimes the lead manager keeps all of the shares or only doles out a small percentage of the deal to other underwriters. The lead manager is the underwriter on the upper-left-hand side of the list of underwriters found on the front page of the prospectus--but not always. There are times when the lead manager is lead in name only and one of the other managers is actually calling the shots. Wall Street can be a funny place. The bottom line is that the lead manager controls the deal and decides who gets the shares.
Although it is time-consuming, individual investors should pay attention to what's called the "league tables"--the lists of leading underwriters published at the end of every quarter in the Wall Street Journal and the New York Times. These tables will give you a good idea of how active a particular underwriter is and, more important, how well its deals have done. Beware of underwriters with bad track records. Bad track records mean the bankers have poor judgment in picking IPOs or fail to do their due diligence.
Also, a bad track record can mean the underwriter is too small to get a crack at the good deals. IPOs that are underwritten by small or regional brokerage firms should be looked at very cautiously. Although there are a handful of midsized brokerage firms like William Blair, which is known for its niche of underwriting mid-Western companies, there are many other inexperienced wanna-bes. Often, an IPO that is underwritten by a small brokerage firm was rejected by the more established players.
A small brokerage firm lacks the distribution of the major underwriters, and it also probably lacks a research department. So, even if the company has stellar results, there is no analyst to toot its horn, and the company falls by the wayside.
An IPO should have at least two underwriters. If a small brokerage firm sole manages the deal, the IPO is suspect for two reasons: First of all, the offering may not be a genuine distribution to the public. There are occasions when an IPO like this is simply traded among that underwriter's brokers, who artificially boost the price with each trade. This is called a "house stock." Second, with only one underwriter, no other underwriter has any incentive to provide ongoing research.
Venture capitalists are playing an increasingly important role in determining which entrepreneurs receive private funding and, thus, which companies are cultivated to the point of being ready to go public. Venture capitalists raise funding from private investors, including pension plans and wealthy individuals. These monies are put in a partnership run by the venture capital firm and then invested in promising start-ups. Venture capitalists diversify their investments so that if they have a nasty surprise with one or two companies, it won't destroy the investment returns.
Among the most active and successful venture firms are: Softbank (invested in Buy. com, Critical Path, Net2Phone, GeoCities); Chase Capital Partners (StarMediat, Kozmo. com, Lycos); Benchmark Capital (eBay, Scient, eLoan); Oak Investment Partners (TheStreet. com, Exodus); Sequoia Capital (Shockwave); Austin Ventures (Southwest regional technology companies); New Enterprise Associates (3Com, WebMD); Norwest Venture Partners (Peoplesoft, Vantive); Polaris Venture Partners (Aspect Medical); and J. H. Whitney (Wellfleet Communications, Compaq). Old-line firms include Kleiner Perkins, Mayfield Fund, and Bessemer Venture Partners. Many of them are located on the now famous Sand Hill Road in Menlo Park, California.
To give you an idea of the magnitude of the influence of venture capitalists, venture funds raised $4 billion in 1993. In 1999, that figure had mushroomed to $47 billion. Venture capital fund-raising topped $65 billion in 2000, with most of that going into Internet-related companies.
Entrepreneurs seek out venture capitalists because they provide easy access to significant amounts of money, more than the traditional "angel" investors of friends and family can provide. In turn, the venture capitalists exact their pound of flesh by taking significant ownership in the company. To hedge against the risk that the start-up turns out to be a dud, the venture firms demand shares at dirt-cheap prices.
The venture capitalist's focus is always their "exit strategy." They want to be able to IPO the company or, failing that, to merge it with another company. Venture capitalists can't sell their stock for about six months after the IPO, so they are most anxious to get in at a low price, to have a good deal, to liquidate their holdings, and to move on to the next opportunity.
Young companies used to incubate for several years in venture firms. When the management and the company were ready for prime time, the venture firms would shop it around to Wall Street underwriters. With the Internet stampede, the process often takes months, not years, and the main function of the venture firms is to serve as a talent scout for start-ups. These days, some venture firms have an "entrepreneur in residence," someone who has previously run a company and who is waiting for the right start-up to come along.
