SBS XII: Going Public: Is It for You?

Thinking of taking your company public? Consider: Ken Seiff took his New York-based company, Pivot Rules, public in January 1997, raising more than $7.5 million. Soon thereafter, his business, a line of golf sportswear sold through retail stores, fell apart. He reorganized as an online retailer of designer clothing, using the proceeds from the public offering to fund the transformation. Says Seiff: "Going public allowed us to run the business with a surprisingly long-term perspective, finding new opportunities and investing in the future."

PowerQuest, on the other hand, is still on the fence. Based in Orem, Utah, this rising software star boasts annual sales of about $30 million, and products that include PartitionMagic. It remains private. "We've had a lot of success. Going public is not the only option," notes CFO Ron Hammond. PowerQuest has tapped into another financing option: venture capital.

Then there are those who just don't think much of the idea. "I think it's a terrible mistake for small business owners to go public. It's probably the worst mistake they can make," insists Gabor Garai, managing partner of the Boston office of national law firm Epstein Becker & Green.

Going public-should you do it now, should you wait and see, or is it destined to be a terrible mistake? The correct answer: It depends.

What Is "Going Public"?

When a corporation goes public, it means, in simplest terms, that the company's shares have been sold to the general public. How you sell shares to the public is dictated largely by the rules and regulations of the Securities and Exchange Commission, or SEC, a federal agency.

The government oversees not just the process of when a company first goes public (called the initial public offering, or IPO), but the financial reporting of the company once it is public and for as long as it remains public. The purpose of this oversight is to assure you disclose to the public all material conditions and changes to your business, so investors have the information they need to understand how your operation is doing and whether or not they want to become involved.

The Benefits

Going public provides a number of potential benefits-money being the primary one. "It's a financing device. It provides access to capital," notes Cyril Moscow, a partner in the Detroit law firm of Honigman Miller Schwartz & Cohn, and an adjunct professor in the law school at the University of Michigan.

Notes Seiff: "We had a terrific relationship with our bank, but it doesn't fund growth capital." If your firm needs lots of capital to grow, going public may be your most viable option because more conventional means, such as bank debt, remain beyond your reach. Being public can also make future financing easier and cheaper by boosting your company's net worth.

Stuart Hettleman, CEO and president of Amertranz Worldwide Holding Corporation, a freight forwarding company in Baltimore, raised $14 million in June 1996. He went public not only to raise money, but to make acquisitions. "We wanted to make acquisitions in which the people acquired would stay with the company. Having the currency of a publicly traded stock, we could use that as an incentive to give the principals in those firms a real vested interest," says Hettleman. Since going public, he has made two acquisitions using this strategy.

As an owner, you'll like the liquidity that comes with running a public company, because it makes it easier for you to cash out your ownership interest, if and when you want.

The Downside

While being public has its advantages, it comes at a price, including cost. Not just the cost of going public (which will be addressed below), but the ongoing costs of reporting to the public (and government regulators) about your financial condition and your business in general. "When you're a public company, the cost of maintaining SEC requirements can easily be in the $100,000-plus range annually," notes Garai.

In addition, ongoing communication with the investment community is essential. The public company now has a variety of "publics" it must consider for the first time. These include the financial press, brokerage firms that make markets in your stock (called market makers), institutional investors (such as insurance companies and mutual funds) and, of course, stockholders and potential stockholders.

There's a more subtle cost as well, namely meeting the expectations of the investment community, often called "The Street." "You're in a glass house," as Hammond describes it.

Also, expect to lose at least some control. After all, other owners must now be answered to. Even if you continue to own the majority of the stock, minority shareholders have rights. Put another way, you no longer can do whatever you want. It's like a marriage, there's someone else-the shareholder-you must consider.

When public, you are required to reveal a great deal about your company, including profit margins and executive compensation packages. Some of this may be information you'd rather keep hidden from your competitors-but will be unable to do so.

