Earlier this year, Steve Schklair, CEO of 3ality Digital, instructed his finance department to start keeping the books as if he had to present quarterly reports to Wall Street. The reason? The CEO of the Burbank, California-based business, No. 378 on this year's Inc. 500, intends to go public. Last year, he rang up $21.4 million selling 3-D camera equipment and technology used in Hollywood blockbusters like The Hobbit: An Unexpected Journey and The Amazing Spider-Man, a more than 900 percent increase from 2007. As 3-D entertainment becomes more commonplace, he believes, 3ality's revenue could hit $1 billion. "As soon as Wall Street stops asking whether 3-D's a fad, it's time to IPO," Schklair says. He figures he will get his shot within the next three years.
Schklair will probably have to wait longer than that. Wall Street may have rediscovered an appetite for stock offerings. But investors have a very definite idea of what they want—and it doesn't look much like 3ality does today. These days, most institutional investors will hardly consider a company with less than $100 million in revenue and a valuation of at least $500 million—far higher than ever before, says Kathleen Smith, a principal at Renaissance Capital, which researches and manages investments in newly public companies for institutional clients. And that's just to get a foot in the door. Investors also want some assurance that these would-be IPOs are recession proof. That goes a long way toward explaining why most of the recent IPOs have been in the social networking, green-energy, and health care industries, all of which have grown even as the overall economy has stalled. "There's a frenzy for the Pandoras and LinkedIns, because they are doing something new, something structurally different," Smith says. "But fear still prevails."
Many founders have decided against going public—long considered the moment of arrival for young companies—and are casting their lot with private investors instead.
Despite the uptick in offerings—including LinkedIn's headline—grabbing $352.8 million IPO in May—it's still a buyer's market. Sixty-seven companies have gone public so far this year in the U.S.-compared with 109 in all of 2010 and just 48 in 2009. But there are still 106 companies that have announced their intention to go public, seeking a total of $20.4 billion, according to ThinkEquity, a San Francisco-based investment bank. A good number of those companies have yet to line up investors. "Last night, I had dinner with a friend in the cloud-computing business," says Tom Taulli, a tech consultant based in San Jose, California. "He had a glum look on his face. He'd just raised $40 million but doubted he'd be able to go public until 2013. And who knows if this IPO market is going to last?" So much for the frothy bubble that many observers have been fretting about.
No surprise, then, that many founders have decided against going public—long considered the moment of arrival for young companies—and are casting their lot with private investors instead. Take Robin Richards. In 1999, Richards's company, MP3.com, raised more than $344 million in a public offering just a year after it opened its doors. And how did that all turn out? In the wake of the dot-com bust, MP3.com was sold to Vivendi Universal in May 2001 for $5 a share—$23 below its IPO price. "There's pretty much no reward that could stimulate me to go public," says Richards, who now leads the job-search and social networking site TweetMyJobs.com. Richards says he's much happier working with companies that do not have to alter their strategies on a quarterly basis to meet Wall Street's expectations. Technology companies in particular, he says, require room to explore, experiment, and make adjustments—space that isn't afforded by Wall Street's increasingly reactionary trading culture.
Bob Parsons, CEO of Web-domain registry Go Daddy, has a similar outlook. Parsons has toyed with the idea of taking his company public; in 2006, he went so far as to file notice with the Securities and Exchange Commission. But in July, he decided to sell a majority stake to three private equity firms, for a reported $2.25 billion. Parsons will continue as executive chairman of the board and the single largest shareholder, but the new owners will decide when it's time for Go Daddy to go public. Should an IPO happen, Parsons won't be the one leading the charge. "I'm too much of a free spirit, an individual who likes to carve his own way," he says. "I've never been associated with a public company; I have no experience at one. You could call it fear of the dark, the bogeyman."
Decades ago, even small companies could raise public capital if they had healthy financials and a clear growth trajectory. In 1996, for example, 200 companies with revenue of $10 million or less went public; 41 of them had revenue of less than $100,000. In 1986, a landmark year for IPOs, even Oracle, one of the biggest names to go public that year (Microsoft and Sun Microsystems also went public in 1986), raised just $31.5 million, after recording $23.2 million in revenue the year before.
Today, Oracle's offering would be a blip on the radar. The 67 companies that had gone public as of mid-July raised an average of $360 million, according to data compiled by ThinkEquity—up 106 percent from the same period in 2010. LinkedIn raised $352.8 million when it went public, and was valued at more than $4 billion. Gaming company Zynga, which filed for an IPO July 1, seeks to raise $1 billion.
