The anatomy of an initial public offering
The process of going public is not as mysterious -- or as costly -- as many private-company owners think. In fact, despite such hurdles as having to switch underwriters in midstream, an expensive delay due to an unexpected audit, and the shock of last October's Crash, Alan S. McKim, CEO of Clean Harbors Inc., swears he would do it again. Let's use McKim's quest for "Other People's Money" to take a look at some of the costs and benefits of becoming a public company. -- R.A.M.* * *
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On November 24, 1987, barely four weeks after Meltdown Monday, Clean Harbors Inc. boldly sold 1 million shares of its common stock to outside investors. In so doing, the seven-year-old environmental-services company changed from a private to a public corporation, and its founder from a Street-unwise innocent who had spent nine hectic months putting the initial public offering together to a contented multimillionaire with a well-financed enterprise to grow.
The transmogrification did not come without a price. For the Massachusetts-based company (symbolized as CLHB on NASDAQ), that price was a palpable $750,000. To it, however, you really should add another $13 million -- the sum that to all intents and purposes was snatched from the CLHB treasury when, on October 19, fate gave CLHB founder and chief executive officer Alan S. McKim what is known in the money trade as a haircut.
It wasn't entirely his fault that the CLHB offering was one of a mere handful of companies to go public in the month after the market collapse. If everything had progressed as planned, CLHB's deal would have gone off a few weeks before, when the IPO window was still wide open. It met unexpected delays, though, and the issue didn't pass through unscathed. The Crash had instantly fried the staple that makes public offerings possible -- Other People's Money -- and McKim had to make severe concessions to ensure he got some of whatever OPM was still available. "One reason we went," he explains, "was to prove we were a viable player in the industry and in the market." More important and less macho, OPM would go a long way toward reducing CLHB's long-term debt -- by then more than $11 million, and most of it personally guaranteed by McKim.
In attracting sufficient OPM to enhance YOM -- Your Own Money -- there are two basic strategies: 1) promise to return it eventually, thus bonds; 2) keep it and don't promise anything, but convey a piece of the action, thus common stock; and, recently, 2a) convey a piece of no action. Not only have this decade's eager investors been willing to donate to businesses with no product, such as biotechnology companies, but to businesses with no business, such as blind pools. Despite the evident eagerness of OP to part with their M, many a private company chooses to remain private merely to escape the prospect of anonymous shareholders peering over its shoulder. Of course, such is the privilege of public ownership, however fractional, and cutting the hoi polloi in is an undeniable cost of OPM. Other than that, though, OPM comes with no strings attached -- once you learn the ropes.
Learning them, warns McKim, is an arduous process. "When the costs start building -- accountants, lawyers, printers -- you begin to have second thoughts. 'I'm supposed to be doing this to raise more money, not to spend more money.' " Even as the bills pile up, though -- or because they're piling up -- it's worth seeing through to the end. "The experience was like being pregnant," surmises McKim in rapturous retrospect. "Every day for nine straight months it was on my mind. Then suddenly one day, it happened." Until that day, CLHB shares had not been freely exchangeable, nor was there an unarguable dollar value that could be assigned to them as collateral or as currency in acquisitions and other dealings. Now, there was.* * *
From the company's founding in 1980, Alan S. McKim had brought Clean Harbors to $46.7 million in revenues for fiscal 1987 with no outside financing other than conventional bank loans. That spring, he decided to consolidate CLHB's expanding position in the competitive industry by going after equity investments. Actually, equity investments went after him. Along with visible growth inevitably come blandishments from venture capitalists and investment bankers, eager to help with such financing. From a passel of eager representatives of both camps, McKim began negotiations with venture capitalists he felt willing to sell part of his company to, and interviewed investment banks capable of underwriting a public offering for late summer or early fall.
On August 19, he formally concluded the private placement, selling about 18% of the company to some venture capital investors in Boston for $5 million. Cost: dilution of his percentage of ownership, theretofore 100%. And he got more than just money. "The firm helped us choose an underwriter, and they brought us credibility," McKim acknowledges. "Now an underwriter could say, 'Here's a company that also has recently done a private placement with a reputable firm, so they must be a good company.' " The same source of credibility became important as a sales pitch at the other end as well; potential customers for the stock could see that professional money managers had been involved prior to the offering.