The last time the venture capital business was white hot was in the early 1980s. Leading companies such as Cisco, Microsoft, and Sun Microsystems were funded. Fed by a boom in personal computers (PCs), peripherals, and software, inexperienced partners gave money to many dubious start-ups. Too much money chased too many look-alike technology companies. The inevitable shakeout happened, and the industry took 10 years to recover.
The venture capital world used to be a very clubby place. There was a handful of old line firms in California on Sand Hill Road, in Boston, and in New York. Today, the venture capital business has more money than it knows what to do with and legions of young turk new competitors. The old-line firms complain bitterly about the tactics of what they call "junior varsity" venture firms who steal deals at the last minute by taking the entrepreneur on a ski trip--that sort of thing. This is what happens when there is too much money sloshing around and too many eager venture capitalists. The investments don't get the attention they deserve. Instead of giving an entrepreneur a few years to develop the business, the venture firm's priority is getting the company processed to do its IPO. Too many me-too deals get done. Too many inexperienced venture capital guys are financing too many inexperienced entrepreneurs. You have to wonder why venture capital money guys with MBAs from Ivy League schools would throw money at companies like Ingredients. com, which competes with at least 50 other beauty-related sites, or VarsityBooks. com, one of legions of sites and stores selling textbooks to college kids.
Eventually, the IPO market turns against the venture capital companies and the entrepreneurs. The whimsically named WebSideStory, a Silicon Valley Web-site traffic analysis firm, couldn't get its deal done, despite the backing of well-known venture firms. Investors were turned off by its small size, shaky revenue model, and insider payouts. When deals go down in the dumps, as Internet retailers and the B2B companies did in the spring of 2000, investors are not going to want to throw more money at people who made bad decisions and at entrepreneurs with no track records. It may mean that entrepreneurs who actually have sound business plans for Internet retailing and B2B cannot get funding. What it means for investors is that they cannot trust the pedigrees of the venture capital firms as a proxy for good business and investment judgment, especially when coffers are overflowing with cash.
So, having selected its underwriter, the IPO-to-be proceeds to work with its lawyers and bankers on the offering documents that it will file with the Securities and Exchange Commission (SEC). During this process, the underwriters and lawyers perform further due diligence. The product of all this work is an S-1 (or F-1 if the company is based outside of the United States). The S-1 has reams of information on the terms of the IPO, the number of shares to be offered, the company's business, and its financial statements. You can get a copy of this document at the SEC's Web site, edgar. gov, or at freeedgar. com. If you want to track filings, IPOhome. com has calendars of upcoming deals and of IPOs that have just filed with the SEC. For any upcoming or recent IPO you can easily link to the exact S-1 you want through IPOhome. com. Just search by ticker or company name, and you will get a brief company profile. On the bottom of every profile, there is a link taking you directly to the company's S-1 filing.
At this stage the SEC reviews the S-1. It is important to emphasize that the SEC does not approve the IPO; it reviews the prospectus to make sure the company has disclosed specific information about its financial position, business, risks, and management. Once this review is completed, the company will get a green light to publish and distribute what's called a preliminary prospectus--the "red herring," so-called because of the red band of legalese running vertically on the left hand side of the prospectus cover. A copy of the red herring can be obtained from the lead manager.
Just by being current on IPOs, you are way ahead of the rest of the pack. You have time to read the S-1. And you have plenty of time to make your interest known to your broker, if it is an underwriter.
PRICING THE IPO
Pricing IPOs is as much an art as it is an objective dollars-and-sense exercise. To figure out what the prospective IPO is worth, Wall Street bankers act just like real estate agents. If you are selling your house, realtors look at the selling prices of comparable houses in your neighborhood to establish an offering price. If your house is in a development built by the same builder, their job is easy. The differences between the houses may be slight. However, if the houses in your neighborhood were built at different times or are vastly different in size, the agents' job is harder.
