How to Become a Corporation

For the vast majority of private companies, going public is impossible if they are too small, are not growing fast enough, lack a good use of proceeds, have weak management, or in a crummy industry. Even for those that can, going public may be ill-advised. It takes real skill for a CEO to convert from running a private company to operating in the public markets, which feature such delights as Securities and Exchange Commission (SEC) reporting requirements, pesky shareholders, and your salary blasted all over the world on the Internet. But for a select few companies, going public is the answer. It is the cheapest way to raise large amounts of capital, bring notoriety to the company, and facilitate stock-based incentive plans. Before you phone Goldman Sachs, though, you should know what's involved.

The requirements

The bar for going public is moved all the time without fanfare. During the peak of the dot-com insanity in 1999, a handful of Ph.D.s with a novel idea and a short business plan-"three guys and 12 pages"-could raise venture capital and go public in six months. Those days are over as burned investors now insist on higher-quality companies with real businesses, profits, presidents older than 25, and CFOs who don't sport orange hair and hi-tops at annual meetings.

A high-caliber management team is paramount, especially in a young company. Experience dealing with public markets is a valuable plus. The chief financial officer is the second-most important member of the team during the Initial Public Offering (IPO). The CFO, who will field most investor inquiries after you are public, should be articulate and have SEC reporting experience. Underwriters often suggest beefing up with additional management talent prior to the IPO. It also helps if managers have significant skin in the game in the form of stock ownership. The IPO process is so arduous that you may want to offer a bonus to key employees if the company completes the offering.

The company should be growing rapidly and therefore have a bonafide use of the proceeds from the IPO. Ideally, the company will have already raised venture capital and/or tapped out its credit at the bank. Investors hate putting money into a company that won't use it to make more money. Plant expansions, working capital, and new product development are the best uses. Repaying high-cost debt is okay. Redeeming shareholders or otherwise sending money out of the company is a no-no. Insiders should never try to sell more than 20 percent of their holdings in an IPO. Insiderselling sends a very bad signal and makes investors wonder, "If the future is so great, how come you're selling stock so cheaply?"

The good part about analyzing an IPO is that unless you are sui generis, you can use the financial and valuation metrics of the public firms in your industry to precisely benchmark your company's performance. The bad part is that while your company may be chugging along, if the stocks of the comparable companies are sucking wind, you probably can't go public. Hopefully the comparable stocks will be closer to their 52-week highs than their lows.

Wall Street goes hot and cold on concepts with maddening frequency. Fads, such as conglomerates, consolidation plays, and the infamous dotcoms, caught fire and were quickly stamped out by fickle investors. Even solid industries, such as health care, energy, technology, and transportation, suffer from investor whimsy. In fact, sometimes only companies in the right industry sector can sneak through a narrow IPO window. For example, healthcare overall may be down, but medical device makers may be hot. Ask the underwriters if you have any doubts about investor sentiment toward your industry sector.

The National Association of Securities Dealers requires at least three independent directors on your board, but more is even better. Also, try not to have more than two board members with the same last name. Furthermore, byzantine ownership structures set up to minimize taxes, high salaries, non-working relatives on the payroll, sweetheart leases, related-party deals, company-owned airplanes, and condos will all have to go.

The SEC generally requires three years of audited financial statements to go public. While accountants can audit prior years if your records were audited by a regional or local firm, they will have to be re-audited by a national firm before any reputable underwriter will take you public. The company's size is a tricky requirement to estimate. Since the first biotechnology offering by Amgen in 1983, revenues and profits have been viewed subjectively. This subjectivity devolved into lunacy during the Internet stock craze, when firms with meager revenues and no ideas about how to become profitable were going public. Investors have sobered up since then and are much less tolerant of tiny companies that have limited track records.

