Proving grounds
Obstacles are high, but some work to go public
by Sarah Brouillard After a four-year lull, the market for initial public offerings has shown signs it's back, say many industry professionals. Unfortunately, most small businesses aren't invited to the homecoming dance.
Nationally, there are just as many IPOs now — about 70 — than there were all of last year, but few are from small businesses. "Things have changed enough in the capital markets that it's more and more difficult for the smaller companies to go public," says Tom Letscher, partner with Minneapolis-based Oppenheimer Wolff & Donnelly, who has helped several small local startup companies over the years go public.
Behaving like dates who've been stood up one too many times, investors are skittish about buying stock in companies that seem risky or that lack a robust balance sheet. They're still smarting from the last generation of young upstarts — mostly technology, telecom and Internet small businesses — that showed so much promise during the booming late 1990s, but quickly flamed out.
What investors want these days is a sure thing, say industry professionals. "They're looking for companies with proven business models," says Letscher. "The only IPOs they are interested in are large, with mature companies that have a proven track record of revenues and earnings."
Aside from overly cautious investors, there's little financial incentive for small companies to go public in today's post-Sarbanes-Oxley world. To improve the quality and transparency of financial reporting, the Sarbanes-Oxley Act of 2002 requires public companies to be compliant with a reformed set of accounting procedures.
Because of it, a ponderous amount of paperwork awaits owners and managers who plan to take their companies public. In addition, public companies are now required to have a majority-independent board — members must pass different tests to assure they don't have relationships with the company's audit, compensation, nominating and other committees.
What hasn't changed, but is still tedious for many owners, is the creation of the company prospectus with the consultation of numerous lawyers, accountants, underwriters and U.S. Securities and Exchange Commission (SEC) examiners. Part marketing material, part financial documentation, the packet is used to introduce and entice institutional investors to buy into the business. An accurate and attractive prospectus requires many drafts.
Getting a company up to snuff with the new regulations comes with a considerable price tag. Expectations, and often costs, are the same regardless of a company's size.
"Sarbanes-Oxley does not distinguish between a large company and a small company," says Marty Bakko, senior tax manager with Minneapolis-based Ernst & Young. "There's no discount for being small."
"There are a lot of odd burdens and obligations and risks that come along with being public," says Morgan Burns, a partner with Faegre & Benson in Minneapolis, who works with companies on IPOs, corporate finance and securities. Recently, he helped take Gander Mountain public. "You only want to do it if what you're going to gain by going public outweighs those."
Minneapolis-based ACI Telecentrics Inc., which went public in 1996, decided the burden was too much seven years after the fact: It terminated registration of its common stock in September 2003, and is currently traded on an over-the-counter bulletin board. Though still technically a public company, delisting has eliminated many of of the expenses — accounting fees, legal fees and insurance fees, numbering in the hundreds of thousands of dollars — that made CEO Rick Diamond's head spin.
Nevertheless, there are local small companies, notably those with a potentially hot product about to hit the market, that are choosing to take the plunge despite the added costs. Pre-revenue companies, such as med tech and biotechnology companies, are sometimes pursued for IPOs by investment bankers, but they're more frequently thinking along the lines of being acquisition candidates, says Letscher.
Not all small companies routinely seeking IPOs are health- and science-related. New Hope-based Viper Motorcycle Co., still in its research-and-development stage, filed a $7.1 million IPO in June, with plans to sell 1.4 million shares at an estimated $5 per share, and 1.4 million warrants for 10 cents apiece. Lane Capital Markets, of Fairfield, Connecticut, is the managing underwriter.
John Lai, vice president of business development, says he anticpates stock to be trading on the American Stock Exchange by the first week of September. In the meantime, the company, which aspires to compete with the likes of Harley-Davidson, has begun shipping its line of motorcycles for retail.
Lai says the company has spent more than $100,000 to get everything in line with Sarbanes-Oxley. "That's pretty high," he says. But officers began the process very early, knowing it would be more expensive to make changes as their IPO loomed larger. "Our people will be used to the reporting requirements," he says. "It's much better — and much less expensive — to get the systems in place early on, from the start."
In the middle of the company's post-IPO "quiet period," Lai wouldn't explain why the company chose to go public. But pundits have speculated Viper Motorcycle needs cash to deal with some financial issues.
Not so tough
Going public wasn't always so tough for small businesses. When Diamond took ACI public in 1996, "things were much easier," he says. Of course, that was before the dot-com bubble burst, before September 11, 2001, before the Enron cooked-books scandal, and before Sarbanes-Oxley raised the bar.
During those headier days, there wasn't as much scrutiny among investors, and the expenses of being public were minimal. Heading a publicly traded company cost Diamond about $150,000 a year — "not very much," he says. ACI provides telephone and Internet-based sales, customer service and marketing services to clients.
