We've all heard the horror stories about just how inhospitable the market for initial public offerings has become. Over the past few years, the number of IPOs has shrunk to a small fraction of what it once was, and tons of respectable companies have seen their carefully conceived and road-tested offerings dismissed without so much as a ho-hum. For those that did manage to raise money publicly, only a few had stock that traded above its initial offering price. In sum, it's been an ugly, ugly world.

So what do you do if you're sitting on top of a company that's doing very nicely, thank you, but needs capital to keep growing? You don't give up. Market conditions have actually begun to stabilize a little, and 2002 could end up being a better year for IPOs in general than last year -- even for small companies, according to the investment bankers that Inc interviewed. "For companies that have their act together, where the fundamentals are good and they're growing the business ... generally, it's a great time to go public," says investment banker Michael Ogborne, director of corporate finance at Thomas Weisel Partners. "The reason is the amount of attention that a good company today is going to get on the road, because there's no one on the road." In the first quarter of this year, his firm counted just 70 IPOs in registration, compared with 120 in the same period last year.

Now that all those flash-in-the-pan dot-coms and starry-eyed founders looking to retire to Bali are no longer clogging up the calendar, market players can focus on helping solid companies with real capital needs fund reasonable expansion plans. "Institutional investors do want 'in' to growth companies and do want to invest in IPOs," says Morgan Stanley managing director Chris Pasko. "What has changed is the definition of a good growth company."

Perhaps not surprisingly, that definition is back to what it used to be. Companies need --

A vibrant industry sector. If you run an Internet or telecommunications-equipment company, you're probably out of luck. But if your company is in health care or life sciences, sectors that have held up relatively well in recent months, you're at least in the running. Software companies will likely make good IPO candidates this year, says Ogborne, because they tend to have fat gross margins -- in the 80%-to-95% range. "Our software pipeline is as good as it's been in 18 months," he says. "There are not 30 companies in it, but there are 10 really solid companies." He also expects to see deals happening in the consumer, financial-technology, semiconductor, and IT-services sectors.

Good numbers. Profitability is a must -- if not now, then definitely within a couple of quarters. As for revenue growth, investors still want to see it, but they've reined in their expectations. These days they're looking for 30% annual growth, not 300%. The minimum threshold for actual revenues depends on the industry. For a software company, $20 million to $45 million in annual revenues is fine, but a consumer-oriented company probably needs to be bigger. Life-sciences companies can go public with smaller revenues -- less than $20 million -- depending on their stage of development.

WIDE OPEN: "For companies that have their act together, it's a great time to go public," says investment banker Michael Ogborne. "There's no one on the road."

Impeccable books. In the post-Enron world, strong business fundamentals aren't enough. IPO wanna-bes have to be purer than pure. That means, for instance, being extra careful to follow Securities and Exchange Commission guidelines on revenue recognition by recording sales only after goods or services have been delivered, not when the sale is made. And it helps to have ample reserves to guard against delinquent customers. "The scrutiny is higher than it's ever been," says Ogborne. Aspiring public companies, he says, "really need to make sure that there's nothing weird or out of order in their financial statements."

Seasoned management. Twenty-five-year-old CEOs fresh out of B-school are out. Management teams with plenty of operating experience in tough times are in. And the longer they've been working together, the better. That said, if you don't already have a chief financial officer who has experience in dealing with Wall Street, hire one now.

If your company can play by these new (old) rules and you decide to try to climb Mount Everest, then it's time to take that first and perhaps most crucial step of finding yourself an underwriter. --Emily Barker

Going Public the Right Way

Popular wisdom has it that IPOs are all about timing, timing, and timing. But that's just not true. The fact is, even the best-timed IPOs can be problematic for companies that attempt to go public with the wrong underwriting firms as their partners. That's "wrong" as in too small, too inexperienced, too undercapitalized, or too far off the beaten path. That's also "wrong" as in "I never even would have thought about going public if this underwriter hadn't knocked on my door and convinced me that I could do it."

Consider the experience of Rebecca Boenigk and her mother, who started a company 13 years ago to build ergonomically designed chairs. At the beginning, going public was the farthest thing from their minds. But then their manufacturing company, Neutral Posture Inc., based in Bryan, Tex., grew so rapidly that it made it to the ranks of the Inc 500 in both 1995 and 1996. Meanwhile, the market for IPOs was thriving, and newspapers were full of accounts of everyday entrepreneurs who had managed to carry out the deals. "By then our sales were at about $12 million, and we were really thinking about it a lot," Boenigk recalls. "Among other things, it seemed like a great way to bring some cash flow to the family, keep control of the business, and help us finance some acquisitions."

Through personal contacts, the CEO started to have conversations with a small regional investment firm about going public. "I was so naïve," she recalls. The fact that running Neutral Posture was the only job she'd ever had as an adult -- and that the investment firm she chose had never carried out an IPO before -- didn't seem like obstacles. Neutral Posture's IPO came to market in October 1997 with the sale of 1.3 million shares of stock (900,000 from the company and 400,000 from the owners and other family members). With an offering price of $6 a share and total fees of more than $1 million from its underwriter, law firm, and auditor, the company and inside shareholders cleared about $6 million. The shares traded on the Nasdaq.

