How often have you heard the expression, “What goes up, must come down?” Nowhere is this more evident than in the stock market. Although it is a lesson easily forgotten in boom times, major market downturns bring it quickly back to the forefront. Hardest hit in 2001 have been IPOs – initial public offerings. The irrational exuberance of 1999-2000 ran into the harsh reality that profits – not revenues – are what drive stock prices. As evidence, a recent study of Internet IPOs in 1999 and 2000 found that only 7% were trading above their offer price as of the end of February 2001.[1]
Moreover, there were some spectacular crash landings:
- Probably the best known is VA Linux Systems, Inc., which rocketed 698% on it’s first day, going from an offer price $30 per share to $239.25. At the end of June 2001 it traded around $3, or 99% lower than that first day close.
- FirePond, Inc., a maker of business-oriented software, zoomed up 356% on its first day of trading, February 23, 2000, going from $22 per share to $100.25. Yet 16 months later, it was trading at $1.01, down 95% from its IPO price and 99% from its all-time high, hit on that very first day of trading.
But at least those two companies are still in business. Consider the fate of the following:
- Etoys, the pioneering online toy retailer, announced on February 27, 2001, that it was closing down its web site within a week, seeking bankruptcy court protection and selling all of its assets. Founded in 1998, the company went public in May 1999 at $20 per share, closing at $76.50 on its first day of trading. After hitting a high of $86 in October 1999, the stock is now worthless.
- Pets.com, the well-known pet supplies company with the ubiquitous hand-held puppet, went boom and bust even faster. The company went public in February 2000 at $11 per share. The stock peaked at $14, but by November – only nine months later – it was virtually worthless, as the company closed it’s doors and started a voluntary liquidation.
Last year, GBR published two articles examining the critical issues that need to be answered before you decide to go public and the process involved if you do. Considering the spectacular failures cited above, and the poor performance of many IPOs in general in the early part of this year, it seems reasonable to ask “Is it still wise even to consider going public?” The answer is still “Yes,” but the expectations and factors for success have changed dramatically. This article will review the changes that have occurred in the IPO market during 2001 and try to discern patterns that may help you decide if your company is a good candidate to make the challenging transition from private to public under current circumstances.
The 2001 IPO Market
The first quarter of 2001 was the slowest since 1990, with only 21 companies going public, compared to 119 for the first quarter of 2000. The second quarter was not much better. Although 26 companies went public, Kraft Food’s IPO of $8.7 billion accounted for half of the total proceeds raised. Moreover, 126 companies postponed or withdrawn their planned IPO in the first half of this year compared to 54 companies during the first half of 2000. The only good news in this statistic is that withdrawals have slowed significantly in the second quarter.
The reasons for the funk in the market are pretty obvious. First, early last year technology stocks were booming. This fueled the rise not only in the Nasdaq – which is the barometer for the technology-heavy IPO market – but in investor expectations, which are the main catalyst in successful IPOs. The Nasdaq had the worst year in its 29-year history in 2000 and hit a two-year low in the first quarter of 2001, leading investors to become very skittish. IPOs are generally risky whatever the state of the market, but in a declining market, that is the first money to dry up. Until the market is fairly sure that either a recession will be mild or avoided completely, a cloud of uncertainty will cause many investors to be very hesitant about taking on riskier investments.
Not withstanding that cautionary note, there are signs that the IPO market is beginning to pick up, although the type of companies that have been coming to market are very different from the high tech start-ups of the late 1990s. June was the best month so far this year with 15 companies going public, nearly one-third of the total for the year. This recent revival, to the degree it may be called that, has featured energy companies, spin-offs of well-established and well-known firms, and perhaps most importantly, companies that have real products and real earnings.
IPO Expectations and Factors for Success
Although the timing of a fertile environment for IPOs remains fuzzy, what is crystal clear is that the expectations and characteristics of a successful IPO have changed dramatically in 2001. Armed with this knowledge, you will be better able to determine if the time is right for your company.
EXPECTATIONS: Whereas a minimum price increase – or “pop” – of 100% on the first of trading was de rigueur in late 1999 and early 2000, a more modest 20-30% pop marks a stellar performance this year. In fact, any price increase above the offering price has been cheered by the marketplace in the difficult environment of the first six months of 2001. The upside of this reduction in expectation is that the investment bankers – the middlemen that will be key players in helping you go public – are putting much more effort into fairly pricing IPOs. Combined with significantly reduced investor frenzy, so-called “money left on table,” or price increases that go to traders and not the company, is greatly diminished. Moreover, your company’s stock price is less likely to exhibit the wild gyrations that have made investors so jittery. In the long run, a realistic IPO price provides a better and more stable platform to measure long term success than quick price run-ups that not only disappear but leave a bad taste in investors’ mouths.
CHARACTERISTICS OF A SUCCESSFUL IPO IN 2001: Of the 47 IPOs in the first half of 2001, only 20 had a “pop” of more than 10% on the first day of trading. Importantly, as of July 3, 2001, 26, or 55%, were still trading above their offering price. An analysis of all 47 IPOs identifies several common characteristics among the winners and losers. (Click here for a spreadsheet that shows the data for the first half of 2001.)
Reviewing these data we see that as of the end of June, 2001:
- Of the 26 companies with current prices above the initial offer price, 18 were even above their first day closing price.
