An IPO for Everyone
Investment pioneer Bill Hambrecht foresees an entirely new way for companies to go public. His vision amounts to nothing less than an IPO revolution -- for founders and investors alike
It's no surprise that small-business owners today view initial public offerings with a jaundiced eye. Blame it on the dot-coms. Many acted as if doing an IPO in record time was their primary reason for being in business. And with so many dot-com failures all around us, the heady era of IPOs has come to a sudden end. -- Not so fast, says investment pioneer Bill Hambrecht. He believes the IPO game will change dramatically in the next decade or so. So dramatically, in fact, that thousands of small-business owners who never before considered going public could soon enjoy IPOs of their own. Consider it a sort of democratization of the IPO market. Small businesses with real products, real services, and real earnings will be greeted with open arms by a waiting investor public. But hold on. Can this be the same IPO market we've watched with equal parts envy and scorn during the Internet era? -- In fact, no. Hambrecht foresees the opening up of an entirely new market for IPOs, thanks to a Web-based version of what's known as a Dutch auction. (In a Dutch, or descending-price, auction, the price of a sale item opens high, then falls until it meets a responsive bid.) Assuming he's right, the rules for taking companies public will change utterly. -- Hambrecht's firm offers a variation on the Dutch auction, which he calls the OpenIPO. Its chief virtue is that bids from individuals are treated the same as bids from institutions. First, WR Hambrecht & Co. -- acting on behalf of a client company going public -- uses the Web to accept investors' bids for shares of the IPO. Next, the underwriter and the client company examine the bids, and the company decides the price at which it wants to go public. All qualified investors who have bid at or above that figure are allowed to buy a proportionate allocation of the stock at the IPO price. -- By contrast, in traditional IPOs, underwriters allocate IPO stock to institutional investors and select individuals, who buy it at a discounted price before it begins trading in the public market. -- To be sure, not every small business will suddenly be able to go public under Hambrecht's approach. But if your company meets certain, fairly basic qualifications, Hambrecht says, it could be a contender.
But who is Hambrecht, you ask, and who put him in charge? For starters, he's a cofounder of investment bank Hambrecht & Quist, which was acquired by Chase Manhattan, now J.P. Morgan Chase & Co., in 1999. Hambrecht has also invested in, and helped take public, many high-tech innovators, including Apple Computer, Genentech, and Sybase. Most recently, he founded WR Hambrecht & Co., a financial-services firm that offers the OpenIPO approach to entrepreneurs and investors.
Hambrecht, 66, discussed the changes coming to the IPO market with Udayan Gupta, an Inc contributor and the editor of Done Deals: Venture Capitalists Tell Their Stories (Harvard Business School Press, 2000).
Is there a new IPO paradigm?
There are many companies out there waiting to go public in a new structure and a new setting. I'd bet there's a huge number of companies, probably as many as 10,000, that are good enough to go public over the next decade.
How would a Dutch-auction IPO work? Where did the idea come from?
All investors get the share price they're willing to pay or lower. But by the same token, if there are six bidders out there and they're all professionals, none of the six can say, "I got a better deal than the other five." You've got to protect investors because you want them back every day. What is material to me as a buyer is that I get the IPO stock at the same price as the other guy does, and I don't look foolish.
I remember going to Amsterdam and looking at the flower auctions. I asked the flower growers why they sold flowers with a descending auction, and they answered that the buyers are all professional people: they do it for a living; they buy for the accounts of other people. I realized that, like flowers, an IPO is very perishable. You have to get rid of an IPO very quickly, or the demand will fade. And as in the flower market, most of the buyers are professional; you have to make them look good.
As I got into it and began digging, I realized a lot of academic work has been done on the subject. In Israel they've been doing Dutch-auction IPOs for decades.
How does pricing work in a Dutch auction?
In a hermetic environment, a Dutch auction should price IPO shares about 3% below what the highest bidder is willing to pay. Therefore, investors should have some more dollars to spend. But we found we don't deal in a hermetically sealed market, so 3% isn't enough. Instead, we found that the right discount price is somewhere between 10% and 15% -- enough to make the buyer feel really good, but not enough to make him flip.
That fits in very well with the original intent of the discount, which is to make you a long-term buyer and a happy shareholder.
Companies aren't interested in getting the absolute maximum dollar amount for their stock. They want a happy bunch of shareholders. And they're more than willing to give away a modest discount if that will start shareholders off on the right foot.
What new kinds of companies can go public through OpenIPO?
To go public, you have to have a successful business model that's going to survive over the long pull. Strong brands generally have that. Normally, a strong consumer brand or a strong business brand has value under any circumstance. So we look hard in the branded area.
There are a lot of personal-services companies that build up a franchise and that can be very attractive. But the business has to have gone beyond one person's ability to do business, and it has to have evolved either brand value or franchise value, or have a position in the marketplace as a permanent player. And if you're going to have a growing business and a permanent business, you have to be pretty geographically spread out -- both in the United States and abroad. You really have to know how to do business in the world markets.