But things went downhill fast. "We stayed at $6 for a little while, maybe a few days. Then the stock went down from there," Boenigk says bluntly. "It didn't seem to matter what we did or what was going on at the company. We even went so far as to hire an investor-relations firm to issue press releases. Nothing helped." When Boenigk used the special password that the Nasdaq had given her so that she could check out who was making a market in her stock, it appeared to her that her underwriter was making the lowest bid to buy and the highest ask price to sell, thus providing no support for her stock.

Even the best-timed IPOs can be problematic for companies that try to go public with the wrong underwriting firms as their partners.

By the time the shares had tumbled to $1.10, the CEO had had enough. "It was a horrible situation. I thought we'd be able to use our stock for acquisitions, but it was practically worthless," she says. "I thought the family would get liquidity, but from the moment of the IPO no one in the family or management ever sold a share. Meanwhile, our outside board of directors was blocking us from trying out new product-diversification efforts for the company. And it was costing us $250,000 a year for all the accounting, legal, and reporting work we needed in order to comply with the regulations for public companies."

Four years after going public, Boenigk took her company private once again, at a cost of about $3 million ($2.27 per share, plus several hundred thousand dollars' worth of professional fees). "Fortunately, we've continued to grow, and we're now at $17 million in revenues. But if I had to do it over again, I would never have gone public," she says, "especially not with an underwriter who couldn't support us."

All underwriters are not the same. Some make promises they can't keep. Some are capable of taking a small company public -- when the market cooperates -- but don't have the resources to help its stock thrive afterward. Some end up abetting the worst blunder a company founder can ever make, by persuading him or her to go public when the timing seems right but really isn't -- or when another source of financing would be a far better option.

It's a reality that many business owners choose to ignore. When big investment banks with well-established reputations on the IPO front won't give them the time of day, many entrepreneurs are willing to take their chances with any underwriter that will talk to them. These days, of course, no one is doing too much talking. But when the IPO window next opens wide, there will be plenty of smaller and less-experienced underwriters who will try to cherry-pick good growth companies before they're big enough and successful enough to attract attention from the top-tier investment banks. So watch out.

Consider some background. Like other parts of the capital markets, the underwriting community has experienced wrenching change in recent years as deal volume has collapsed. Last year there were only 28 underwriting firms, down from 54 the year before and more than 100 in the mid 1990s, according to Richard Peterson, a market strategist at New York City-based Thomson Financial and the author of Inside IPOs. The good news is that many of the "bottom feeders" have closed down or retreated, so the group that remains, at least for now, tends to have greater experience and proficiency. The bad news? With a smaller universe, it could be even harder for a small company to get the attention of a top-tier underwriter. That increases the chance that companies will be forced to pitch their stories to, or be solicited by, regional or local underwriters, industry-niche specialists, or novice investment firms.

Some of those second-tier firms can prove to be every bit as capable, especially within specific sectors or regions, as the so-called bulge-bracket firms that top each year's deal lists. A good example is C.E. Unterberg, Towbin, which has handled only six IPOs during the past three years but has offered a good bit of expertise in the health-care market. Or A.G. Edwards & Sons, which has carried out only three IPOs since 1999 but boasts a strong track record in secondary offerings for midwestern companies. So it's not absolutely essential that small companies planning IPOs make connections with the nation's top handful of underwriters. On the other hand, the second-tier group as a whole is more of a mixed bag (often with less expertise across industry lines), which is a big reason why entrepreneurs need to proceed cautiously with them.

Serena Software Inc., in Burlingame, Calif., which manufactures enterprise software for large corporations, learned that the hard way. Serena was founded in 1980 and has enjoyed debt-free status and uninterrupted profitability since its first year of operation. "During the late '90s, we knew we wanted to go public," says Mark Woodward, the company's CEO, "because we wanted to be able to incentivize our employees and raise cash and have the stock currency for future growth-oriented activities. But it was completely impossible to get any of the top firms to pay attention to us, because we weren't a super-fast-growth company and we didn't have any venture capitalists involved."

ROAD WARRIOR: "I've had to work very hard to expand our analyst coverage in the stock market," says Serena Software CEO Mark Woodward.

Serena managed to go public in February 1999, but the company needed to rely on an underwriting team that consisted of three small second-tier firms. "We raised $60 million, which was great. Our market capitalization got as high as $2 billion, and even now it's still around $1 billion," notes Woodward, whose company's revenues are now just under $100 million. "But the truth is, I've had to work very hard to expand our analyst coverage in the stock market. When you go public with a second-tier firm, it's difficult to attract coverage by the big research analysts, and it's hard to win the Fidelitys of the world as your long-term investors, which is what you want because those are the kind of investors who will give stability to your stock."

The best underwriters have very strong ties to the institutional market -- mutual-fund investors, insurance companies, and other institutional investors. "These firms look consistently to place around 80% of their IPO offerings with the best of those investors, meaning those buyers who have a history of making long-term bets on companies," notes Jeremy Dickens, a partner and cohead of the capital-markets group at Weil, Gotshal & Manges, a New York City-based law firm. Less-desirable underwriters tend to rely on teams of brokers to place the bulk of their IPO offerings with retail customers (meaning, individual investors) or hedge funds -- funds that tend to aggressively turn over their holdings.