- Most of the winners were either profitable or virtually debt free, or both, prior to the IPO. In stark contrast are the losers, where just about every one had losses, debt, or both. This is in line with what John Fitzgibbon, IPO editor of financial information provider WorldFinanceNet.com, wrote recently: “The IPO market went from insanity to stark naked reality in 2000. What has surfaced out of this is that earnings matter … it’s gone from the dreams to reality, and the pendulum has swung from story companies to solid companies.”[2]
- Compared to the losers, many more of the winners had virtually no debt. This is especially obvious if you remove the five start ups which normally would have no debt due to their inherent risky status. The lack of debt provides much needed assurance to the market that debt payments won’t significantly reduce or wipe out future earnings.
- As might be suspected, energy related firms dominated the list in the first half of this year. But the record-breaking energy prices in 2001 did not guarantee IPO success. Of the 16 energy companies going public in the first half of 2001, eight, or half of them, were trading at or below their offer price at the end of June.
- One unusual characteristic of many IPOs in this period is their size. Last year, the minimum proceeds to make the process worthwhile would have been at least $75 million. In the first half of 2001, 14 of the 47 IPOs were for less than that, with the smallest IPO raising only $7 million. That is potentially good news for smaller companies that previously would have not even considered going public, given the large amounts – especially expenses – involved.
- There is one fairly clear sign of improving health in the IPO markets. Without the six $1+ billion IPOs, the average amount raised is about $133 million. However, the second quarter’s average was $160 million, more than two and one-half times the $59 million average for the first quarter.
In summary, in the IPO market of 2001, the successful IPO is one that involves a high quality company with a proven business model, as evidenced by stable and profitable operations. In the words of Bill Brady, head of equities in Credit Suisse First Boston’s technology group, “We expect this year to be more rational, a smaller number than last year.”[3] Part of that rationality includes expecting first day stock price increases of only 10-40% to indicate a successful IPO instead of last year’s moon shot increases of 100% or more. Moreover, there appears to be a ready market for much smaller IPOs than in the recent past.
WHAT TO DO NOW
The IPO market is definitely not dead, but it has not yet completely shaken off its grogginess. Until it does, there are two main steps you can take. One has to do with timing, the other, preparedness.
First, be a keen observer of the markets in general and the IPO marketplace specifically so that you will become sensitive to optimistic improvements. Further interest rate cuts will be one indicator, with some estimating that a federal funds rate of 3-3½% by fall is possible. It stood at 3 ¾% at midyear. A turnaround in the decline in the growth of gross domestic product (GDP) would be another. That turnaround does not appear to be happening yet. Initial reports show that GDP grew only 0.7% in the second quarter, following an weak 1.3% in the first quarter of 2001.
Another indicator to watch would be the consumer confidence index, which has recently begun to improve. Finally, and probably most importantly, look for a significant increase in the number of IPOs coming to market. June 2001, with 15 companies going public, was the best month of the year to that point, although still far behind historical averages. The best way to do this is to be a frequent visitor to two primary IPO web sites, ipo.com and hoovers.com. Both sites have a wealth of information about the IPO market and statistics on successful and pending IPOs.
Next, like the Boy Scout motto says, be prepared. While you will be unable to predict with absolute certainty if the market has turned, you can take steps to have your company ready when you and your advisors think the time is right. While I will not try to predict the future, based upon successful IPOs thus far in 2001, it is very clear that the IPO market is looking for a very different kind of player this year than last. It expects a successful candidate to exhibit much more than just a great idea that has a hint of profit potential down the road sometime. Your company should have a well-established market presence, a finely-tuned business plan, very low or zero long-term debt, and finally — and most importantly — either past profitability or near absolute assurance that you will be profitable soon after the IPO. While energy firms have dominated thus far, a wide range of other industries are also represented, from retail apparel to health care to investment services. The common factor among all of them is past profitable operations. Moreover, for technology firms, past profitability or low debt is all the more important due to continuing skittishness regarding these types of investments.
Finally, don’t shy away from the idea of going public just because your company only needs $10 or $20 million. Conditions are such that the market will likely be receptive to any well qualified candidate in just about any industry. As Gregg Nabhan, Morgan Stanley’s head of global equity syndicate put it, “There is plenty of liquidity for quality … top tier issuers are going to have access to capital.”[4] If, however, your company is still perfecting its product and market, or if you can not forecast profitability in the near future based on a well-documented business plan, you may have to wait until the markets — especially the Nasdaq — are on a solid upward trend and investors are willing to finance riskier IPOs.
If you don’t think you can wait that long, another option would be to seek private funding from venture capital funds. According to a recent article in the Wall Street Journal, many funds have an “embarrassment of riches” because the market slumped just after a lot of money already had been raised. While these fund managers are being more careful where they invest, David Chao, managing general partner of DCM-Doll Capital Management, Menlo Park, CA, is quoted as saying that venture funds will be “more involved with them [companies they invest in], as they should be. They’ll be rolling up their sleeves, helping businesses and making those businesses work.”[5]
If this involvement is indeed successful, your company could then be in a much better position to make the move from private to public status, especially if the IPO market has loosened up.
[1] “Investors Discover Gravity as IPOs Return to Earth,” Wall Street Journal, March 7, 2001).
[2] “Once-Sexy IPO Market to Styart 2001 Slowly,” Reuters, December 30, 2000
[3] “IPO’s Expected to be Fewer but Bigger in 2001,” LA Times, January 15, 2001
[4] “KPMG Consulting Shares Post 30% Gain in First Day of Trading, Wall Street Journal, February 9, 2001
[5] “Venture Funds Fulsh with Cash Become Cautious,” Wall Street Journal, January 2, 2001
