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IPO Reform: Some Immodest Proposals (Part 2)

Joseph W. Bartlett, Founder of VC Experts.com


There are a number of reasons why venture capital has flourished in the United States, surpassing the performance of any other country or region (at least until now), some of which have to do with the legal and accounting structure which has been, sometimes overtly and sometimes stealthily, friendly to emerging growth finance. However, there are certain, undeniable problems with the current IPO system.

In the first part of this article, we looked at the current IPO process and identified some of the most apparent flaws. This week, we present a series of specific (immodest) proposals for IPO reform.

Coverage

First, focusing on the analysts and their limited ranges, this problem may take care of itself as and if a modern day equivalent of Glass Steagall passes. We may, sooner rather than later, see a rule that the business of analyzing and reporting publicly on public securities must be divorced from the business of agenting their sale. Is this likely to happen? On the one hand, a conservative federal legislature may be highly wary of a reincarnation of Glass Steagall. On the other hand, the SEC, of late and without much push back from the Congress, has been rigorous in enforcing the independence of public accountants, compelling them to shed significant profits from their consulting businesses or, at least, to distinguish between clients. However, I, for one, do not think a negative approach is, of and by itself, the way to go.

Thus, I do not believe that simply dividing investment banking and securities analysis would do the trick adequately. The reform I prefer entails the establishment of security analysis as a separate (and presumably independent) business which, if rightly structured, would extend the reach of the analytical community to any company with a specified minimum level of investor interest. As indicated, there is a chicken and egg problem underlying the current landscape. If a company's fortunes are subject to published analysis, then investor interest will follow in most cases, including interest from individuals and the small cap mutual funds. The idea is, therefore, to structure the rules to the end that either (a) existing institutions (law, consulting and perhaps even accounting firms) are induced to organize subsidiaries or affiliates, open to all, which hire, train, qualify and publish the results of securities analysis; and/or (b) alternatively, free standing organizations, ultimately mimicking the 'Big Five' spring up to provide the service, if the price is right.

Finding the money for this function should be the easiest part of the problem to solve. Assume there are 8,000 public companies which lack analytical following. Assume 4,000 or so are in a position, and have the wherewithal and motivation, to attract analytical coverage. The price, then, could be $100,000 per company per year. That number is well under what many companies in the orphanage now spend in terms of executive time, travel costs and the like in order to stimulate investor interest. We are talking about a lot of money, $400 million a year, even if you assume a good analyst makes a million dollars a year for covering a maximum of 20 companies. To get 200 analysts, you need $200 million, which leaves $200 million left over for the guys who all cover Microsoft, etc.

If the project correctly sorts itself out, it is a win/win situation. Conflict of interest is negated and investor choice is enhanced ... the best analysts would get the most money, bonuses for finishing at the top quartile based on the always correct influence of hindsight. Analysts will develop track records and be judged thereby ... compensated, hired and fired on the basis of performance like everybody else, instead of how many investment banking clients they snare.

Costs of Going Public

The next issue to tackle has to do with the extraordinary, often prohibitive, costs of going public under the current regime. We are talking about up-front costs of $2 million in cash, not counting fees and expenses to the investment bankers, a portion of which is designed to compensate the professionals for the fact some deals may abort at the last minute and leave them holding the bag. A large part of that significant expense is driven by the awkwardness of the process itself and much of the rest by the threat of liability under Section 11 of the '33 Act ... absolute liability if something goes wrong. If the hypothetical Man from Mars were to revisit this costly and inefficient system imaginable, we suspect he or she would come up with a series of recommendations like the following:

First, the Congress should repeal Section 11. There is no reason for near-absolute liability in the sale of public securities, as opposed to other transactions. The threat of securities fraud is obviously real and difficult; but Section 11 is not the way to police it. In fact, if one were to get rid of the Hollywood-opening type of marketing system in favor of a more thoughtful and leisurely (if you will) review of the issuer and its prospects by investors and professional advisers, then the system would be much more reliable, transparent and free from intentional fraud. One, although not the only, way to go about the business would be along the following lines ... our second recommendation.