Diamond decided to take the company public for "one reason and one reason only," he says: Excited investment bankers, hot for his industry, persuaded him it was a good idea.
They started calling Diamond as soon as 1994. At first, he wasn't interested and said no to their pitches. He and his partner didn't need the money, having avoided debt during much of the company's history. And ACI was doing phenomenally well as a private company, posting 50 percent growth each year. The year before it went public, ACI posted $6 million in revenue; when ACI went public, it was in the middle of a $10 million year.
Diamond's ears perked up only when the right deal came along. He was game when investment bankers said they could do a $7 million IPO, with he and his partner giving up only 25 percent equity. "You have to say, boy, you'd be pretty dumb not to say yes to that," he says, adding, "No business has ever gone bankrupt being overcapitalized." Around that time, a dozen or so companies from the sector also went public.
ACI stock traded at $5 share, and over the next few years it traded up to $6.50 a share. Besides the sizable capital infusion, going public gave the company a lot of credibility, says Diamond. "We were able to sell into some very large clients that probably would not have given us the light of day."
Those high times were fleeting, however. Fiscal year 1998 was a particularly bad patch, as ACI lost its largest client and its stock started to drop. The ship was righted for the next three years, with the company returning once again to its 50 percent year-over-year growth. But, like thousands of other companies, ACI was "hit horribly" by the economic repercussions of Sept. 11. Most of ACI's clients are in the telecom and financial services sectors; ACI's billable hours for those companies dropped by 50 percent between August and September of 2001.
Says Diamond: "They got a severe cold. We got pneumonia." The company caused its own misery the following year when it stopped growing its clientele, and got caught off-guard when new sales dried up. Diamond also invested millions in new service capabilities and technology for online, real-time, live-agent customer service on clients' Web sites. Such a market hasn't materialized yet.
"It's great stuff, but unfortunately no one wants to pay for it," he says. All through this time, Diamond's industry lost much of its appeal among investors and analysts.
The other shoe dropped once the SEC began to heighten and tighten auditing and reporting standards after 2000. Diamond found keeping up with the ensuing paperwork "distracting." He'd rather have staff "spending their time on the business, not just filling out more forms." Rising costs were also a factor, as the new high-scrutiny environment caused liability insurance rates to skyrocket "for us, our directors and officers."
He's become increasingly aware of how difficult it is to be a small publicly traded company. "We saw the public markets change to the point where, now, if you're not doing at least $250 million a year in revenues, it's almost impossible to get an analyst to cover you," says Diamond. "If you don't have the analyst coverage, you're not going to get any play in the stock. If you're not getting any play in the stock, shareholders aren't going to be happy…they're not going to see the liquidity in their investment.
"It got to the point where there was no real value to our shareholders, nor to our company, because we were just sitting there, kind of languishing."
Dream deferred
The dream is certainly not dead for small businesses aspiring to go public, say market observers. But it may have to be deferred until a company gets big enough or attracts enough interest among analysts and institutional investors. A market capitalization of $100 million, at the very least, is a reasonable milestone at which owners might consider going public, says Letscher.
Owners should consider other exit strategies and financing options beyond the stock market. Selling to a larger company, or wooing venture capital and angel investors, are viable alternatives. "An IPO is a financing event — nothing more, nothing less," says Jon Salveson, head of investment banking at Piper Jaffray & Co. "IPOs must always be considered in relation to other sources of growth financing."
Ultimately, companies should wait to be asked to the dance. Only when a reputable investment banker comes calling can a small business — or any business — successfully go public, says Burns. Investment bankers underwrite IPOs.
Diamond of ACI has a bad taste in his mouth over his experience with investment bankers. But most have an accurate read on the market.
"They'll be pretty honest with you. If they think [an IPO] can get done, they'll do everything they can to get it done," says Burns. "If they think it's too early, it usually is."
But if the timing's right, a slippery slope may result. With investment bankers comes "research coverage from the research arm of those banks so that institutional investors will buy your stock. That's how you gain liquidity, and that's how your enterprise value increases," he says. "You need to have the ear of the institutional investor, you need to have their interest, and you need their money, to be successful as a public company."
[contact] Marty Bakko, Ernst & Young: 612.343.1000; martin.bakko@ey.com; www.ey.com. W. Morgan Burns, Faegre & Benson: 612.766.7000; mburns@faegre.com; www.faegre.com. Rick Diamond, ACI Telecentrics Inc.: 612.928.4700; www.acitel.com. John Lai, Viper Motorcycle Co.: 763.732.0778; johnl@vipermotorcycle.com; www.vipermotorcycle.com. Jon Salveson, Piper Jaffray & Co.: 612.303.6000; www.piperjaffray.com. Tom Letscher, Oppenheimer Wolff & Donnelly: 612.607.7000; www.oppenheimer.com.
