Marsh Business Advisors, LLC
"CAPITAL"
Prepare Today To Strike When IPO Market Is Hot
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
December 10, 1993
When is the “best” time for a company to go public?
The answer is during a "hot" market for initial public offerings. Right now, the IPO market is beyond hot, it's blistering. It's projected that in 1993 more than $50 billion will be raised in IPOs, a 25 percent increase over the record $40 billion raised in 1992, and five times the 1990 figure.
This IPO frenzy hit a fever pitch recently when Boston Chicken, Inc. sold 16.7 million shares in its IPO at $20 a share. Demand for the stock was overwhelming, and the stock closed at $48.50, up$ 28.50 for the day. This put a market value on Boston Chicken of some $800 million. Not bad for a company that last year posted a net loss of $5.9 million on revenues of $8.6 million.
I've had a desire many times for Alaskan king crab, Boston cream pie, Buffalo chicken wings, Memphis barbecue, Florida key lime pie, Maine lobster, Idaho potatoes, Kentucky fried chicken, Mississippi mud pie, New England clam chowder, a Kansas strip steak, New York pizza, a Philadelphia steak sandwich, a Coney Island hot dog, even Texas toast. As an investor, however, I have no appetite for Boston Chicken, especially if I'd have to pay one hundred times revenues per share. How distasteful.
When do hot IPO markets occur? Typically it happens when the general level of interest rates comes down, and investors seek higher returns from investing their money, rather than lending it.
Since interest rates are lower now than they've been since the Great Depression (a somewhat sobering fact), this is a good time to explore the advantages of taking your company public.
I thought it would be appropriate to examine these issues from both a theoretical and a practical standpoint. For the theory, I dug up some old lecture notes from Professor William Schwert's corporate finance class at the University of Rochester's William E. Simon Graduate School of Business Administration. For the practical viewpoint, I contacted the gentleman who took his company public in one of the most successful IPOs in local history: Thomas Golisano, President and CEO of Paychex, Inc.
Textbooks on corporate finance give the following reasons for issuing public equity. The issuer can lower its cost of capital, eliminate a "wealth" constraint, provide liquidity for current shareholders, shift monitoring costs from private investors to the Securities and Exchange Commission, and learn from stock price movements.
The company can lower its cost of capital by going public because investors will no longer demand an "illiquidity premium," that is, they will accept a lower return on their investment if they know they can sell their stock at any time. The owner of an illiquid investment in a privately held company will demand a higher return if liquidity can be achieved only by an act of the company, rather than by an act of the investor.
Eliminating a "wealth constraint" is a fancy way of saying raising money for a profitable project when there is no other means of raising the money. Very often, banks won't (and shouldn't) provide money for a speculative project, and venture capitalists may demand a very high return for their illiquid investment in a private firm. The logical alternative is to issue public equity, taking advantage of the lower costs of capital.
Providing liquidity for current shareholders is of critical importance for two parties. The first is the stockholder in the private firm who wants to cash out and do something else with the money. The second keenly interested party is management; they want to provide liquidity so they don't have to listen to their shareholders continually whine: "When am I gonna get my money out?"
Monitoring costs are incurred by investors and lenders by spending time to keep tabs on their investment in a company. These costs are passed on to the company, either directly (in the form of fees) or indirectly (in the form of a higher capital cost). "Shifting monitoring costs" is academic jargon for "passing the buck" and means that instead of the company paying for the monitoring costs, the SEC (read: American taxpayers) picks up the cost.
Theoretically, the managers of a publicly held company can learn information from movements in the stock price. The catch here, of course, is that the managers have to believe that the stock market is not composed of idiots, and that when investors don't like management's actions, the market sends the stock price down, and the opposite explains why the stock price goes up.
Paychex was in business 13 years before it went public in 1983. Tom Golisano outlined to me the reasons behind the Paychex IPO. Public investors are willing to provide capital at a lower cost than are private investors. Paychex needed several million dollars to finance a significant upgrade to its computer system. In addition, Tom felt that the managers of Paychex could get feedback on their performance from changes in the stock price.
But how much can be learned when Paychex's stock seems to defy gravity and moves in only one direction: up? The stock hasn't always moved up. One year Paychex added lots of staff, new salespeople, new offices and overhead. Productivity tumbled and the stock market reacted by sending Paychex' stock price down. This quickly caught senior management's attention, and steps were taken immediately to improve operating performance. The results are obvious.
So far, this comparison shows that Tom Golisano's practical reasons for an IPO were identical to the theoretical reasons. But Tom had two other compelling reasons: 1) credibility with customers and suppliers and 2) attracting and keeping key employees.
Managers very often don't want to enter into business agreements with another company unless it can be demonstrated that the company has the wherewithal to uphold its end of the bargain. Publicly held companies disclose a great deal of information, including their financial statements, to the public. Tom said that as a public company Paychex could show its annual report to prospective customers and suppliers, and gain instant credibility.
Paychex's most valuable assets do not appear anywhere on its balance sheet; they are its employees. In order to attract key people, a compensation package that includes stock options was designed.