IPOs are much the same. Instead of houses, the bankers look for companies similar to the prospective IPO. On Wall Street, these companies are called "comparables," or comps. Sometimes the job is easy. When Ralph Lauren went public, it was a snap to look to Tommy Hilfiger, St. John's Knits, and Warnaco as similar companies. The bankers then ask the research analyst to forecast revenues, earnings, and cash flows. They compare these statistics to the revenues, earnings, and cash flows being forecast by the research analyst in consultation with the IPO's management.
Using the forecasted growth rates of revenues, earnings, and cash flows, the bankers compare the IPO to the already public companies. They ask themselves if the IPO has a better or a worse brand, better or worse growth rates, and better or worse prospects. If the IPO is in a strong position, as was Ralph Lauren, with respect to its brand and the buzz surrounding the pending IPO, the deal may be priced at a higher price, usually based on price-to-earnings (P/ E) ratios, relative to its peer group of the already public companies. If the IPO is a third-or fourthtier player in the market, then the IPO will be priced at a discount to its peers.
It may seem obvious, but it is still worth stressing--the choice of comparables by the bankers can have a major impact on investors' acceptance of the proposed valuation of the IPO. For example, suppose the pending IPO is a biotech company doing research in genomics. The bankers would choose the hottest stocks in the sector, not the laggards, even if the laggards' businesses are closest to the IPO's business. That's Wall Street. Their job is to sell the deal, not to seek the truth.
Most of the time, investors docilely accept the proposed valuation, simply because most of them don't do independent research. If you are interested in an IPO, ask your broker what the comps are. If your broker doesn't know, have him or her call headquarters or talk to the research analyst. Most large brokers have highly organized procedures for doing IPOs, and the "selling memorandums" containing information about the deals, including comparables, are readily available. Be pushy. When you get the information, use your common sense to evaluate whether the banker has chosen the right comps.
The bankers set the price that's printed on the front page of the prospectus at the time they send the prospectus to the printer. Markets go up and markets go down, so the ultimate price of the IPO can be higher or lower. Also, if the drumbeat on the IPO heats up as a result of a great road show reception or rising stock prices of its peer group, the price can wind up being higher.
GETTING THE WORD OUT
The company's management is eager to go out and tell their story. Legally, they have to stick with the script in the prospectus. Few do. Management pitches the IPO at the road show breakfasts and lunches and at one-on-ones, meetings at which elite prospective investors get to grill management in private. They speak about their company's future and answer a few questions. More important, the Wall Street research analyst will opine about the company's revenue and earnings prospects.
One company, Webvan, an online grocer, let members of the press into its road show and then openly talked with reporters about information that wasn't in the prospectus. After the press published the interview, the SEC forced Webvan to delay the deal.
The road show process normally takes about two weeks. It starts with a "teach in" at the underwriter's headquarters, which is usually in New York. At these meetings, management makes their presentation, and the analyst runs through his or her financial model. The questions at these in-house meetings are often tougher than those at the actual meetings with prospective investors will be. Brokerage salespeople tend to be blunt and ask tough questions because they don't want to stick their important institutional customers with a bad IPO. Management makes any necessary nips and tucks in their presentation after the teach-ins and then may do a few key one-on-ones with elite investors to get the buzz going on the deal.
A large IPO that has U.S. and non-U.S. tranches (amounts of stock that are set aside for particular countries) can take longer. If the underwriters plan to sell the deal internationally, the next stops are London, Edinburgh, and Glasgow. And with the dramatic mergers of European stock markets, more IPO managements will be making the trip across the Atlantic and to the Frankfurt and the Paris bourses. Tokyo is an occasional stop, too.
On returning to the states, management may make a few more New York stops, due to the high concentration of large institutional investors. Then it's on to Los Angeles, San Francisco, Minneapolis, Chicago, Philadelphia, and Baltimore. Road shows almost always stop in Baltimore because it's the headquarters of mutual fund powerhouse T. Rowe Price. The next-to-last stop is Boston, home to giants Fidelity and Putnam. The last stop is New York for the big lunches and dinners in the five-star hotels.
