Little Fish, Big Pond

The lure of public markets can prove treacherous to overly eager companies.

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Craig Rogers spends his days in a place he calls “bulletin–board hell.” As vice president and treasurer of Cell Robotics International Inc., an Albuquerque manufacturer of laser-based medical devices, Rogers routinely copes with investment bankers who won’t touch his deals and brokers who won’t trade shares of Cell Robotics stock.

Since going public in 1995 by merging with a public company, Cell Robotics has failed to muster sufficient revenues to secure a Nasdaq listing, a key to luring market makers that support the stock. “We’ve been struggling as a stock, but not as a company,” says Rogers.

True, Cell Robotics, which is still in the product-development stage, lost $1.5 million in the first nine months of 1998, on sales of $1.1 million. Rogers insists, however, that its prospects are “as bright as anyone’s.” Still, trading is relegated to an electronic bulletin board, a high-tech version of the pink sheets that used to circulate with details about public companies too small for Nasdaq. Investment policies bar many institutional investors from owning such stocks, and few brokers handle stocks that are not listed.

Far from supplying greater access to capital markets, public status has hampered Cell Robotics. “It’s a bit of a misnomer that just because you are public, it will be easier to raise money,” Rogers says. Other observers share this jaundiced assessment.

“There is a mystique to being public that a lot of companies chase after, even if it means not trading on one of the major exchanges,” says David Farber, former CFO of Magic Cinemas, a movie-theater operator that he and a partner sold to Regal Cinema in 1997 after mulling an initial public offering. “But often, it doesn’t make sense. You have all the disadvantages without many of the benefits.”

To fund the development of laser devices designed to draw blood samples almost painlessly, Cell Robotics tried on three occasions to sell its stock in secondary offerings. It had to scrap the first attempt and settle instead for a smaller, more-expensive, and more-onerous private placement. Twice afterward, Cell Robotics accepted a hand from Paulson Investment Co., a small, regional firm in Portland, Oregon, that relies in part on brokers making cold calls to lists of potential investors. “In all three cases, we were left with no choice but to accept smaller, lower-priced offerings than expected,” says Rogers. “I’m not sure [being public] has helped us much,” he adds.

Cautionary tales seldom hinder managers drawn to visions of bountiful equity markets. Who can blame them, especially now? Equity markets have never been richer or success stories more prominent. News of one–Priceline.com, which zoomed recently from $16 to $69 on its first day as a public company, before ever claiming a nickel of profit– eclipses dozens of dismal outings by companies like Cell Robotics.

Too Early?

Meanwhile, with visions of mansions in Palm Beach, investors are fanning the trend. “If a company has access to cheap capital in the public market, it should jump at it,” says James Melcher, president of Balestra Capital Ltd., a New York asset management firm. By his lights, companies should launch IPOs “as soon as possible” in some cases, before venture capital firms seize control in exchange for capital.

An increasing body of evidence suggests, however, that public venues are much less congenial than managers of fledgling public companies want to believe. Cumulative returns for all companies that went public between January 1, 1986, and August 31, 1996, trailed the overall market in their first three years as public companies, according to Ernst & Young LLP. A separate study, by Broadview International LLC, a mergers-and-acquisitions investment bank, concluded that more than half of all technology IPOs since 1992 currently trade below their offering prices. The Ernst & Young study suggests why: Nearly two thirds of the companies that floundered after an IPO were not adequately prepared for going public, their managers admit.

Many of these managers viewed going public as an end in itself, says Joseph Muscat, national director of Ernst & Young’s IPO advisory services. “Winners and losers are not decided on the first day,” he warns. Managers should view going public as a process rather than a transaction, he argues. The most successful IPOs are ones that “weigh the time and preparedness of the company against the opportunity in the capital markets,” according to Muscat.

Fallen Angel

Far from opening a path to easy street, going public too soon sends many companies careening into potholes. Even routine scrutiny can sap managers’ time and energy, and IPOs often face far worse. Because IPOs are hitched to high growth expectations, investors do not take kindly to disappointments, even slight ones. “Because of the high premiums paid, investors expect very high returns,” says Paul Deninger, Broadview International’s chairman and CEO. If the growth rate so much as hiccups, the stock price can tumble. “On our road show, investors made it absolutely clear that the level of tolerance for bad news is one quarter,” says John Reiland, CFO of Neon Systems, a software company based in Sugar Land, Texas.

