Too Public Too Soon
On Friday, August 13, 1982, Ferro fuidics Corp., a manufacturer of high technology proucts using magnetically controlled liquid, ushered in its second year as a public company with a breathtaking surprise for shareholders: a loss of $2.2 million for fiscal '82, ended June 30. Of course, this was hardly the first time a company had run negative figures in its first public year. The loss at Ferrofluidics, however, was notable not only for its magnitude in relation to sales of $7 million, but also for the extraordinary item that in large part caused it: a one-time write-down of $1.3 million on supposedly sophisticated inventory, much of which the company had purchased for cash a bare 18 months earlier.
The gush of red ink undoubtedly would have escaped national notoriety had not the company gone public "far more prematurely than we intended," as co-founder and president Ronald Moskowitz admits. Had the company stayed private, the complications of this decision and other problems Ferrofluidics was to experience would not have arisen; there would have been only the board to contend with. To a professional capitalist, the write-down would be considered little more than an unexpectedly high cost of going into business. But now every move had to be taken under the scrutiny of the public eye -- a not always well focused instrument, Moskowitz was to learn. Some 300 calls from institutions, mutual funds, pension-plan holders, and just plain man-in-the-street stockholders flooded Ferrofluidics's Nashua, N.H., switchboard in the two days following the announcement of the loss, each caller demanding to know what had gone wrong.
Similar demands were also coming more ominously, from the Seeurities & Exchange Commission and the National Association of Securities Dealers, under whose auspices Ferrofluidies's stock was traded over-the-counter (symbol: FERO). The rapidly shrinking stock price reflected the owners' gloomy realization that assets valued at more than $1 million suddenly had been deemed irrecoverably worthless, like so much caviar spoiling in the sun. In August, on volume of 2,370,000 shares -- a sixfold increase from the previous month's level -- FERO was sliced in half to a bid of 1 5/8, amid rumors that the company was in deep financial trouble. Ordinarily, such rumors might have been squelched by the sponsoring underwriter of the new issue. Unfortunately for Ferrofluidics, precisely one month afterits public flotation in July 1981, the underwriter, John Muir & Co., had sunk into voluntary liquidation, leaving fresh-born Ferrofluidics without its primary market maker and financial-community mentor.
Ferrofluidics's open-book troubles go back to early 1981, when Moskowitz, as any chief executive officer of a young company must on occasion do, was weighing alternatives for capitalization in order to continue expansion. Until that time, the company had been finaneed largely through four infusions of venture capital. With its rarefied technology (there are only 300 people in the field in the world, and half of them are at Ferrofluidics, says Moskowitz), it had opened domestie and overseas markets in computer peripherals and other industrial processes. But 12-year-old Ferrofluidics was still struggling. Back then it didn't matter: Investors like First National Bank of Boston and TA Associates, also in Boston, were sympathetic about the volatility of start-up situations, and were willing to be patient so long as the company's strategic plan remained intact. The trouble was that, although Moskowitz felt that "going public always was our destiny," Ferrofluidies's strategic plan didn't include a scenario for what happened next.
When the Muir salesman came knocking, Ferrofluidics was working on the state-of-the-art development of a huge computer-controlled silicon crystal -- growing furnace that would sell for $500,000. To finance this grand instrument, Moskowitz, the seientist behind the fluid (together with co-founder Ronald E. Rosensweig), had been considering a few typical private sources, ineluding tapping previous investors for yet a fifth round of venture capital. Alternatively, with a balance sheet still unsullied by long-term debt, he might have floated a loan. The last mode to be considered was going public. For one thing, there were losses still ahead, and for another, it would entail considerable expense and diversion at a pivotal stage when the company could least afford the time and money.
Then Ferrofluidics was contacted, out of the blue, as Moskowitz recalls, by new issue -- hungry Muir. Public money would come in much more cheaply than a private placement or a loan, Muir argued. Stock dilution would be considerably less, and the underwriting fees would be lower than interest payments. "I said, 'Wait a second, we're not ready to go public,' " says Moskowitz. "But they made us an attractive offer. We weren't totally satisfied with the arrangement -- the timing, the price of the stock, the number of shares, and a lot of other things."