Normally, only institutional investors are invited to the road shows, which take place in private hotel dining rooms. When the IPO market gets very active, bankers and investors joke that the only bottleneck to more IPOs is the availability of hotel dining rooms. These occasions can be elaborate. For example, celebrity designer Donna Karan appeared at the New York road show when her company went public and handed out goody bags of Donna Karan accessories for the invited. After cookie maker Keebler's packed New York luncheon, attendees were given duffle bags full of Keebler cookies and toys. We took extra boxes of Cheez-Its and Chips Deluxe back to the office at the request of our hungry staff.
The attraction of the adult goody bags handed out at the road shows means that analysts always have to be vigilant. At the Martha Stewart road show, large pastel canvas bags were handed out to attendees. The bags contained many Martha goodies, including maga-zines, cleaning instructions, a hat, and other items. In conversation with another attendee, our analyst spotted a man snatching up her goody bag off her chair and then furtively scurrying down the hall to the elevators. She took off in full pursuit and caught him at the elevator bank; but at five-feet-two-inches tall, she wasn't strong enough to wrest the bag away from the six-footer. So she took someone else's bag. Eat or be eaten.
The New York road show for the World Wrestling Federation was nearly a carnival. Voluptuous, scantily dressed women strutted around the hotel ballroom. Some of the male featured wrestlers were present. The normally staid Wall Street investment crowd was gaga. Many of them came prepared with cameras and asked for autographs. During the Q&A (question-and-answer period), one analyst asked Vince McMahon, the tough-talking CEO, how he was going to deal with the recent departures of featured wrestlers to rival World Championship Wrestling owned by Time Warner, which had recently acquired Ted Turner's Turner Broadcasting System. "I'd love to talk with that S-O-B about it," he responded, referring to Mr. Turner.
Instead of having to deal with these free-for-alls, elite investors get invited to one-on-ones. Other settings may be small private dinners, usually staged at private clubs. When Revlon went public, they had such a dinner, but the main attraction wasn't CEO Ron Perelman; it was several of the well-known fashion models who attended. Trying to unfairly influence the heavily male Wall Street crowd, perhaps?
As a sidelight, in the 1980s there was a big controversy about the locations at which these meetings where held. Many Wall Street houses favored having them at the private clubs to which the upper management of the brokerage firms belonged. Big problem. Many of these clubs didn't admit women. Sometimes the female bankers or investors had to enter the clubs through the back or kitchen entrance and scurry up the stairs to the meeting room.
With all of this road show activity, you might reasonably ask how institutional investors find the time to study each company. The answer is that they don't. Company managements complain that there are too many companies going public for investors to be knowledgeable. With hotel dining rooms crammed with competing IPOs, how does an investor decide which ones to go to? Basically, the institutional investors go to the presentations given by the companies with the most predeal buzz and maybe the best goody bags. Packaging the IPO is all important.
Regrettably, individual investors and members of the press are not invited to road shows. The process of attending road shows used to be very casual. Just about anyone in proper business attire could walk in. But fears of SEC scrutiny and increased demand to attend the limited-seating road shows forced underwriters to restrict attendance and to check guest lists carefully.
Feeling pressure from small institutions and high-net-worth individual investors, many underwriters have started Web road shows. These Web presentations almost always have the actual presentation given by the company's management. Some even have the live audio. However, access to this information is restricted by the SEC, so many underwriters won't give out the Web addresses and passwords to individual investors who don't have a certain threshold of assets at the brokerage.
Back to the road show. The IPO has just finished that last big New York road show. It's late afternoon, and the management team collects at their underwriter's headquarters to await the actual pricing of the deal. The stock markets close at 4 P. M. New York time. The price negotiations are about to begin. It took them six to eight weeks from filing with the SEC to get to this point. They're excited because many of them are about to become paper multimillionaires. They want the best deal they can get.