You also must have people with business sense. It's the vision of management, more than anything else, that determines how a company is going to do. Good management comes in very different packages, and what you have to do, of course, is to look at the key players' record, their background. Are they people who know how to run businesses? Are they people who know how to build businesses? And if they're real young, it can be a real problem -- the way it was in the Internet space. Many of the really good ideas were generated by the young technology people. But they just didn't know how to run a business.
Can you give an example of a good OpenIPO candidate?
Ravenswood Winery is a good example. Taking that company public got them money that really was not available privately. It was amazing to watch the impact of the public markets on Ravenswood. They had a real sales spurt. They became kind of a national name. They already had a strong brand when we took them public; that's why we took them out. But going public really added to the value of the Ravenswood brand. If three years ago, someone had said that Ravenswood was going to sell out for $150 million [Ravenswood was acquired in April by Constellation Brands for roughly that amount], you would have said he was crazy.
It was the combination of public money coming in, the exposure the public market gave them, and also being our first OpenIPO that gave Ravenswood a lot of publicity -- and that spilled over into its sales. The company grew very rapidly, and everything worked.
"I'd bet there's a huge number of companies, probably as many as 10,000, that are good enough to go public over the next decade."
Going public adds tremendous assets to a company. It gets them money -- permanent equity money -- on a very reasonable basis. It gets them publicity. It allows them to expand their management group because of stock options and equity ownership. I honestly think the companies that go public are the companies that are going to survive.
In the last few years IPOs have been built on very dramatic assumptions and very aggressive growth plans, and have been marketed to a certain kind of investor. That investor is looking for the next Cisco, the next Intel. But I'm convinced there are lots of people out there who are more than happy to buy stocks in companies they respect that aren't necessarily projecting such dramatic growth.
That's one of the reasons why I think IPOs should be auctions: to go out to a company's affinity group and the individual investors who know the company's products, and to offer stock to them. That's the whole point.
We also found that in the institutional market there are lots and lots of middle-market investment advisers. They're always looking for new and unusual ideas and are willing to look in industries that are not in vogue. The whole point of the open IPO is to go out and reach buyers who don't normally participate in conventional, investment-bank IPOs.
Where will the next batch of these IPOs come from?
A huge portion of the pipeline is technology companies, but there are businesses in other areas as well.
We've had some success in the consumer-branded areas. For example, there are hundreds of independent wineries, and among them, there are a dozen or two that have very strong brands and that could be very good candidates for the public markets.
The model that I always have in my head is an initial public offering we did at H&Q for Neutrogena, the soap people. We did an offering for them back in the '70s. CEO Lloyd Cotsen had to buy out some of his partners and his father-in-law, who was the founder. Neutrogena went public and stayed public for over 20 years. And it grew. The people who bought that stock -- there were some who held it the whole way -- were rewarded when the company sold out to Johnson & Johnson for roughly $900 million.
"The whole point of the open IPO is to go out and reach those buyers who don't normally participate in a conventional IPO."
That was a perfect example of a company that went public to provide liquidity to its partners and to allow management to fix the balance sheet. It was a great cash-generating business, so Lloyd didn't have to raise any more money. He never had to sell out, and he didn't sell out until he decided that he wanted to do something else with his life.
There will also be some franchises that ultimately will go public. Some law firms will go public, because there are some very strong franchises in that field. Some venture-capital companies will go public -- I would love to own a piece of Kleiner Perkins. There are going to be a lot of businesses like that, where going public will be one way to capitalize on the value that the partners have built.
What about liquidity and exits? Are we looking at letting many investors into an environment where you encourage long-term investing and discourage short-term investing?
We're realistic enough to know that the biggest challenge is making sure that we can provide liquidity in the aftermarket. People will not buy IPOs if they think they won't be able to sell their stock later. We're now spending a lot of time developing Web sites that integrate research on small stocks with stock auctions.
Can you really create a new marketplace for companies that need capital?
Yes, if we can rewrite the definition of a successful offering. Companies don't have to subscribe to the notion that if the stock doesn't go up by 15% to 20%, they're going to dissatisfy the investor.
A lot of work needs to be done. First, you have to demystify the going-public process and take a lot of the costs out. If a company is getting a prospectus written and going on a road show, that ends up costing $2 million. That's a lot for a small company. We know now what part of the prospectus people read: they read the summary, they read the business strategy. I think investors would be happy if a company simply put its own projected business model on the Web, as some countries already allow.
There has to be a change in the way information is provided. At the moment, only a thousand or so companies get decent Wall Street coverage. We seriously think there's going to be a change in the way both analysts and investors do research. The Web gives you the perfect way to make research about small companies available to everyone.
To make an Internet IPO work, the underwriter has to show that it can create a real aftermarket, a liquid market, and be an information source about the companies that it is taking public. The reason Andy Klein's Spring Street Brewing Co. offering didn't work was that a pure Internet IPO won't work if people aren't assured there will be an aftermarket. [Because Spring Street Brewing acted as the underwriter for its own IPO, no investment firms made a market in the stock. Spring Street sold the stock and by default was the only buyer.]
To make our OpenIPO work, we had to build the Internet capabilities and provide both liquidity and information. Without liquidity and information, institutions will not buy a stock.