An important factor in deciding who should manage the offering, McKim learned, is not only how the deal is handled or what its terms are, but the support the underwriting firm does or doesn't provide after it's done. Does the firm continually research a company and publish reports on it for prospective investors? Does it understand and have a commitment to the industry? Will it make a market in the company's stock? Investment bankers have been known to underwrite an IPO, then act as if they'd never heard of it once the flotation is out. Lacking such promotion in the aftermarket, particularly among institutions that can buy large blocks and thus buoy the price, a stock may fall of its own weight without being undermined by negative developments. If that happens, shareholders become disgruntled and sell even more stock into the decline; then market value shrinks, and acquisitions and additional financing become difficult.
One of the underwriters McKim favored that March was Kidder, Peabody & Co., a prestigious New York City broker with an investment banking arm. Kidder wanted exclusive "left-side-of-the-page" status as sole manager of the deal, as opposed to being part of a team of two or more comanagers that prominent IPOs often use. McKim didn't like the idea of putting all his eggs in one basket. Kidder countered that it had a cadre of environmental-services experts who would be able to market CLHB's stock and talk it up strongly in the aftermarket, and at first McKim agreed.
Another problem arose, however: McKim determined that some of Kidder's corporate customers were competitors of his in the industry (indeed, at that time McKim was negotiating with one of Kidder's customers). Kidder didn't acknowledge a conflict, inasmuch as a given investment bank often services more than one company in the same industry. But McKim appraised the relationship as chancy. "We felt it would be difficult for them to take sides with the big players and at the same time push Clean Harbors." In August, a lesser light -- Robertson, Colman & Stephens of San Francisco, a specialist in emerging growth companies -- was brought in as a comanager. A month later, Kidder, Peabody withdrew. "A smaller firm was right for us," McKim concluded, "because we were a small firm as well.'
The same logic didn't hold when it came to a CPA. Before the task of compiling financials for the registration got underway, McKim had ditched the accounting firm that had brought him this far, and switched to one of the Big Eight. With someone like Arthur Andersen & Co. signing off on it, the offering would take on substance in the eyes of investors. CLHB's next audit was an eye-opener -- for McKim. Not only were the fees "much higher," he was to discover, "but the scrutiny of our books was far greater than we had been used to." Not that it was all Arthur Andersen's doing. The rules of an IPO seeking more than $7.5 million in public funds oblige the corporation to audit and report on any significant acquisitions made in the previous three years. CLHB had acquired two subsidiaries of a large corporation in that time, but they were so minor that they had been spun off without audits. The new auditors had to go back and reconstruct pro forma figures as best they could. That painstaking process, McKim calculates, cost an extra $150,000 in pre-IPO accounting fees, and held up the offering a precious two months.
Ordinarily, such a lag would not have resulted in the 40% fleecing that Wall Street laid on CLHB in November. At worst, in the span of several weeks a bull market might roll over into the beginnings of a bear market, and demand for IPOs would slack slowly enough for investment bankers to fine-tune downward adjustments as it faded. That way, no one gets a haircut; a trim around the edges, maybe.* * *
With few exceptions, an intent to sell securities to the public has to be registered with the Securities and Exchange Commission. The SEC screens the application and usually finds a few things that have to be cleared up for the protection of investors. For example, unlike CLHB's, whose issue entirely comprised authorized but unissued stock, offerings that consist wholly or mainly of prior stockholders have been ruled ineligible for various reasons. The avidly watchdoggish SEC will give the go-ahead only after everything is deemed kosher.
CLHB had so many contracts, each of which had to be described at length, that the completed document it filed with the SEC in September was close to a foot and a half thick. Since public investors are unlikely to peruse any tome that barely fits under an airplane seat, the essential information is distilled into a 60-page-or-so brochure called the offering prospectus. (The exhibits themselves are stored in the attic of the SEC.) In it, every situation that has a bearing on the business, however remote or embarrassing, is described. The results of gathering such minutiae -- a process known as due diligence -- can make surprisingly florid reading.