Unlike with a publicly held company, stock options in a privately held firm - with no means of liquidity - may not seem as valuable and thus may not attract the necessary key people.
With all these wonderful reasons for being a public company, why in the world would anyone keep their company private? Because there are costs associated with being a public company, and some of these costs, although unquantifiable, are very high.
The costs include disclosure costs, agency costs, reporting costs, corporate-control costs, and underpricing.
Disclosure costs are those that result from the publicly held company being forced to divulge proprietary information. Rest assured that competitors, customers and suppliers read and use all the information that the publicly held firm is required to disclose.
Agency costs are the real, but very difficult to quantify, costs that result from the divergent goals of a principal and his agent. In this case, the shareholders (the principals) of a publicly held firm hire managers (the agents) to run the company. Although it is changing, managers often own very little stock in the public companies they run. The stockholders want the managers to work hard and maximize the value of the stock.
If the managers own very little stock they may not work so hard, and may prefer to spend a lot of money on perks for themselves. Quantifying agency costs is difficult because each situation is different, but it's a safe bet to say that there were some mighty excessive agency costs incurred by RJR Nabisco under Ross Johnson - including 26 corporate jets and a three story hanger with marble floors! Maybe I'm a skeptic, but I just don't see how the manufacture of that critical resource, the Oreo Cookie, warranted 26 jets.
Reporting costs include all the bills from accountants and lawyers associated with submitting financial and legal information to the SEC and to shareholders. I have not yet found an accountant or a lawyer who works for free, and I've stopped looking.
Corporate control costs - another important sounding phrase - means nothing more than managers of a publicly held company hand a lot of power over to the shareholders. If a private company, which is owned by the managers, has a lousy year, or a couple of lousy years, the stock price doesn't explicitly drop and the managers probably won't lose their jobs. The owner/managers just find it difficult to fire themselves. (Human nature, I guess.)
If a public company has a lousy quarter, let alone four consecutive lousy quarters, the stock price drops. If the stock price keeps tumbling, one of two things happens. Either the board of directors fires the managers, or the company gets taken over and the new owner fires the managers. If you don't believe me, call Kay Whitmore or Steve Jobs.
The last cost is underpricing, which is the difference between the offering price and what the stock is "worth" on the day of the IPO. The investment bankers who underwrote the Boston Chicken IPO priced the issue at $20 a share. On the first day of trading the stock market valued it at $48.50 a share, resulting in underpricing of $28.50 a share. Had the investment bankers been better able to value the stock, they could've set the offering price at $48.50 and that would have netted Boston Chicken an additional $476 million in proceeds from the IPO. Because of the underpricing, that $476 million went to the investors that the investment bankers lined up before the IPO. They bought in at $20 and when trading started, they watched the price climb throughout the day to $48.50 and then they sold their positions. Not a bad day at the office, huh?
The investment bankers claim that underpricing is necessary in order to induce investors to buy the untested stock. Over the last several decades, underpricing has averaged 18 percent. That may not sound like much, but on a $100 million stock offering, the underpricing represents $18 million that went to somebody other than the issuing company. I don't know about you, but I wouldn't want to leave $18 million on the table. (I wouldn't want to leave the interest on $18 million on the table.)
If you're thinking about taking your company public sometime in the future, start planning now. Carefully consider all the benefits and the costs discussed here. If you decide to proceed with an IPO, consider the following actions to improve the chances of a successful offering and at the same time to reduce underpricing.
~ Hire a reputable, nationally certified public accounting firm to audit your financial statements beginning now. An investor in San Diego probably will be unfamiliar with a local CPA in Rochester, regardless of his or her quality. If the financial statements aren't audited, they will be suspect. Managers complain about the high costs and needless expense of audited financial statements. The real cost is when the investment bankers tell you that you can't take your company public because your financial statements aren't audited.
~ Hire a reputable law firm that is intimately familiar with the requirements of publicly held companies and dealing with the SEC. The wrong legal advice will cost you a fortune, and may preclude you from going public.
~ Begin interviewing reputable investment banking firms to underwrite the offering. Reputable investment banks tend to be headquartered in New York, Boston, and San Francisco, and have branch offices in London, Frankfurt and Tokyo. You may wish to reconsider investment banks headquartered in Denver, Santa Fe, and Tampa with branch offices in Duluth, Joplin, and Fargo. If you plan on going public in the next several years, start the interviewing process now so that you can become familiar and comfortable with them, and they can become familiar and comfortable with you and your firm.
~ Lastly, try to have lunch with the CEO of every public company you can. Learn everything you can, because running a public company is very different from running a private one.
The IPO market goes in cycles, from stone cold to blistering hot over the course of several years. Confounding your efforts to time this cycle and take your company public "at the top" is the fact that the cycle is different for different industries. A couple of years ago biotech IPOs were hot. A couple of months ago telecommunications IPOs were the rage. Now it seems that rotisserie chicken restaurants are in vogue, and real estate investment trusts may be the next hot IPO issues.
While it may be too late to catch this hot wave, by preparing now you may be able to catch that next one.