LEAVING MONEY ON THE TABLE
Management and their bankers are at IPO ground zero, the capital markets desk. By this time, the management is exhausted by the non-stop road show regimen but also more exhilarated than at any other time in their lives because they are on the brink of achieving wealth beyond their dreams.
At the capital markets desk, the managing directors of the underwriter review the key institutional indications of interest; this is called the "pot." They and the management go over the totals from the less well heeled institutional investors. If a portion of the deal will be sold to individual investors, then they review those orders from the retail sales force and from the co-managers. The head of capital markets discusses the orders with the heads of institutional and retail sales. Capital markets is effectively the middleman between the investors, who want the price to be as low as possible, and the company, which wants a higher price. All the head of capital markets wants is a successful deal.
As the former head of a major underwriter says, "IPOs go up, or they go down, they rarely stay stable. It's not in the nature of an IPO."
The capital markets desk and management work well into the evening. If the capital markets desk think that they can raise the price of the issue, they call around to key investors to see if they're still in the deal. Lesser investors are not called; they are informed the next morning if they got shares and what the price is.
The advent of the Internet changed the ways that IPOs are priced. The huge one-day pops on Internet stocks increased the stakes of getting IPO shares and made the process increasingly competitive. It also made it more difficult for the lead manager to gauge the real demand for an IPO. This is because investors, knowing that they will get a tiny amount of what they ask for, place orders many times greater than what they really want for hot deals.
One of the early Internet IPOs, theglobe. com, an Internet community that allows people to create their own Web sites and that was dreamed up by two Cornell University undergraduates, was originally set to price at $11 to $13 per share by its lead manager, Bear Stearns. However, because the market for both IPOs and small-capitalization stocks was rocky in late 1998, theglobe. com was priced at $9 in November 1998. Trading in the stock opened at 11 A. M. at a staggering $90 per share. What happened?
When Bear Stearns started marketing theglobe. com to investors, the stock market was still reeling from the near collapse of Long-Term Asset Management, a Greenwich, Connecticut-based hedge fund started by well-known Wall Street "rocket scientists." Shortening the tale a lot, the portfolio managers grossly misplayed computer-driven models for betting on interest rate movements and came close to causing a short circuit in the world capital markets. Only massive financial infusions from large Wall Street houses and the help of Federal Reserve Chairman Alan Greenspan staved off disaster.
So Bear Stearns knew that institutional investors were ultra cautious. And, they also knew that theglobe. com's founders, Todd Kriselman and Stephan Paternot, then 25 and 24 years old, respectively, were eager to price the deal and raise money. So did they get cheated by raising only $28 million when the public was willing to pay $90 per share for the 3 million shares offered, or $270 million? Was money left on the table?
These strange differences in pricing are part of the wonderful world of Internet stocks. Both Bear Stearns and theglobe. com had every reason to push the price up as much as they could. However, given the orders Bear Stearns had from institutional investors on the eve of pricing, the bankers decided it was better to have a successful deal than one that was aggressively priced. Indeed, under ideal circumstances, the offering price is set so that the IPO will trade above its offer price.
Sentiment on Wall Street can change in a flash. On the morning of the pricing, institutional investors decided that this deal was a winner and plunged in with aftermarket orders. And individual investors, excited by the deal, told their brokers to buy the stock. Many investors went through online brokers. Most of these buy orders from individual investors were "market" orders. All of these orders created a huge well-up of demand for the stock. The quoted stock prices were forced upward just as if a dam had broken. And, as is so common during episodes like this, the upward spiraling stock prices created even more demand. Many investors, able to get instant gratification by buying online, put in market orders; having to pick up the phone to call a broker often allows time for some reflection.