Airing typical corporate laundry in its own prospectus, CLHB confessed that it had provided the executive vice-president and his family with two cars for personal purposes, and also had provided him with certain sums in connection with the education expenses of a family member. Then there was the matter of one plane and two helicopters that CLHB was leasing from a certain B & A Leasing Corp., to which CLHB had made sizable loans. Explaining away a modest fleet of aircraft probably would not have needed such copious detail as appears in CLHB's prospectus, had not a major B & A stockholder been one Alan S. McKim.
By simply studying the information required of every prospectus, not only can everyone in the western hemisphere, including salaried employees, calculate how much richer the founder is becoming with each uptick in his company's stock, they also can note how much he and fellow executives are paid. "It's discouraging for others to see the higher salaries," McKim frets. "I certainly didn't like my salary out there." If employees become surly, they can be mollified with stock options or other diversions, but the required table of upper-management compensation also has the potential of turning key officers into expensive fodder in industry infighting. 'Hello, Mr. Jones? I see you're making only $70,000 over at Purified Waters; we have a similar position here at Sanitary Landfills, and we can offer you twice that." No wonder McKim considered doing his IPO in London instead. Here, he complains, "You end up showing your competitors exactly what your business is.'
While the SEC reviews the prospectus's contents -- over a period of time that can range from a few weeks to a few months -- the underwriter prints a preliminary version known as a "red herring" (probably because large red letters on the cover page warn readers of the contents' changeable status). Bearing the underwriter's guess as to what the price of the offered securities will be, the humble herring is disseminated to prospective investors. In one endless night at a Boston financial printer appointed with beds and big-screen TV, McKim camped out with a battery of accountants and lawyers -- CLHB's counsel, of course, on the clock even as they napped. "It was very tedious," McKim recalls. "Every single word had to be checked and analyzed. If we wanted to say that the business believes it is the largest company in New England providing a full range of environmental services, the lawyers would worry that certain phrases could be misinterpreted and get us into trouble." It falls to attorneys to forge the subtleties of prospectus prose, but a CEO has to be present, says McKim, "to make sure what they say is the way it is." And the CEO had better be right, because the burden of accuracy falls on his company. The nit-picking so rattled McKim that he decided to visit his wife and kids sometime around 3:00 a.m. "You guys can make the changes," he counseled the attorneys. "I'm gone.'
But he wasn't gone for long. After the prospectus was put to bed, McKim embarked on what are called road shows. Organized by the underwriter, the shows take place before gatherings of well-fed institutional investors, and consist of presentations of the company, its management team, and its proposed deal. The grueling and repetitive nature of the shows compares unfavorably to a political campaign, observes McKim. "We'd end a breakfast meeting in Chicago and rush out to be in Minneapolis at noon for lunch. Then back to the airport to make dinner that night in New York. By the time you're done, it's close to the next day.'
For two weeks McKim and two other CLHB officers scoured the country's financial centers, flipping charts, screening slides, and avoiding rash predictions (the SEC allows discussion of only what's already in the prospectus). The underwriter keeps tabs on how much is ordered at what price: 10,000 at $9.50; 30,000 more at $9; another 50,000 if the issue goes off as low as $8.50. "As you travel from city to city," McKim remembers, "it's like finding out how many people are voting for you. You call up after each show and ask how's the book? What's the pricing like? If nobody ordered any, you think you did a lousy job.'
After the road shows' tents are folded and major customers have declared for or against, the underwriter's book collectively determines at what price within the target range the entire flotation can be sold. If the price is lower than hoped for, the company might reject it. When the SEC acknowledges that all the disclosures have been properly stated, the final price is announced and printed -- in black -- on the publication's now-slick cover. The SEC's effectiveness declaration is valid for 90 days, during which interval -- not to waste time, usually that very morning -- the deal is consummated as the underwriter at last signs, and the security starts trading in the public market. If the stock was fairly priced and the CEO goes back and does his job well, it should go up and up and make everyone -- you and the Other People -- exceedingly rich.