Disclosure Standards

The next chapter in the project to enhance the attractiveness of valid and productive IPOs is to reform the standards of disclosure so that they are both realistic and affordable for legitimate issuers and their functionaries. The first chore is to make the standards understandable and clear. And the place to start is with the Regulations S-X, S-K and the definition of generally accepted accounting standards ("GAAP"). The idea would be to convene a committee not only of accountants but also of investment professionals, principally venture capitalists, who are charged with the responsibility of making investments in this space. The committee is asked: What, in terms of transparency, do you deem most valuable? The committee might take off from the "SEC-inspired" Garten Committee report.[1]

Offhand, I can think of a number of items, which are not highlighted in current financial disclosures:

  • Effect of Dilution: What is the practical economic effect of the overhang of employee options and other securities capable of diluting the IPO investors' percentage interest? Can dilution be expressed by a number that explains what it would cost to buy back all the warrants and options and options at the proposed IPO price?
  • No Liability for Forecasts: Professional private investors want to look at forecasts, and this means it is time to insulate the issuer from liability of any kind (absent outright fraud) in connection with the promulgation of a forecast. No other standard will produce the desired results.[2]
  • Past Performance: Perhaps the most reluctantly produced number by the management of any company is how the firm has been doing against the prior plan. Presumably, there are forecasts in connection with previous private placements; variance reports keyed to those forecasts are highly instructive.
  • Cut the Clutter: Reduce the number of subjects which go into the prospectus. Cut back to the model of a well drafted private placement memorandum and identify sources within the company where the investors can access information.

The point is that we spend a good deal of time quibbling about matters of very little importance. Who cares whether the company records a one-time charge for the issuance of cheap stock, warrants or options in anticipation of an IPO? Investors want to know the dilutive effect of those derivative securities and be able to compare apples and apples ... how rich is the option plan vis-…-vis industry comparables.

Diligence Requirements

Once that chore has been accomplished, then another blue ribbon commission should be contemporaneously devising a legislative articulation of the appropriate levels of the diligence required of the various professionals, breathing life into the idealistic (and unrealistic) current requirements (see Judge MacLean in Bar Chris) and the penalties for failure to comply. In a perfect world, we would take plaintiffs' counsel, as private attorneys general, out of the picture, since much of that litigation is meretricious. In fact, if it can work, I would like to see a carryover of the insurance notion (currently available to back up representations and warranties in M&A and private equity transactions) imported into the IPO space. Why not create a pool to which all IPO candidates would contribute, underwritten either by major carriers, or by the market through the asset-backed securities device, and compensate therefrom victims of outright fraud and deception.

The core idea is to take the thrill out of the process and turn it into a relatively pacific business transaction, gradually and efficiently introducing public investors to a new security and initiating trading in that security when and only when sufficient investor interest has eventuated and the stock has been sufficiently incubated (through an active due diligence process performed by paid proxies for potential investors) so that the securities are in fact ready for market.

Dutch Auction

Next, I would make whatever small changes are necessary to accommodate (as the sole or primary option) the Dutch auction pricing formula currently promoted by W.R. Hambrecht. Thus, at some point in this leisurely process, an aspiring issuer, after sufficient prodding and poking has taken place, indicates publicly its appetite on the sell side ... how many shares it proposes to issue (perhaps a minimum and maximum offering), without specifying the price. Maybe a couple of electronic road show conferences are scheduled for final Q&A with interested investors in an electronic document room. The issuer schedules the opening of bids two weeks or a month from the date of the announcement, and everyone then has a chance to make whatever inquiries each sees fit, and to submit a bid. The bids are opened on the specified date and the price is established at the lowest price which clears the market. With this much time to sort out the orders, it may even be that same day settlement is realistic, diminishing to the vanishing point the possibility of 'fails' in the time between T-1 and T-3; successful bidders would be required to wire the funds immediately, thereby taking some of the rules out of the underwriting function ... and, in the process, a good deal of cost and expense. The amount of the securities locked up would be a disclosable item; locked up securities held by insiders would be freed from restrictions ratably over a period of time ... one percent a day for the next 100 business days, so as to eliminate a land rush, on the 180th day.