The process of going public entails considerable costs, not just financial, but relating to the demands on the attention of management. Says Seiff: "Going public requires an extraordinary amount of investment in time and effort by key managers to draft the prospectus, negotiate the deal, and do the road shows [when management goes to brokers and investors to promote the public offering]. Hettleman was surprised by the demands made on him: "We really had to dedicate much more time and energy than I would have ever thought possible."

One last downside: You exclude other financing sources if you go public, namely venture capitalists who won't subsequently invest in your firm. Typically, a private company gets venture capital financing and then goes public, not the reverse.

Are You Ready To Go Public?

The investment community wants to see certain attributes in a company before it will get excited about its going public:

• "The market looks for a company that has the potential for large future earnings," notes Moscow. Seiff was able to take his company public because, as he notes, "there was enough growth in the golf industry to create several successful golf sportswear brands." Investors were betting his would be one of the winners. If his market wasn't on a fast-growth curve, it's unlikely he could have gone public.

Garai says that for a company to go public, it should be able to convincingly claim at least a 30 percent compound annual growth rate. In their book, The Ernst & Young Guide to Taking Your Company Public, Blowers, Ericksen and Milan suggest anticipated annual growth rates need to be in the 15 percent to 25 percent range.

• Predictability is important. "The key is being able to predict your revenues and earnings," says PowerQuest's Hammond. If your company's performance is erratic, if your earnings bounce up and down more than a basketball in the hands of Michael Jordan, if you've not really identified your market-find another source of investment capital. Wall Street hates surprises. Notes Garai: "Small companies are inherently less stable in terms of growth, so they can't be managed on a quarter-by-quarter basis. But the stock market wants to see you predictable on a quarterly basis."

• Size counts. If you are very small, you probably cannot go public. Companies that need only $1 million or $2 million find it difficult to tap into the public markets because of the costs of going public and the fact that such small amounts of money are generally not enough to fund really high-growth businesses. There's no set minimum, but if you need less than $5 million or so, going public may not be your best bet.

Note: Recognizing that small firms often do not need to raise millions of dollars, the SEC created the Small Company Offering Registration, called SCOR, which allows a corporation to raise up to $1 million, with some restrictions. For more information on SCOR, visit the Web site of the North American Securities Administrators Association [www.nasaa.org/helpsmallbusiness/geninfo.html].

• For most companies, their greatest asset is management. Brian Coventry is a vice president at Southeast Research Partners, an underwriter in New York. What does he look for in a company? "Management, management, people who are unstoppable." You need a strong management team, one that can wow both an underwriter and The Street.

• A way to stand out. It's hard to go public if you have a "me-too" business. After all, why would anyone invest in a company basically the same as others, but not as established or as proven? Hammond of PowerQuest says investment bankers typically ask him two questions: 1. Who are you like? and 2. How are you different? Knowing how a company is like others makes it easier for investors to understand the company, its market and its opportunities. By asking how it is different, they want to know how you will compete and prevail, and not, as Hammond says, just "bump heads" against the competition.

• You are ready. Beware of going public before your company is mature enough. Notes Coventry: "The worse thing is to release disappointing news. You lose credibility and it's very difficult for a young company to earn that back."

The Process

To successfully go public, you need to prepare-sometimes years in advance. You must "groom" your business in ways that will interest Wall Street. For example, you want a history of growth-of both revenues and profits. As always, there are exceptions (such as a hot technology), but generally, you need to show investors that you know how to make a buck.

You will typically need a minimum of two years of audited balance sheets and three years of audited income and cash flow statements, so if you think you might like to go public during the next two or three years, consider having your financial statements audited, starting now.

Develop a strong business plan that shows your goals, markets and growth potential. The business plan demonstrates to outsiders that you know what you're doing, that you have a vision for your company, and that you know how to get there.

How important is a good business plan? Seiff states: "The fact that we were extremely well positioned, had some creative marketing and a good business plan were at least as important for going public as growth."

But don't confuse having a plan to go public with having a business. Moscow warns: "Going public is not a business plan. In times of an excited stock market, business owners will start a company with the intent of going public. That's a mistake. Going public just a method of financing-a very expensive method of financing."