As it turned out, CLHB's stock not only was fairly priced, but was significantly underpriced. Had the issue emerged before October 19 as planned, McKim intended to sell as many as 1.5 million shares of common stock at as much as $15 each, for a possible gross of $22.5 million. After October 19, the underwriter discounted the offering to 1 million shares at $9 each, a gross of only $9 million. Before the meltdown, based on fiscal '87's earnings, at $15 per share the IPO was pegged at a hefty price-to-earnings ratio of 44 -- then not out of reach for a dynamic company in a surging industry. But with the collective price/earnings ratio of the conservative Dow Jones Industrials having been trimmed from over 20 to 15.9 in a couple of months, even the multiple of 26 to which CLHB's share price was reduced could have met with resistance from Crash-shocked investors.
McKim could have postponed the offering and tried again later, but after all this effort and expense, CLHB was ready and, come hell or high water, CLHB was going. The disappointed McKim shrugged off the damage as a cost of doing business. At that, it's a cost many would gladly pay. As owner of 4,716,082 shares, on the day that CLHB went public with a million more, even at $9, its 32-year-old founder was verifiably worth $42,444,738; his two children, holders of 140,000 shares in trust, another $1,260,000.
After offering costs and the underwriter's discount, Clean Harbor's IPO netted more than $8 million. Combining that with $5 million received three months earlier from venture capital investors, CLHB repaid more than $12 million of its indebtedness in fiscal 1988 and stands to save considerably on interest expense. Indeed, perhaps $1.2 million in the next full year. On each of the 6.7 million shares outstanding after the offering, nearly 18¢ that earlier would have gone to debt service now will appear on the bottom line as instant earnings. Even 8¢ a share in aftertax earnings is significant for a stock selling at a P/E of 26: it would translate to $2.08 a share in CLHB's stock price, an extra $14 million in its market value (number of shares outstanding multiplied by price per share), and a $9.8-million increment in the founder's personal net worth. The wonders of OPM!
By March, CLHB stock had climbed past $15 in the open market, proving that the precrash price was tenable postcrash, after all.
It was a nice, if bittersweet, ending. But for McKim, that wasn't the whole of it. In July 1988, approximately eight months after its original offering, Clean Harbors Inc. sold a second stock issue, this time of 1.1 million authorized shares, plus 255,591 additional shares from selling stockholders.
Why so soon? Because there wasn't enough stock out there in the public market to interest big money, McKim felt. Companies with a float large enough to accommodate institutional buyers and sellers get almost 60% more for their stock than similar companies with an insubstantial float, he determined, concluding that CLHB's own stock had been hurt that way. His insistence on pressing ahead after the Crash with a lesser amount had come back to haunt him.
Not too pitiably, however. "The experience was fantastic, and I would do it all over again," exults McKim, apparently a glutton for punishment as well as for a decent standard of living. "I wouldn't even change the timing.'
In a trailer parked in a suburb of Boston, virtually within nose-shot of the country's dirtiest harbor, 24-year-old Alan S. McKim founds Clean Harbors Inc. (henceforth CLHB, its NASDAQ symbol) to transport, treat, and dispose of hazardous materials. Capitalization: $13,000. Employees: 4. CLHB books its first Fortune 500 customer: Texaco. CHLB hires local firm, Gerald T. Reilly & Co., as certified public accountants.
Dow Jones Industrial Average: 785
Fiscal year ends, revenues $1.5 million. Employees: 18.
Fiscal year ends, revenues $4.2 million. Employees: 34.
CHLB acquires two small divisions of a large corporation for $3,240,335.
Fiscal year ends, revenues $32.2 million. CLHB in good shape; long-term debt about $5 million. Employees: 287.
McKim receives first query from venture capital firm: does he want to raise some capital by selling part of the company?
McKim receives first query from investment banker: does he want to raise capital by going public? McKim figures he's pushed bank borrowing far enough, mulls over both queries.
CLHB amicably fires CPA Gerald T. Reilly & Co. Reason: accounting firm too small. Besides, in IPO, big-name CPA connotes credibility. Arthur Andersen & Co. hired.
Fiscal year ends, revenues $46.7 million. Employees: 380. CLHB undergoes corporate reorganization; new entity is legal parent of all eight subsidiaries acquired over the years.
One-hundred-percent owner McKim wants employees to "feel some ownership," so splits his stock 269-for-1. Automatic multiplicity of shares enables CLHB to initiate stock-option plan. Key employees offered options to buy stock at equivalent of $2.70 per today's share. Pretty good deal: fair market value independently appraised at $5 a share.