Perhaps the only way to get a good gauge on what is acceptable is to look at your projected market capitalization (stock price times shares outstanding post-offering). The bare minimum market cap for an institutional quality IPO is $150 million. For example, if the forward price-to-earnings ratio for firms in your industry is 15, you need to have projected earnings of at least $10 million (15 x $10 million = $150 million) to go public. Although there are underwriters that will take smaller firms public, you probably would be better off staying private than going public with a small market cap and limited institutional interest in the stock.

The players

There are numerous parties involved in an IPO. The process cannot start until all the parties are assembled. These include the company's management team, the company's attorneys, the underwriters, the underwriters' attorneys, the company's accountants, and occasionally bankers or other advisers.

After the company, the most important parties to the transaction are the underwriters, also called investment bankers. There are 40 or so quality underwriters in the United States. The top firms, like Merrill Lynch, Lehman Brothers, and Morgan Stanley tend to concentrate on the largest companies, but make exceptions for smaller, rapidly growing companies. There is a small middle tier that includes technology boutiques, such as SG Cowen and Thomas Weisel Partners, and a larger group of smaller regional firms, like McDonald & Co. and Robert W. Baird.

You should first identify a number of qualified underwriters to interview. Your legal advisers and accountants can make recommendations. Also, you can research who has done other IPOs in your industry by looking at www.ipo.com and reviewing public filings at the Securities and Exchange Commission's Website, www.sec.gov. Before interviewing investment banks, be sure to provide them with a business plan containing a detailed forecast for at least the next two years, as well as three years of historical financial statements.

The two types of underwriters in a public offering are managers and syndicate members. The managers are the ones you will be working with day in and day out for (depending how it goes), four to six months. The syndicate is largely immaterial to most transactions and will be selected by the lead underwriter later. For an IPO, you should always have at least two managers. Multiple managers give you more horsepower, aftermarket research and trading support. A good rule of thumb is one manager for each $25 million in gross proceeds.

The managers are directed by the lead manager, who is selected by the company. The lead spot is highly coveted because it counts towards industry "league tables" (the scoreboard for investment banking) and because there is serious money involved. The difference between lead manager and co manager on a typical $50 million deal with two firms is about $500,000 in fees.

Investment banks will bring a team of bankers and a "pitch book" containing promotional materials on their firm, analysis of the company, its valuation in the public market, how the offering will be positioned, and timing. Three things will become obvious: (1) whether the investment bank has done its homework (if not, maybe they have more important things to work on-a bad sign); (2) whether the firm has a decent track record in your industry (most statistics are slanted through creative manipulation); and (3) whether the underwriter is enthused about your company or just going through the motions. (Do they have a plane to catch in two hours?) The highest-caliber investment bankers will be distinguished by how artfully they can sidestep a question.

The one key person you will not meet is the research analyst, who will cover your company after it goes public. Although research analysts are no longer allowed to participate in pitches, the lead manager's analyst is the single-most important person on the deal team, and can be the difference between $50 million in net proceeds and $500,000 down a rat hole. The analyst markets the deal to the firm's sales force as well as to institutional investors. Analysts prepare quarterly financial models that become the "numbers" the company must hit in the future. Because analysts are so valuable, a number of rating systems have been developed to help exploit them, including the Institutional Investor All-Star list and the Wall Street Journal's All-Star survey. Ask for references from institutional investors and copies of research reports.

It is extremely important to choose underwriters you like and in whom you have confidence. After you have selected two or three managing underwriters, you will have to choose the lead manager. This Solomon-like assignment is highly unpleasant. The underwriters will wail and moan like little kids, complaining that if they don't get the lead their children will have to go to public school, etc. Stick to your guns and keep in mind they are paid many hundreds of thousands of dollars per year. Pity is wasted on these guys.

If you haven't figured it out by now, undertaking an IPO is extremely expensive. The company will spend at least $500,000 for legal, accounting, printing, travel, and other costs. The underwriters get paid by receiving a gross spread, or commission, on the amount of stock sold. For all but enormous IPOs, this amount is 7 percent.

