IPO (Initial Public Offerings)

• Introduction
• Why Go Public?
• The Role of the Underwriter
• The Stages of an IPO
• An Example of an IPO: NSIL

Introduction

While following this process, I learned a lot about the IPO process, and seeing how much mis-information is spread around on the bulletin boards, I decided to share some of it.

Why Go Public?

• To raise capital for product development
  This is the traditional path for a technology company: One or two bright people have a great idea for how some new invention can be used to build great new products. First they take their own money to try to build a demonstration prototype. Typically they get about halfway. Then they use that to get a venture capitalist to finance development of an actual usable product. When they start shipping a product, they have an IPO. At this point the venture capitalist gets paid back, and the rest of the money is used to finance the production ramp-up.
• To settle power struggles, such as inheritance issues
  A company may have been successful as a private company, where the management team is the same group of people as the owners/investors. Then circumstances change: One of the principals wants to retire, or changes in the industry make it clear to the management team that the comapany needs to change direction, but they can agree in which direction. They need to restructure the company to resolve these issues.
• To spin out a division in order to resolve a merger deal
  A company with operating divisions in different industries (or different geographical markets) may have had good synergy between divisions, but when a merger is contemplated, it is found that some parts of the old company compete with the new partner. Sometimes this is resolved by merging those divisions with the corresponding divisions in the other parent company; sometimes investors or government regulators insist that the competing divisions must survive under new ownership. An IPO is one way to achieve that.
• To spin out a division to open new markets
  AT&T found Sprint and MCI reluctant to buy AT&T's equipment, and spun out LU to resolve the issue.
• To get media attention
  Barnes and Noble spun out its internet business as a separate company in order to ride the "dot-com" hype-fest.
• To free a viable subsidiary from the death shadow cast by an ailing parent.
  In the long run, the value of a publicly owned company is determined by the business fundamentals: Earnings, growth, etc. But in the short run, the perceptions of the public and of the market may be manipulated by factors unrelated to the fundamentals. One of the ways that management can try to shape perceptions is by adjusting the structure of the company.

The Role of the Underwriter

The underwriter acts as the company's agent on Wall Street. The underwriter and the company agree on a number of shares and a price per share, and the underwriter basically buys all the new stock at the agreed price and sells it into the market. Generally, the an estimated price range is determined a couple of months ahead of time; the final price is set the day before trading begins. At the time of pricing, the deal can still be scuttled by either the company or the underwriter. Once the pricing is committed, the underwriter carries the risk if the price is too high.

The Stages of an IPO

1. Announcement of Intent
   Generally, the intent to make a public offering will be announced prior to making an SEC filing.
2. Selecting an Underwriter
   It is desirable to have a well-respected firm as the underwriter. An underwriter's reputation depends on their track record of prior IPOs in the particular industry sector.
3. Prospectus
   A formal prospectus must be written and filed with the SEC (Form 1). This will outline all the material facts about the company, and if the facts change, a revision must be filed (Form 1/A - A for Amended).
4. Road Show
   With the prospectus in hand, a representative of the underwriter travels with company management to give presentations to people in the brokerage industry to persuade them that this new stock is a good investment opportunity, and to persuade them to take an allocation of the new stock.
5. Allocations
   The newly created stock is sold by the company to the underwriter at an agreed-upon fixed price. The underwriter usually allocates a significant fraction of the stock to other brokerages, who can either sell it for the house account, or - more commonly - offer it to their best clients at the fixed price. This opportunity to take IPO stock at the issue price and sell it on the same day is one of the few guaranteed ways to make money legally. The underwriter's own employees are not allowed to take allocations, but they can give them to their friends at other brokerages, who will then return the favor next time they manage an IPO.
   After the road show and allocation negotiations, it will be fairly clear if the brokerage houses in general agree with the proposed price range.
6. Pricing
   The evening before the offering, the company management and the underwriter's group will meet to finalize the price ... or kill (postpone) the deal "due to unfavorable market conditions". They have to set the price below their assessment of a realistic long-term price, in order to make sure that the underwriter won't lose money as they unload their allocation during the quiet period.
7. First Day
   Before the open, the new stock symbol will have been loaded on the NASDAQ computers, and brokerages will have posted bids on behalf of investors who do not have allocations, but have faith in the new stock. Around 11 AM, the first offers to sell will be posted, and for the next hour, trading will be frantic as the stock struggles to find its price.
   At this time, the underwriters and the partners with allocations will typically offer a trickle of shares at twice the issue price. If there is a lot of demand, they will then keep raising the price, if not, they will drift downwards until the demand appears. Usually, the volume during this hour adds up to between a third and half of the offered stock. A stock with a lot of hype and great public interest may continue to float up during the day; it may close at three times the issue price and keep rising for the next week or two. Note, that this represents a situation where the underwriter is taking a huge profit that rightfully should have gone to the company via a higher issue price.
   More commonly, if the price was set right, the stock will close the first day 40%-60% above the issue price.
8. Unloading by Underwriter
   Over the next week or two, the underwriter will slowly release the stock offering into the market at a controlled rate. During this period, the stock will often drift lower until the underwriter finishes unloading and the market stabilizes. For most investors, this is the best time to buy into the new stock.
9. Quiet Period
   In order to ensure a level playing field, the SEC insists that the prospectus (as filed with the SEC) is the only information from the brokerage houses to potential investors. This restriction is relaxed after about 3 weeks. This period is known as "the quiet period".
10. Regular Coverage
    After the quiet period ends, analysts at the brokerage houses can start recommending the stock in their newsletters etc. This generally will lead to upward movement.