With the intention of going public in early fall, McKim completes interviewing of underwriters. His criterion is not so much the particulars of the deal, but how much promotional support underwriter can provide after it's done.
After interviewing five serious contenders, McKim selects Kidder, Peabody & Co. Main reason: it follows and understands environmental-services industry.
Traditional all-hands meeting to sketch out responsibilities and sequence of events takes place in offices of CLHB's attorneys. More than a dozen functionaries from both sides in attendance.
Appears offering could go off about $15, or about 44 times '87 earnings.
CLHB hires small West Coast investment banker, Robertson, Colman & Stephens, to comanage deal. McKim's reservation: because Kidder had other customers in the same industry, possibly Kidder wouldn't pay proper attention to CLHB; a small firm is more attuned to a small business.
Stock is split again, this time 18.52-for-1. The odd divisor handily turns the number of outstanding shares into an even 5 million. In addition, nearly 18% of CLHB is sold for $5 million to venture capital investors, chosen from among other interested venturers "primarily because of their knowledge of the industry." The arrangement adds 638,994 shares to outstanding stock. Based on the sale, CLHB worth about $26 million.
As bull market roars, $15 a share cinched. But not quite: as it turns out, this is the Dow's all-time high.
Arthur Andersen finishes reconstructing the financial effect of the April 1985 acquisitions. (The divisions did not have separate audits when acquired, and the SEC requires pro formas showing effect of recent acquisitions as if acquired three years before date of offer.) Cost: $150,000; 60 days' time.
Directors vote to authorize 20 million shares of common stock, of which, after the IPO, 6,638,994 would be outstanding. The rest could be sold in future offerings, used for acquisitions, provided to employees, or merely allowed to sit there.
Because of possible conflict of interest, Kidder, Peabody withdraws. Robertson, et al, becomes sole lead underwriter.
Offering registration filed with SEC. IPO is planned within 45 days for 1.5 million shares at $13 to $15. Official waiting period begins, pending SEC sanction. During the period, CLHB and its underwriter discreetly market the shares via red herring (printing costs: $150,000). All systems go.
Various conferences with underwriter, begin to discuss possible 1) postponement, 2) repricing, 3) resizing, 4) withdrawal of IPO. Final decision: reduce price by 40%, from $15 to $9 per share; reduce size by 33%, from 1.5 million to 1 million shares; reduce net to CLHB by 60%, from around $21 million to around $8 million.
Road shows begin. Underwriter arranges for McKim and fellow executives to fly in and out of money centers across the country, talking up CLHB to gatherings of prospective purchasers. Some days they visit three cities. First city: Boston.
Road shows end. Last city: San Francisco.
CLHB sells 1.063 million shares of common stock (the underwriter went slightly over the allotment, as is its "green shoe" prerogative) to public at $9, nets $8,147,305. With 6.7 million shares outstanding, CLHB is worth more than $60 million. Not a seller himself, CLHB founder now holds 71%, or more than $42 million worth.
Stock falls to $8.50 bid. Was it pricey, after all? CLHB founder now holds $40 million worth.
Fiscal year ends, revenues $73.5 million. Employees: 680. Financials show that more than $12 million of debt has been repaid through proceeds of the two 1987 stock sales.
Stock surpasses $15 price McKim originally had hoped for. Of course, CLHB doesn't get a penny of the $6 the Crash gypped it out of.
McKim receives M.B.A. from Northeastern University, no doubt to the satisfaction of professor of management Daniel J. McCarthy, a director of CLHB.
Because the scant number of public shares available in the open market is inadequate to satisfy institutional buying, to increase its float CLHB files for a secondary offering of 1.1 million additional shares; stock now trading at $15.50, CLHB now worth more than $100 million.
Filing becomes effective, CLHB sells 1.1 million more shares at $15.50; this time, some shareholders piggyback on the offering by selling 255,591 of their own. CLHB now worth about $125 million. As owner still of about 58%, founder now worth $72 million.
Massachusetts governor breaks ground for $6.1-billion cleanup of disgracefully vile Boston Harbor. Clean Harbors stock bid $18.50. Employees: 831.