But I thought you wanted to cut out the institutions ...?
The average deal we've done is 50% institution, 50% individual. Make no mistake about it, the right institutions want to play. The right institution is the guy who has a dedicated small-company fund. But in the current process, those institutions also have been sifted out.
We are targeting the guy who really looks for special situations, who is part of a smaller fund that may be part of a bigger fund family. The whole point is not to exclude institutions, but to see that large institutions don't have a built-in advantage.
When did the lightbulb go off? When did you decide that a new approach to IPOs was needed?
I seriously started considering it after the Hambrecht & Quist IPO, in 1996. When we went on the road show, we suddenly hit a difficult market. There were some institutions that weren't going to buy our stock. But eventually, we hit a few who liked the story and gave big orders for the stock. The deal came together -- the market improved a little the week we were doing it. All of a sudden, all these institutions that didn't like the stock came in with orders. There was no way the other underwriters or H&Q could say no to them. We ended up distributing a lot of stock into the hands of people I knew didn't want it, who were buying it purely for the flip. So when our stock went up a couple of points, they flipped it. The guys who really wanted the stock ended up buying it in the aftermarket.
That's when I started thinking, "Why shouldn't we find people who really want to own the stock? Why should we give the stock to people who are going to flip it and only pay us back in commissions?"
Are there any experiences that reinforced your belief in the need for an alternative?
The Boston Beer IPO. My impression was that Jim Koch, the founder, really didn't want to go public. When he finally agreed to sell, he made it a condition that some of the stock had to be offered to his customers. Goldman Sachs and H&Q managed the deal, but neither knew how to do it. So Jim researched it and found out that you could advertise a new issue. He put coupons about the stock issue in his six-packs, and within a month or so we had 120,000 checks for a total of $55 million.
We didn't know how to distribute the stock efficiently. So we brought in Advest and a couple of brokers, rented a fulfillment program from Dreyfus, and eventually pulled it all together. But we gave only $15 million of the offering to Boston Beer's customers. We sent $40 million back. It bothered me. There was all this demand that was left unfulfilled.
What struck me also was the enormous retention rate for people who bought that $15 million worth of stock back in 1995. I made a deal with Al Rossow, who was then the chief financial officer, about tracking those shareholders. About a year ago, when Al left, about half of those people still held the stock.
It became clear to me what was happening. Your most loyal shareholder -- the shareholder you can bring into your IPO -- is either your customer or somebody who for whatever reason respects your company.
What was it about that high retention rate that you found so interesting?
That this was hopefully a way of building a brokerage business without having to advertise, especially with the advent of electronic brokerage and the unfulfilled demand that was out there.
I was convinced that the IPO stock was being distributed to the wrong investors. More accurately, the stock was not going to the right people, not to the people who really wanted to own the stock.
It was when I really started to look at our distribution at H&Q -- and started looking at other distributions -- that I realized the stock was systematically being placed in the hands of the big-commission players, who were usually not long-term investors. It's so much more profitable for the big investment banks to give the stock to institutions. The underwriters don't pay the brokers who sell to institutions very much, so the underwriters' gross margin on the commissions is much higher on institutional sales than on retail sales. Probably even more important, the underwriters have a reciprocal flow of orders from the institutions, and this means more commissions.
"Companies aren't interested in getting the absolute maximum dollar amount for their stock. They want happy shareholders."
I became convinced that as long as you've negotiated IPO prices that are below what the market is offering, you are, in effect, creating guaranteed profits for a group of investors. But you're also giving away something of real value, taking something away from the balance sheet of the company that's going public.
My reaction was to set up an underwriting firm geared to electronic brokerage that could place the stock more efficiently in the hands of long-term investors. At first, it hadn't occurred to me not to use a conventional underwriting form. But then I realized that the only way you could change the whole structure was through an auction.
Can you give any real-life examples of how Dutch auctions might work?
Take Instinet Group, which is a securities broker that offers institutional investors an electronic system for stock trading. Instinet is a believer in electronic markets. So when it was going public, it wanted to position itself as a new-age investment firm; it had thousands of trading terminals out in the institutional market. But it was afraid that under a normal negotiated deal, only a couple hundred of those customers would get Instinet stock, and the company would then have a very angry customer base. So the question for Instinet was, How do you satisfy that demand?
When Instinet decided to go public, its lead bankers agreed that we at WR Hambrecht would handle approximately a fifth of the offering. That allowed Instinet to tell its customers that if they wanted stock, they could go to our Web site and make a bid.
It was a fascinating experience. The Instinet IPO this past May was a 32-million-share offering, a $464-million deal. Our share was approximately 6 million shares. We could have done the entire deal ourselves. We ended up with bids for 74 million shares. Credit Suisse First Boston, the lead bankers, wanted to price the Instinet offering at $12 to $13. But based on our bid prices, CSFB ended up having to price it at $14.50. The stock opened at $18.50 and has traded around $17 to $20.
To me this is a perfect example of the Dutch auction's finding the right clearing price. It found, almost to the dollar, what the offering price should be.
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