Provided you have a qualified corporate securities attorney and a Big Four accountant, your team is complete. If not, you need to hire them. Make sure your attorney has worked on numerous IPOs before and is current on the SEC's vagaries. If company counsel is inadequate, the transaction will quickly bog down and costs will balloon.

The process

Every offering is different, but each has three main components: (1) due diligence and drafting, (2) registration, and (3) the offering itself, also known as the roadshow. If everything goes smoothly, the whole thing could be done in about four months. But if you hit numerous snags, it could take six months or more to complete.

The due diligence and drafting stage has two goals: educating the underwriters about every nuance of the company and preparing the registration statement, called an S-1, that will be filed with the SEC. Due diligence is the term for the legal responsibility of the underwriters to exercise care in their examination of the company, and in theory protect the poor shareholders from buying dreck. The underwriters will ask a grueling series of questions over several days. They will interview members of management and conduct background checks. Get all the skeletons out of the closet right away. Surprises are costly.

The drafting of the S-1 is done en masse by the "working group," which can consist of 12 or more people. This impossibly cumbersome process helps ensure that nothing falls through the cracks, and allows everyone to put in their nickel's worth. (You'll swear some of these guys are paid by the word.) The registration statement must contain specific informa-tion in a form set out by the SEC, and can run from 75 up to several hundred pages in length and take six or more weeks to draft.

The registration phase is the period after you have filed the S-1 and before the SEC exhausts its commentary on your filing. The SEC reviews the documents and sends out comments about 30 days later. With luck, you will have all the comments resolved to the SEC's satisfaction within another two weeks. This phase of the transaction can be maddening because it is the only one controlled by an outside party. The S-1 will be refiled several times until the SEC is satisfied.

If the underwriters feel market conditions are receptive, the roadshow will begin right away. Thousands of copies of the prospectus (the guts of an S-1) will be printed and delivered to prospective investors. The prospectus tells investors how many shares you are offering and the preliminary price range. Other than the prospectus, all selling done by the underwriters' sales forces and the company on the roads how is oral (statements must be consistent with information filed with the SEC).

Institutions (mostly mutual funds) typically purchase 70 to 80 percent of an IPO and individual investors purchase the rest. The lead manager will arrange a jam-packed roadshow schedule to maximize the company's exposure to important institutional investors, such as Fidelity, Putnam, and T. Rowe Price. Generally roadshows last for 10 to 14 days, cover 12 to 15 cities, and include as many as 100 meetings with institutional investors.

Roadshows are a logistical challenge, especially when there are many other IPOs going on. Underwriters frequently agree to split the cost of leasing a corporate jet for the roadshow with the company-definitely the way to travel if you can afford it.

Roadshow presentations are made by two or three key members of management to institutional investors in "one-on-ones." Presentations are made using either slide shows or "flip-books," depending upon the size of the audience. Roadshow travel is grueling, and you have to repeat the same stupid, 35-minute presentation over and over. But it's the way deals are done; most institutions will not buy stock on an IPO if they have not met management.

Towards the end of the roadshow, the order book will start to build. Institutions give "indications of interest" that are non-binding but serious expressions of demand. On the last day of the roadshow, the underwriters and the company negotiate the IPO price based upon the order book. (If there is no book, you should plan on being private for a while.) The underwriters want the price to go up strongly in the aftermarket (it's good advertising for the next deal). However, if the price skyrockets on the first day of trading, the company sold stock too cheaply. The stock should go up a little bit (10 percent to 15 percent), but not be flat and certainly not down.

An IPO that falls below its offering price is known as a broken deal. Companies with broken deals usually cannot raise public equity in the future (one of the primary reasons to go through all this in the first place).

Broken deals also attract the vermin of Wall Street-attorneys who run shareholder lawsuit factories. They file dubious lawsuits that are nonetheless costly to defend and sometimes extract large settlements. So leave a little money on the table for investors. Just don't leave a lot.