An Example of an IPO: NSIL

• Announcement of Intent and selection of Underwriter
  ??-Jun-1998 - Osicom chairman Par Chadha outlines intent to spin off NetSilicon division during Osicom's quarterly investor conference call. At this time, the intent is to do a "rights offering" instead of a regular IPO.

  Osicom's motivation is clearly to try to escape an aura of doom-and-gloom that hung around the company that summer. The management has led investors to believe that major orders for DWDM equipment is right around the corner, but as the orders keep slipping down the calendar, "the street" is losing faith in Osicom and the stock is faltering. The hope is to point out that NetSilicon is valuable, and Osicom shares represent that value.
  The concept of a rights offering represents Chadha's resentment of the Wall Street brokerages. Just like he took Osicom public by a reverse merger, he wants to give the profits of the offering to loyal stockholders (including himself) rather than the brokerage houses.

  ??-Jul-1999 - Tucker Anthony is named as the lead underwriter.

• Prospectus
  26-Aug-1998 - The original S-1 proposes a "rights offering" whereby 6.2 million shares will be issued at $5/share, of which 2.9 million will be offered to current holders of Osicom stock.
• Modification of Intent - not announced.
  Over the next months, it becomes obvious that "the street" is not supportive of an offering that will not "pay its dues" to the brokerage houses, and the loyal investors are not ready to commit new money.
  In late September, the stock reaches an all-time low, and Osicom schedules an investor conference call to discuss business strategies. Par Chadha announces an intent to spin out both NetSilicon and GigaMux and distribute the shares retained in both divisions to FIBR shareholders as a dividend. After which, the mostly empty Osicom holding company may be sold or liquidated. Osicom stock price starts recovering, eventually peaking in April 1999.
• Revised Prospectus
  11-Mar-1999 - A revised prospectus names Dain Rauscher Wessels as the lead underwriter with Tucker Anthony as co-manager. No more "rights offering": NSIL will sell 2 mio shares, FIBR will sell 1 mio shares and retain 9 mio shares. Shares to be offered to the public at $14/share.
  21-Apr-1999 - Amendment: Pricing range drops to $10-$12. NSIL will now offer 2.3 mio shares, FIBR only 700,000. FIBR will retain 9.3 mio shares.
• Selecting a new Underwriter
  02-Jul-1999 - A revised prospectus names CIBC World Markets as lead underwriter with Piper Jaffray as co-manager. NSIL will now offer 3 mio shares, FIBER will sell 2 mio and retain 8 mio shares. Offering price range $8-$10.
• Road Show
  A road show is undertaken in late July. In preparation for the road show, the S-1 is updated on 20-July-1999 with more current financial data. The IPO is set to go around 08-Aug-1999; put the offering is rescheduled for September after the market gets nervous about "internet stocks".
• Allocations
  Without a full road show, allocations are negotiated, and the IPO is set for 15-Sep-1999. This time around, the brokerage houses are presenting NSIL as a great opportunity, and the press is almost uniformly positive.
• Pricing
  14-Sep-1999 - The offering is priced at $7/share. Since this is outside of the range in the prospectus, the S-1 must be revised yet again.
• First Day
  15-Sep-1999 - The first wave goes up to $15/share, but settles in around 12.875.
• Unloading by Underwriter
  Over the first week, the price keeps drifting slowly down towards 11, until a press release naming 3 VPs of sales and marketing with excellent credentials boosts it by $3.5/share in a single afternoon.
• Quiet Period
  We shall see.
• Regular Coverage
  We shall see.