Again and again, this scenario was repeated in late 1998, all through 1999, and into 2000, as investors flocked into Internet IPOs. Was money left on the table? Theoretically, yes; but practically, no. Both the management and the underwriter want the IPO to succeed. So, they under-price a deal a little. That way the buyers of the IPO get compensated for the risk they are taking by owning an untested, new company. That's only fair. And the benefit to the company is that stockholders are happy. The positive returns from a successful IPO mean a lot to management in terms of branding and good publicity. Besides, they have only sold a small percentage of the company. If the IPO does well, they can come back for another round to raise more capital and sell insider shares in what's called an "add on financing."
As the industry veteran scoffs, "Money on the table? That's a convenient way for someone to second-guess you a couple of days later. It's advertising money."
One final observation about the process of going public. It is very time-consuming. The management of the company are focused on selling themselves, first to the bankers, then to the research analysts, and finally to the investors. They are not focused on their business. Smart managements set their business up to run on autopilot for six months.
THE POWER OF RESEARCH
Before an IPO is public, the management of the company and the underwriters are in what's called the quiet period. The SEC prevents the underwriter from issuing any research on the company and restricts management's comments to what is contained in the prospectus.
But 25 days after the IPO, the Wall Street underwriters can issue a research report on the IPO. And these research reports are always glowing paeans to the bright prospects of the company, the ability of management, and its focused business strategy. We have never seen a negative research report issued by a brokerage firm on a deal it has recently underwritten.
When companies go public, they typically have the next two quarters of revenues and earnings locked up by shifting the timing of booking revenues and expenses. And the company has sat down with the underwriter's research analyst to critique his or her model of the company's financial results for the next one to five years.
This information is made available to the institutional investors in the IPO prior to the actual offering. After all, if you didn't have a forecast of what the company's expected revenues and earnings are going to be, how can you value the IPO?
At the end of the quiet period, the analysts issue their reports. These reports typically don't have much long-term effect on the stocks. However, with some thinly traded OTC stocks, the market makers who buy and sell the stock try to goose the stock price about the time they expect the report to be issued. Institutional investors know that these initial research reports are always positive and contain little in the way of surprises, either positive or negative.
Even when the IPO in question has a problem early on, Wall Street research generally glosses the problem over and looks to the bright side. For example, Loislaw. com, an Internet-based provider of state and federal legal information, went public in late 1999. It competed directly against Westlaw and Lexis, both of which are large, well-established providers of case law and regulatory information to law firms. Enthusiastic investors pushed the stock up from its $14 offering price to a high of $47. Then, four months after going public, management announced that revenues would rise to $2.3 million for the final quarter of 1999, up 95 percent from $1.18 million the previous year.
Sounds good? Not really. That's because the key analyst was expecting more. And, the next day the analyst reduced the rating from a Strong Buy to a mere Buy, lowered the 2000 revenue estimate by 25 percent, and remarked that "revenue is taking longer to materialize than originally expected." Despite the dramatic reduction in the financial forecast, the analyst concluded that Loislaw's "land grab" (attempt to wrest market share away from competitors by giving product away for free) was the "right" strategy.
As in every case where an IPO disappoints Wall Street within months of its debut, the punishment was severe. Loislaw stock immediately dropped to the low twenties and then continued on its way south. Institutional investors apparently decided that Buy really meant, Sell, Sell, Sell.
If you are an investor at a full-service brokerage firm, you should insist on getting that firm's research on IPOs once they are out of the quiet period. Many discount brokers allow you access to Wall Street research for a fee. Other ways to obtain Wall Street research are high-lighted in Secret 12, "Finding the Right Resources."
The entire IPO process, from finding an underwriter, drafting a prospectus, and meeting with investors to finally pricing the IPO, can take six months. Companies treat the process with much respect because it is time-consuming and may cost 5 percent to 7 percent of the funds raised plus up to $2 million in legal, printing, and accounting fees. That's $7 million to $9 million for a $100 million deal. They also know, or should have been told by their venture capitalists or underwriter, that the future of the company hinges on how well management presents itself during the IPO process and how well the company meets the expectations it laid out during the road show.
Now that you understand the IPO process and players, you will be able to position yourself to get IPO shares.