Going Private

I suggest a quasi-fix for now public companies mired in the orphanage ... some 7,000 or 8,000 trading by appointment only. Many of these are good companies which went public (some through backdoor mergers into shells) inadvisably. They are strangling: They cannot finance publicly with their stock price in the cellar (except through toxic preferred stock); and few investors are buying PIPEs these days. Undervalued by Wall Street and unloved by analysts, an increasing number of companies are sidestepping the quarterly earnings game by going private. Last year, 62 publicly traded companies or units of public companies went private. That's 11.4% of all takeovers of publicly held companies that year, compared with 2.2% five years earlier. It's also 77% more than the number that went private in 1999.

As U.S. Bancorp Piper Jaffray Inc. notes in its "Endangered Species Updates," going private has become especially attractive for companies languishing in the purgatory of small- to mid-capitalization. Despite strong projected cash flows, such "market orphan" firms fail to attract institutional investors or coverage from the research departments at investments banks.

As a result, their shares trade at multiples of cash flow significantly below sale multiples for better-capitalized peers and at prices well below their IPO levels. Of companies in the Standard & Poor's 500 index, those with market caps below $100 million trade at 60% discount to the rest of the market.

Conveniently, undervaluation of small- to mid-cap issues coincides with growing inflows into private equity funds. Last year, financial buyers controlled $63.5 billion, up 61% from the previous year. Private equity groups can provide not only capital and managerial expertise, but also the credibility that is necessary to assuage reluctant lenders in a tight debt market.

From private equity's perspective, target companies ripe for private control share certain characteristics. Those include an enterprise value that reflects a single-digit multiple of EBITDA; strong projected cash flows and a substantial amount of cash on the balance sheet; adequate debt capacity; low trading volume; and relatively erratic earnings histories, including failures to meet analysts' earnings expectations.

Characteristics also include devalued employee options; able but frustrated senior management; and an inability or unwillingness to complete strategic acquisitions because of a low stock price or dilution concerns. Problems are amplified where the company is in a sector that is disfavored by investors. From the target company's perspective, going private involves numerous advantages. Companies that go private find it earlier to:

  • Pursue long-term growth strategies instead of Wall Street's quarterly goals;
  • Concentrate on their business plans and enhance shareholder value without expending time and money on investor relations programs and filings with the Securities and Exchange Commission;
  • Divest themselves of tangential businesses where covenants in their banking agreements had constrained them from doing so; and
  • Improve employee morale and provide incentive to management.[3]

While going private under the present rules is easier than it has been in the past, the bulk of the "going private" transactions involve cash-out mergers financed by buyout funds. My suggestion is akin to the "check the box" regulations in the tax law. Allow management and the board to put the case to the shareholders and ask them to vote on a return to private status. Any company with fewer than, say, 2,500 shareholders would be eligible. No one has to sell or is squeezed out (except odd lot holders) ... maybe a simple, and cheap, and continuous tender to all holders and the owners of those pestiferous warrants which infernally confuse the balance sheet, coupled with reverse splits ... until the magic number is reached (say, 2,500). Listed trading ceases; public reporting is no more, meaning no more artificial pricing (and no more artificial plaintiffs). Let the business proceed in peace and quiet in the absence of the now-entirely-superfluous public registration.