During the past few tumultuous years, all kinds of investment banks -- big and small -- were overly optimistic about their ability to bring IPOs to market. For instance, in 2000 there were a whopping 318 withdrawals of IPO registrations. But as the public-offering market gradually recovers, the most successful underwriters undoubtedly will be those that combine selectivity and high standards with a keen understanding of what their institutional clients will and won't buy.

"It's better to have a good firm advise you to wait than to try an IPO with a less reliable firm and fail," says John Egan, cohead of the private-equity group at the Boston office of law firm McDermott, Will & Emery. "If your employees, investors, and customers start to expect an event that doesn't happen -- even through no fault of your company's -- you can start looking a little shopworn. People get demoralized or distrustful."

Mediocre underwriting firms can harm their clients with more than bad advice. "Entrepreneurs may tell themselves that the worst that could happen to them is a failed IPO, but that's just not the case," emphasizes Glenn Kaufman, a managing director at American Securities Capital Partners, a private-equity firm based in New York City. "The worst is, your company succeeds at going public, but it never finds a home with investors, it never gets any analyst coverage or attention, and it's got an underwriter who cannot or does not support its performance in the aftermarket. So you've got none of the advantages of being public but all of the costs, obligations, and challenges of public reporting."

The best measure of an underwriting firm's strengths (or lack thereof) lies in the services it performs after a stock goes public. "When we're thinking about taking one of our portfolio companies public, the first thing we look at is the research capabilities of the underwriting firm. We'll look for an investment bank that's got the best research analyst in our industry," says John Castle, chairman and CEO of Castle Harlan Inc., a New York City-based private-merchant bank, which manages more than $27 billion in assets. "That person will be best able to understand what's going on in our company. And he or she will have the credibility within the investment community to present us and our prospects in the most effective light."

A top-quality underwriter can help a company's stock, whereas a subpar firm can damage it, through support (or lack of support) for that stock in the IPO aftermarket. No illicit activities or covert stock manipulations are involved. It's as simple as this: If an investment bank believes in a stock that it has underwritten, and if the bank is sufficiently capitalized to back up that belief with its actions, then it will buy the stock aggressively when others are selling. It will then either hold the stock as an investment or gradually sell it to institutional investors, helping to stabilize the price either way.

For entrepreneurs who are investigating possible underwriters, the best measure of a firm's success is the average aftermarket performance of its IPOs. When analyzing that statistic, keep in mind that it's probably fairest to focus on a stock's performance during the first 12 months after its IPO. That's because even the best underwriters can't prop up a sluggish stock indefinitely. After a while, the only thing that will move the price upward is good corporate results.

In the end, that's why Mark Woodward is now happy about Serena Software's IPO. The company has delivered on everything it promised. It has continued to grow, and it's been consistently profitable. As a result, a top firm has now assigned an analyst to follow Serena, and two other firms are getting ready to do the same.

Happy endings do happen. But for entrepreneurs who want to improve their odds, it's best to remember that IPOs have a lot in common with high school proms. A lot depends on who takes you there. And sometimes it's better to stay home.

Jill Andresky Fraser is Inc's finance editor. Emily Barker is a senior staff writer.

Biggest Little Underwriters
Firms that have the most experience in taking small companies public

# of IPOs Below
$40 Million
Total #
of Issues
(1999 - 2001)
Total Proceeds Raised,
in Millions
(1999 - 2001)
Credit Suisse First Boston 22 180 $24,291 23.62%
JP Morgan 13 68 $4,916 8.58%
Deutsche Bank AG 10 61 $4,665 15.36%
Lehman Brothers 8 60 $5,785 7.04%
Merrill Lynch & Co. 8 75 $12,940 4.74%
Paulson Investment Co. 7 8 $191 -30.52%
FleetBoston Financial Corp. 6 76 $5,488 27.35%
CIBC World Markets 5 19 $1,473 10.60%

*As of March 31, 2002, for all IPOs conducted during the previous 12 months.
Source: Thomson Financial, New York City.

The Price of Going Public
Expenses can vary widely, but these are typical.

Underwriting fee (negotiable, but doesn't vary much in practice) 7% of offering
SEC filing fee $92 for each $1 million raised
Nasdaq initial listing fee (depending on the number of shares outstanding) $105,000 to $155,000
National Association of Securities Dealers filing fee $0.0001 x the number of shares, plus $500
Legal fees $300,000 to $500,000
Accounting fees $300,000 to $500,000
Printing expenses (for the prospectus, which sometimes must be printed and circulated several times) $200,000 to $300,000
Transfer-agent fees (to an outside firm for keeping track of shareholders and transferring stock certificates) $10,000 to $20,000
Blue-sky fees (if there are no state registration fees) $5,000
Miscellaneous (for the road show and other expenses) $100,000
Directors' and officers' insurance $500,000 to $1 million

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