Under pressure to meet quarterly expectations, young companies manage for the short term when they should be focused on longer-term objectives. “Managers don’t always make the best decisions under that kind of pressure,” warns Dan Brotten, of consulting firm PriceWaterhouseCoopers. And once a company stumbles, investors are generally unforgiving.

Second chances are rare, comments Brotten. “You need to have the infrastructure and systems in place,” he says. Legal and accounting costs alone can sandbag a new company, while selling, general, and administrative expenses can balloon quickly. “A lot of companies go public too early,” says Cell Robotics’s Rogers. “They have the perception that it is going to solve all their problems, but the expenses can compound their problems.”

So when is a company ready for an IPO? Requirements vary according to industry and investment climate, among other factors. Rogers suggests that companies wait until they can post $4 million in net asset values–Nasdaq’s minimum listing requirements.

It is clear, though, that new Internet companies have changed the IPO landscape. Candidates for IPOs once needed upwards of $20 million in revenues, evidence of a growth rate exceeding 20 percent, and five straight quarters of profits for underwriters with household names to consider them. Today, legions of Internet companies go public with minimal revenues, no profits, and astronomical growth expectations pinned to the barest of evidence. As deals stoke demand, and vice versa, investment bankers are hurrying to fill up the pipelines with anything that sounds like it might succeed.

Hot sectors come and go, of course, according to fickle investment climates. Biotech stocks ruled in the early 1990s, then roll-up consolidators grabbed the limelight. As the rush to take advantage of each market opportunity turns to a stampede, a familiar pattern emerges: Quantity trumps quality. Strong demand has shortened the time-frame for public offerings. Two Dog Net Inc., in Livermore, California, plans to offer Web-based content and navigation tools for children. It filed for an IPO in March. The company has only nine employees and barely $50,000 in revenues. Another Internet offering, Quepasa.com, a Spanish-language net portal that filed for an IPO the same week, lost $6.9 million in its first year of operation.

Choosing to Wait

Some managers are wary of the perils awaiting companies that go public too hastily. Despite appeals by some investment bankers, Neon Systems elected to build a track record before going public. “We felt we had a responsibility to make sure we had a business model that was reasonably predictable and sustainable to be in the public arena,” says CFO Reiland. The company has had 10 straight quarters of earnings growth, when many companies going public have no earnings at all. In the first few days of trading, the stock, which Reiland considers a partial Internet play, shot from an offering price of $15 to a high of $50, where it remains at press time.

By selling only a quarter of the company to public investors, Neon Systems seems to have ample opportunity to return to the well–but only if the company delivers. “If we stumble,” Reiland says, “the other 75 percent is at risk.”

For some companies, waiting is the only option. While Internet IPOs flourish, other sectors want for investors. Companies that produce software and microchips are delaying public offerings these days, says Broadview’s Deninger. The reason: Consolidation and growth among traditional technology companies make it harder for upstarts to compete. “A $20 million operating system software company is not going to go public and compete with Microsoft,” Deninger declares. More of the time, these companies are swallowed before an IPO is realistic. Last year, for instance, 1,892 closely held technology firms were bought by other companies, while 147 completed public offerings.

Outside of hot sectors like the Internet, going public is even more problematic. U.S. Laboratories Inc., a San Diego-based provider of quality controls in the construction business, has floundered in its brief life as a public company, after twice delaying a public offering. It stalled the first time last fall, when markets turned sour, and a second time three months later because its financial statements were stale. It finally sold shares in late February for $5.75 with warrants, and the price soon slid to $4.

“The whole time we were going public, we constantly questioned whether the timing was right,” says CFO James Wait. He is warier today of investment bankers who urged U.S. Labs to proceed. “I don’t think any of them tell you the whole story,” he says.

To be sure, the windfall that comes from a public offering can often give a company the capital needed to succeed. But without sufficient infrastructure and a reliable track record, public pressure may be more than some companies can handle. For them, bulletin-board hell awaits.

Joseph McCafferty is an associate editor at CFO.

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