Long Runway Alternatives

If a company has in mind going public at some time in the future, it would be open for the issuers (as it is now) to start filing voluntary public reports: Not a registration statement, but an abbreviated version of the same, which could be filed at any point in the journey from the embryo to the IPO. There would be no trading in the issuer's securities, or no public trading at least; but the public, including the investment banking and analyst community, would have an opportunity to look at the company in depth and over a period of time. (Read here a necessary amendment to Rule 502(c) regarding "general" solicitation and "general" advertising, to accommodate a streamlined version of interim PIPES.) The company would be able with impunity to file for confidential treatment of specific items, subject, as is now the case under Regulation FD, to releasing that information to parties willing to sign non disclosure agreements. Information would be posted on-line on the company's web site and track generally Forms S-1 or SB-1. If the company wanted to pay the freight, as a form of spring training (if you like) for an IPO, it could be authorized (or indeed required) to pay the $100,000 and solicit analysts' reports from the newly organized Big Five. The company could conduct quarterly Q&As on-line and make information available to the analysts ... and to all hands under Regulation FD, if you like. But, since there would be no trading, it could limit the flow of information as it saw fit. Any time after filing a new version of a Form 10, the company (again at its leisure ... no time table at this point) could solicit a letter of comment from the SEC staff and submit a listing application. The bulk of the initial documentation could be assembled in-house, tracking the forms and other examples of comparable public companies. The current custom ... a first, 'all hands' meeting and drafting session with 15 or 20 people (mostly bystanders) in attendance ... would be avoided, along with the consequent expense.

Interest would then build over a period time, if at all, in the company. And, if the deal held promise, the 'usual suspects,' i.e., the investment banks, would come calling. By the time the bankers had risen to the bait, much of the legal infrastructure would have been cleared away ... the letter of comment filed and responded to, accounting issues sorted out with the Chief Accountant's office, some objective appraisals from the analyst community circulating and some institutional and retail interest aroused.

The Long Runway scenario is illustrated by a hypothetical case study set forth in the third section of this piece.

We aim to keep you up-to-date. If interested in commenting on the above, sign up for the VC RoundTable, and discuss this in our Forum on Initial Public Offerings.


joe@vcexperts.com

[1] To quote from the Committee Report:

"Investors need a variety of information to project future profits and cash flow. Historical financial results are a starting point, but are rarely adequate by themselves. Investors need to understand the company's business model, the market for its products, the specific tangible and intangible assets that provide its competitive edge, and the quality of its management team. They also need to understand the key milestones for the development of the company and its progress on achieving key operating performance measures. Sometimes, the investors would also like to receive financial projections from the management of the company. Investor then take all this information to develop their profit and cash flow projections. The sum of this information about intangible assets, operating performance measures and forward looking information is the focus of our conclusions about improving the disclosures. (See below for examples of intangible assets and operating performance measures.)"

Intangible Assets

Operating Performance Measures

Brand names

Customer acquisition cost

Patents

Revenue per customer

Trademarks/copyrights

Number of customers

Proprietary business processes

Inventory turnover

Skilled employees

Cost per unit

Business Alliances

Market share

Product licenses

Time to market

Loyal or locked-in customers

Revenue pre transaction

Customer lists

Employee turnover

Desirable locations

Manufacturing throughput

Preferential rights (e.g., drilling)

Order backlog

Landing rights

Revenue per employee

Airwave spectrum rights

Revenue from new products


[2] I endorse the recommendation of the Garten Committee (which I arrived at before seeing the report.)

"Expand the safe harbor provisions of the PSLRA of 1995 for disclosures of forward looking information and softer historical information about intangible assets and operating performance indicators. For example, a broader prohibition against private suits could be considered. Even more ambitious would be the creation of a special section in investor communications (annual reports, investors presentations, company web sites) that would be entirely exempt from private suits. Investors would be cautioned about the lack of remedies they would have with respect to the information in that section. (Emphasis supplied.)

[3] "Orphan Story," Kaynor & Pereira, The Daily Deal (Aug. 28, 2001)