The first outsiders you generally bring onboard are accountants and attorneys who have experience with the going-public process." You need a good accountant and good lawyer," notes Seiff. "You want them to be honest with you. What's involved, what the physical, mental and emotional commitment is, the reporting requirements and the real likelihood is of your being able to go public."

Then you'll need an investment banker, a stock brokerage firm that will act as your underwriter. Consider it the manager of your IPO, which includes helping structure your offering, creating a market for your stock, and supporting your stock once it starts trading. Says investment banker Coventry: "The investment banker helps the CEO and management to access the market, to value their company. And then it's the investment banker's job to maximize the value of the company. There are two parts to my job: Work for my client, the company, to raise capital; and for shareholders, to turn over every rock and not miss anything (which refers to finding all the warts and weaknesses of the company, so shareholders know what they are investing in)."

Your underwriter, attorney and accountant will walk you through the registration process. You'll need audited financial statements and a registration statement. This is a legal document with information that basically goes to the SEC, although is available to the public upon request.

The part of the registration statement that is best known and arguably most important is the prospectus. This is a public document whose purpose is to disclose all information that might be material to investors. An important point: The prospectus is not a marketing tool used to shill stock, nor does it suggest that the SEC or any other government agency has approved the stock as an investment. This is a disclosure document, period. What investors do with the information it discloses is up to them. The SEC never approves an offering in the sense of saying it is a worthy investment.

The prospectus contains a great deal of information, including:

• The structure of the deal (price of the stock, number of shares sold, percent of the company's total shares being sold to the public, how many shares-if any-insiders are selling).

• Use of proceeds (how the money raised will be used).

• History of the company to date.

• Background of the principals (top management, board of directors).

• Financial statements.

• Risk factors to investors.

• Analysis of the business and its markets made by management.

How is it decided how much your stock will sell for and how much money you will raise? This is usually concluded via negotiations with the underwriter. The underwriter wants the stock to be priced low enough that it can successfully sell the stock to the public and have it rise afterwards. The company going public, of course, is generally desirous of getting as much money as it can use. Also, expect to sell 25 percent to 50 percent of your company; usually offerings don't go above or below this range.

Note: Here's a quick way to estimate how much money you may potentially raise. Assume other companies in your industry have a price-earnings multiple of 20, your company's annual after-tax profits total $1 million and you want to sell 30 percent of your company to the public. By multiplying your earnings ($1 million) by the p-e multiple (20), the capitalization of your company is $20 million; this is the total value Wall Street is likely to give. If you sell 30 percent to the public, you could raise, gross, $6 million (30 percent of $20 million).

Time and Costs

If short of cash, don't view an IPO as a quick way to obtain needed money. Going public is a somewhat long, drawn-out process that Moscow estimates usually takes about six months, including finding an investment banker and doing the preparations. This includes about eight weeks from the time you file a registration statement until it goes effective.

An IPO is expensive. Generally, the larger the offering, the lower the percentage of the money raised to fund the IPO. That's because many of the costs are the same whether you raise $5 million or $50 million. Moscow says that on the lower end, expect to spend 10 percent to 12 percent on the IPO.

Of course, the process becomes extremely expensive if you go through the work and the market turns against you and you can't go public (this happened to a number of firms during the summer of 1998, when the market went down). Having an unsuccessful IPO is a risk you must consider.

Should you go public? That depends. If you can profitably use the money and have an exciting business, do it. But if you have a slow-growth business or need money to bail you out of trouble, look elsewhere.

Positioning Yourself for an IPO

The accounting firm Ernst & Young, which works with public companies, charts a series of steps required for a successful IPO:

• Identify both personal and corporate financial and non-financial goals for you and your key stakeholders.

• Benchmark where you are in the marketplace, what you want/need to accomplish, and what critical initiatives will get you there.

• Build an internal/external team that will help lead the company through the IPO process.

• Run the organization like a public company prior to executing the IPO, so that

areas that need attention can be identified.

• During the IPO, stay in control. This is where the promises are made, the story is told and the company is priced.

• After the IPO, focus on delivering your promises to stakeholders, investors and analysts. Challenge your company to grow to the next level of value --and continue to exceed market expectations.