The new-issues market was then showing signs of slowing down after its hectic pace of the previous year. Aftermarket prices of growth stocks had peaked and were declining. And while, shortly before, underwriters had been launching new companies at prices well over preliminary estimates, now such open-arm welcomes for initial public offerings were cooling. Moskowitz sensed the chill in the air. But "on balance, the plusses outweighed the minuses," he reasoned. "We figured, there's a window now, and a window is finite in duration. Who knows when the next one is going to open? It could be a year, it could be five." If no less a hotshot firm than Muir, then the country's fifth leading underwriter (in dollar volume), was sure Ferrofluidics could successfully make its debut at this juncture despite having no track record to speak of, why cavil?
Ferrofluidics's board, however, thought otherwise. Moskowitz had to plead with them to take the public route, and eventually the reluctant directors gave him the go-ahead. "We didn't advise him to do it, but we acquiesced," recalls Harvey Mallement, a board member from Harvest Ventures Inc., a New York group that had invested some seed money. "Going public too soon is fraught with risk," Mallement counseled. "The public puts tremendous pressures on a company. With the amount of capital available in the private market, there's really no hurry." Mallement felt strongly that no company should consider going public until it has at least $500,000 in earnings -- about twice Ferrofluidics's profits that year.
On July 16, 1981, Ferrofluidics became a public company. The offering of 2 million new shares (plus another 500,000 from previous holders), at $2 each, went off without a hitch. After costs and commissions, the company netted $3.6 million -- more cash, even, than could be used at the time. The move cost Ferrofluidics $325,000 -- more, certainly, than the expense of a private placement. But if it hadn't gone public, it would have received less money and given away more of the company (perhaps twice as much Moskowitz estimates) through a private placement.
A born worrier, Moskowitz fretted that when Ferrofluidics began to report steady earnings, the per-share numbers would be embarrassingly low and dissuade new investors. And by coming out through Muir, with its reputation for obscure offerings, Ferrofluidics might be considered a rank speculation -- an appellation that made Moskowitz, with his visions of Ferrofluidics becoming a respected international conglomerate, most uneasy. As far as Moskowitz was concerned, Ferrofluidics already was becoming a blue chip -- the chip in question being the ubiquitous circuit etched on shiny slices of silicon wa fers that make electronic products smart.
Even if he had really wanted to worry, only in his wildest nightmares could Moskowitz have imagined John Muir goinging down the tubes a month later and taking with it a substantial inventory of Ferrofluidics stock. (And he could have added an epilogue: the demise about three weeks later of another FERO market maker, M. S. Wien & Co.) But the denouement turned out relatively happy. When Muir did depart the scene after running afoul of the SEC because of violations involving newissue disclosures, FERO stock was the only Muir issue that closed unchanged that hectic week. A Boston broker, Fechtor, Detwiler & Co., took in the Muir inventory that threatened to be junked into the open market. Moskowitz ascribes the rest of the firmness to the Ferrofluidics employees and vendors who, in coming in contact with the company's operations, wanted a slice of the action. They spoke for half the flotation and would have gone for more. "We didn't even need an underwriter," Moskowitz figures, with only a slight hint of hyperbole. "These people didn't know who John Muir was in the first place, so they could care less."
Sensing that there was bound to be apprehension about Ferrofluidics's impending market entry, Moskowitz had held a locker-room talk and informed his employees that they were going to remain a company oriented to the long term, despite attracting public stockholders who were accustomed to short-term results. "You can watch the newspaper every day to see what the stock price is," he coached, "but I'm not. The stock will follow the business in time." Sure enough, as Ferrofluidics's revenues soared (sales were up 60% in fiscal 1981), so did its stock. FERO was INC. 's leading stock market gainer for 1981 in a bad year for many high-tech issues (see INC., May, page 67), and ran up to 4 1/4 bid early in 1982, more than doubling its price within eight months of the initial public offering.
And if he kept to his no-peeking pledge, Moskowitz was spared the horror that was to befall the rest of the stockholders after the August announcement. In similar situations, many other public-company CEOs might have deferred or chipped away at the extraordinary loss until the books could absorb it and management wouldn't appear quite so inept. But not Moskowitz. You have to be unswervingly objective, he insisted, just as if you were examining the books to buy the business. "My definition of 'right' hasn't changed just because we have a few more shareholders," he declared. "Later on, we can always sell the inventory for more, and they won't get mad at you then."