WHAT ARE THE MOST COMMON ARRANGEMENTS WITH AN UNDERWRITER?
The best underwriting agreement to work toward is a firm commitment. In it, the investment bank serving as underwriter guarantees to buy all the securities at the offering price (less its fee, usually 7%). The underwriter risks being able to resell them to outside investors, swallowing any that remain unsold. After the crash, Clean Harbors' underwriter understandably got nervous about so sweeping a commitment, and drastically reduced both the offering price and the number of shares.
For a company whose stock is not that much in demand, there's the best-efforts underwriting, in which the underwriter acts as an agent selling as many as it can to third parties. Usually, there is a predetermined minimum under which the deal is canceled. Common stock in only modest demand is often dressed up with a warrant "kicker" (a free certificate for more stock at a certain price in the future), and sold as a unit. The problem with best efforts is that if sales fall short of expectations, it's almost impossible to prove that the underwriter didn't try hard enough. A company can always skip an underwriter altogether, and struggle through the IPO process on its own.
When a public offering looms too large for a single investment bank to guarantee as lead underwriter, one or more underwriters may join in as comanagers, pooling the risk. One is apt to be strong in institutional buyers, another in retail, another a specialist in the industry involved, and so on. For Clean Harbors' 1.1-million-share offering of July 1988, made barely eight months after its initial public offering, the original underwriter was joined by a comanager.
WHAT IS A SECONDARY OFFERING?
A major benefit of going public is that once accomplished, a company can return to the public marketplace for additional financings. The subsequent times around, the offerings need not consist of common stock; for example, because there is now an independent value for that stock, a flotation of convertible debentures (debt obligations that can be changed into common stock if doing so is advantageous to the holder) is more readily priced and sold.
The procedure is the same as for an IPO. It includes SEC filings, using an underwriter, and road shows. Sometimes insiders piggyback their shares on secondary offerings of company stock -- a handy way to cash out large blocks without depressing the stock price.
HOW DOES AN IPO GET PRICED?
In a firm commitment such as Clean Harbors', how many shares to issue and what to charge for them ultimately is the underwriter's call. The decision is based on a tricky blend of factors. Among them:
1) Phase of market; for obvious reasons, an IPO is apt to do better in a bull market than in a bear market.
2) Price-earnings ratios of companies with similar book values and similar growth records.
3) Investment interest in the particular industry; when CLHB's IPO was in preparation, waste-management companies were in demand.
4) Whether the company is well known and its IPO is apt to be "hot.'
5) How the issue will affect book value per share; the more stock issued and the higher the price, the severer the dilution.
Every underwriter has a network of potential investors -- institutions, brokerage houses, retail customers -- that it can sound out to determine an allotment and a rough price range. The allotment is fixed early on, and the price is settled only at the last moment after the road shows are completed and firm orders are booked. The price settles at the level where the entire allotment can be sold without going over. Thus a buyer bidding $8.50 for Clean Harbors stock wouldn't have gotten any; a buyer willing to pay $10 would have had its order filled at $9.
Although an underwriter can back out of a deal up to the last minute of the last day, few do. If there is any doubt that a given price or number of shares is tenuous, better to get institutions to commit to large chunks by underpricing and/or underallotting the issue. But by how much can be an elusive calculation, even for experienced underwriters. In 1986, Home Shopping Network Inc.'s underwriter badly missed that price level when it sent off the IPO at $18 a share, only to see the stock soar virtually straight up to $282 (on a presplit basis). The under-allotted 1-million-share initial public offering of Genentech Inc. in 1980 was released at $35. Demand was such that in a few hours it was selling for $89, and closed at $71.25.
WHAT ABOUT FOREIGN EXCHANGES?
A company doesn't have to go public in the United States. The practical foreign exchanges for a small-company IPO are London, Vancouver, and Toronto. CEOs find London appealing because of its shorter and more readable prospectuses, among other things.
Some foreign-exchange complications:
1) currency fluctuations affect stock values;
2) lack of prestige;
3) awkwardness in using the shares in acquisitions and key-employee incentive programs.
Among recent London IPOs: Mrs. Fields Inc., Borland Inter