Both of those companies are in hot industries. They also had achieved considerable scale before testing the public waters. LinkedIn had revenue of $243 million when it filed. Zynga's revenue tops $597 million. Lots of other companies, and their investors, don't have the patience to wait that long before their liquidity events. As a result, entrepreneurs at small and midsize companies are choosing to sell to larger, strategic acquirers. That has removed a lot of hot start-ups—outfits that probably would have gone public a generation ago—from the IPO equation. Some notable examples: the personal finance website Mint.com, which was acquired by Intuit in 2009 for $170 million; Zappos.com, which was acquired by Amazon.com in 2009 for nearly $900 million; and, more recently, Admeld, a Web advertising firm, which was acquired by Google for $400 million in June.
What's more, Wall Street has outgrown smaller IPOs. Institutional investors have consolidated to a point that some of the biggest firms, such as T. Rowe Price and Fidelity, manage funds with hundreds of billions of dollars in assets. Behemoths like these might commit to large deals, but they don't bother with smaller IPOs, says Doug Gonsalves, who heads investment banking at ThinkEquity, which underwrote the recent offerings of OpenTable, Active Network, and Zillow. The investment opportunity isn't large enough, or the stock would lack sufficient trading volume.
As a result, the companies that are determined to go public must wait. Cornerstone OnDemand, a human resources software company based in Santa Monica, California, held its IPO on March 17—11 years after launching. The reason for the wait? Scale. Going public was part of the plan from the outset, says CEO Adam Miller. "We went public when we were able to attract top-tier banks," he says. "You have to achieve a certain market cap, or it's not interesting to them." In 2010, the company hired Goldman Sachs to underwrite the deal, which raised $136.5 million. Cornerstone estimates its revenue will be around $72 million in 2011.
By the time it went public, Cornerstone had revenue of $46 million, making it one of the smaller companies to IPO in 2010. Still, to reach that size, the company abandoned its original plan of financing growth through cash flow and took on two rounds of venture capital, one in 2007 and another in 2009. Taking on later-stage funding is increasingly common, says ThinkEquity's Gonsalves. But adding another round of funding also means ceding ownership and, in some cases, giving liquidation preference to new investors. That makes it more difficult for an entrepreneur to get a solid return on his or her years of hard work.
"I've invested a boatload of my own money into this, so there'd better be a liquidity event down the line," says one entrepreneur.
In addition to private equity, closely held companies also can take advantage of new marketplaces such as SecondMarket and SharesPost, which are designed to provide liquidity for shareholders in advance of an IPO. These markets assign a valuation to the company and allow well-heeled investors (participants must meet certain income or net worth requirements) to purchase shares from current shareholders. So far these markets have not been used to raise capital for companies themselves. But several social-media companies, including LinkedIn, Facebook, and Twitter, have used such secondary markets as a way to let employees exercise their stock options and bide their time while pondering or preparing for an IPO.
Some economists worry that the lack of access to public capital for smaller players could stunt economic growth and job creation. "This is a market in which Netscape and Microsoft could no longer go public at the stage that they did," says Reena Aggarwal, a professor of finance and business administration at Georgetown University. Sure, there's always private capital. But "the multiples you can get from private equity are much less than you could get on the public markets," says Paul Kedrosky, a senior fellow at the Kauffman Foundation, which recently unveiled a proposal dubbed "The Startup Act." Among the act's provisions: Ease access to public markets by reducing regulatory requirements for companies with market caps of less than $1 billion.
And yet for many entrepreneurs, the IPO remains the most prestigious rite of passage in American business. "It's the most exciting thing, the ultimate stamp of success," says Zach Nelson, president and CEO of NetSuite, which ranked No. 12 on the Inc. 500 in 2004. NetSuite went public in December 2007, one of the last companies to do so before the recession.
The longer road to the IPO means more pressure for entrepreneurs. But that isn't stopping the latest crop of young CEOs from trying. Schklair, of 3ality Digital, is one of the optimists. He acknowledges he needs to reach at least $100 million in revenue before he can get a suitable valuation, but an IPO will continue to be his goal. "I like the idea of building this company, and I think the IPO gives us the opportunity to build it further and take a little cash off the table," says Schklair. "I've invested a boatload of my own money into this, so there'd better be a liquidity event down the line." And if he has to wait, all the better. "We're in that steep part of growth—so we'll be worth a lot more."
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BURT HELM is a senior writer for Inc. magazine. In 2013, his Inc. feature “After the Squeeze” was awarded the Stephen Barr Award for Feature writing, and his stories “After the Squeeze,” and “Turntable.fm: Where Did the Love Go?” received awards from Society of American Business Editors and Writers. Prior to Inc. he worked as a reporter for Bloomberg News and a department editor for Businessweek. He is a graduate of Yale University with a double major in Physics and English. He lives in Brooklyn, NY.