His director of finance begged him to take the write-down more slowly, and the majority of his board complained that it was an exceptionally aggressive stance. But Moskowitz won out. "I communicate with my stockholders quarterly," he explains, "and I try to tell it as it is. We project ahead a quarter or two with clear visibility, and I had been telling them we expect to have losses all year long, even into next year. We don't try to cover up losses; we spotlight them. In dealing with any group -- shareholders, employees, or bankers -- there's nothing like candidness. You have a plan, you know where you're going, and you're taking steps to get there. The worst that can happen is somebody will disagree with you." Such disagreement was almost inevitable: On its now-open-to-the-public books, the write-down looked like an expensive meal of crow resulting from a poor business decision.
The presumably smug seller of the nowworthless hardware was a New England branch of Varian Associates, a Palo Alto, Calif., electronics company that was marketing a crystal grower of its own. But what couldn't be stated on the balance sheet was the intrinsic value of what else besides the obsolete inventory had been acquired from Varian. This included intangibles such as patents, a noncompete covenant, "low-tech" know-how of furnace assembly, and, most important, workers who could put everything together. "It's not high technology, but is it important! How can you inventory people?" Moskowitz asks. The self-contained team of experienced arc-welders, hardware designers, and other skilled laborers and engineers that came over from Varian helped Ferrofluidics pick up the pace toward production of its silicon crystal -- growing system. Now it expects to have several evaluation systems installed by February, and to be rolling shortly thereafter. The write-down can be considered to have paid for perhaps two years worth of time in systems develsion to scrap the latter. "One of the dangers of premature public offerings " notes Mallement, "is that decisions aren't always understood by the public." The decision was made in August. By accounting standards, the write-down had to be reported as part of the old year even though the fiscal year had closed on June 30. Trash-canning every cent of the obsolete inventory at once was a conservative accounting procedure, insists Mallement, himself a CPA. "I'm not happy with public companies that don't follow conservative practices. We had very little choice. It turned out that Ferrofluidics misjudged the cost of getting into business. That's not an unusual mistake for a small company when it's involved in a new product."
Most stockholders stuck with the company, according to Moskowitz's review of stockholders' names, even to the extent of buying more shares as the stock price plummeted. Despite Muir's forced silence on Wall Street, Ferrofluidics now has an impressive total of 20 market makers, including some major brokerage houses. "Every stockholder has come from brokers pulling in investors pulling in more investors. Not one has come from a corporate finance department. We're an anomaly of the process. It's the way it should work. There's nothing packaged, no one took it out there promoting bullshit. It was really a matter of that we needed some capital, and Muir got it for us." But Moskowitz also acknowledges that there is a cost in being public that is particularly penalizing in the early stages. "It takes more of my time, because ultimately people want to talk to the president of the company. That's what I mean by being premature. If it wasn't a public company, the time would be spent in looking at strategic opportunities or in building markets. In a small, emerging company, those are more critical needs."
Even so, not all was idyllic as a private company, either. Although the SEC wasn't looking on, Moskowitz's initial investors were. Some sat on Ferrofluidics's board. If expectations weren't met, as they weren't in the early years when the company fell badly behind, the investors wanted to know about it. "You could expect them to come visiting," Moskowitz puts it. "In many respects, the reporting requirements were even more rigorous. But the plus side is that they're a finite group. You call in three or four major stockholders, meet with them, and sort things out. And they're not afraid of losses, because that's what venture capital is all about."
There is a cash drain in being public as well, says Moskowitz, who estimates that the yearly costs exceed those of staying private by $100,000. When the quarter closes, there are 45 days to file a 10-Q form with the SEC, and those financial results are also sent to stockholders and the financial community. At the end of the year, a formal, slick annual report has to be prepared, instead of a typewritten letter from the president, and proxies have to be mailed out for corporate elections. There are attorneys and stock transfer fees and stockholders meetings. And none of the cost includes the half of the director of communications' time that now goes toward responding to stockholders and investment analysts.
Even though the furnace is yet to be proved -- and Moskowitz admits that a failure in the field could set the company back again -- the company is on to the next project. Ferrofluidics suffers what Moskowitz calls an "antidilemma": It enjoys far more opportunities in the technology of magnetic fluids than it has financial resources to pursue. But twice-shy Moskowitz won't go back to the public well to water the next idea. This time around, he is studying a research and development limited partnership structure, in which a separate body of investors takes the risk. "Any product we're looking at can afford reasonable royalties," says Moskowitz of his high-margin markets. "And the shareholders are happy, because they have more products coming sooner. Besides," he adds, "I don't want to bury the company in red ink as we did last year."
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