Monday, April 23, 2012

No Exit

(Laura welcomes responses in the comment field beneath each blog entry).

During 2000-2008, virtually every private company’s investment oriented PowerPoint or Private Placement Memorandum  I saw (as Compliance Officer of a boutique investment bank), concluded with a “hockey stick” graph of escalating profitability, with a liquidity event in two years.   The magic number was always 2 years, regardless of likelihood, because this is what companies thought investors wanted to hear.  I cringe when I still hear that.  The liquidity event was usually posited as an IPO (initial public offering) with an occasional alternative of being bought out by a large public company.

To outline all the reasons I have long thought that going public early is a bad idea and an expensive mistake for small companies is another article for another day.  But here, I will outline why and how  small private companies are shut out from public capital, and what I think the liquidity options are in the near future for companies worth less than $50 mm.  

Initial Public Offerings  (IPOs)
The number of IPOs and their funding totals have declined as both the age and value of the companies has risen, raising the bars for companies considering this access to capital.  Statistics vary in frustrating ways for something that should seem so easily measurable, so consider the two following scenarios that follow the same trend line, but with different numbers. 

The first is documented in an informative RR Donnelly speech in March, 2012:  One long standing bar is that since 2003, the majority of those that launched IPOs were previously funded by more than $10 mm of venture capital. (So companies that haven’t already raised any outside capital might refocus their attention to growth first). Another is that the age of companies going public has risen from the rather ridiculous youth of 3-4 years in 2000-2002 to a more sensible 6-9 years of records, as was the norm in prior decades. The number of IPOs in each of the past three years has been about 100 – 150, raising $41-44 billion, far below the frothy years epitomized by 2000, with 446 deals raising $108 billion.  But even with this reduction in the number of deals, to companies presumably older and “field tested,” from 2004 to date, a sobering 22- 39% have not hit their offering price, despite heavy and expensive lifting by those companies’ marketing, PR, IR staffs and hired investment bankers.  They didn't mention the ones that withdrew after starting the process.
The second scenario, here gleaned from the excellent charts and graphs of of Greenwich CT, but that I have read elsewhere, too, shows much less volume. They count a measly 53 US IPOs in 2011, a precipitous plunge not only from 125 the prior year, but from a high of 486 in 1999. Perhaps unsurprisingly, the number of IPO withdrawals has increased in the past three years, from 48 to 52 to 67 last year.  (Did RR Donnelly use the start-out-the gate number?) The Jan-April withdrawals in 2012 are even with those in 2011.  The dollar volume raised by the IPOs differs, too.  These sources cite $97 billion in 2000 declining to $36 billion last year.  Both sources agree that the average age of companies making an initial public offering have aged, but the Renaissance numbers are MUCH OLDER than the others.  They identify the average age as 10 years in 2000, 15 last year, and 27 years old for those so far this year. 

GrowThink points out that the number of US IPOs since 2001 remain lower than the 1980s.    
The final barrier to entry is the value of the companies.  This is tough to assess, because pre-money valuations are usually described by those wanting to attract the money to prove the valuations!  Not a very virtuous circle.  But it appears that the market is not particularly interested in companies worth less than $50 mm and certainly not those less than $20 mm.  

Entrepreneurs who want to say, "we should go public" should instead do their homework to research and analyze the trend line and the differences cited here, before being swept into enthusiasm by service providers who will be paid no matter what happens once the bell rings. This summary doesn't even address the costs of going public and staying compliant, year after year, which is another topic to scrutinize carefully. 

My black and white recommendation is that if your company is pre-revenue, pre-breakeven, or even pre-$20 mm valuation, don't even think about an IPO. Doing so derails far too many companies from focusing on legitimate expenditures of time and money to grow market share, customer base, or profit margin. 

Reverse Mergers
The alternative route for small companies was, since 2000, a fad called reverse mergers.  This is no longer an option for many companies either.   “Reverse merger” means that a private company buys a public one, often a “shell” company that has no operating business.  Reverse mergers are faster than going public the old fashioned way and have been used by some sneaky firms and their service providers to go public without fulfilling the investor disclosure obligations of firms that file for IPOs, such as audits and SEC filings. However, even with such attractions, 2011 saw the fewest number of reverse mergers in US since 2004, 166, well down from even the prior year’s 258.  Currently, there is a glut of 1900 shell companies for sale, up from 1200 last year. 

The reverse merger doldrums are likely to remain.  Why?   Financial regulators have caught up with the “end run” many of these firms were undertaking to get access to investors.  Rules have been put in place to protect investors after a series of fraud allegations and SEC enforcement actions.  The “poster boy” for bad behavior has been the 43% of Chinese companies listed on US exchanges via reverse mergers, many with poor managerial oversight and little attention to American financial disclosure laws.  29 of these companies were delisted last year.   Investors lost an estimated  $34 bn due to misrepresentations by Chinese reverse merger companies.  The companies themselves, lost, too:  Chinese Reverse Mergers Index fell 62% in 2011 compared to flat S&P 500.  The only people who seem to have benefitted from this fad were the service providers, who encouraged private company management to pay them to find shells and then take them through the steps to become public.  Might this money have been better spent by legitimate companies to generate additional sales or product development?  You be the judge.  In any case, the SEC has taken to task a number of these service firms, among them NY Global, whose leader, Benjamin Wey (Wei), is under investigation by both the FBI and SEC.   Since 2009, several companies that gave optimistic speeches at reverse merger conferences have quietly left that business altogether, and clearly by the stark decline in activity, others have, too.   

Going forward, companies that choose to be listed on any tradable American exchange (this does not include the notorious pink sheets) by any method have to perform better than in the past before they can move up to more prestigious exchanges or they will be delisted.  For example, they will  have to fulfill some of the same financial disclosures as the “big boys” like annual audits, an annual report, and all quarterly reports, whereas before, many languished with penny stocks and nary a quarterly statement for years at a time.  What a concept for firms trying to attract capital from investors or for CEOs bragging about heading up some tiny public company!  Are there really that many people with disposable income in their pockets ready to be spent on a company that doesn’t even pay to audit its financials?  Hey, have I got a deal for you!

Foreign Exchanges
Some American companies eschewed American exchanges altogether in favor of going public on European or Canadian exchanges.  Like the reverse merger approach, these exchanges offered fewer regulatory hurdles than NYSE and AMEX, but fewer investors, too, so, understandably, the number of foreign companies on the TSX (Canada) and AIM (UK) has declined.  As of March 31, 2012, there are only 89 US companies listed on the TSX and most of these are in oil, gas, and mining, primarily mining.   Why this paucity of American companies?  The TSX attracts many more listings (about 3800 altogether) than LSE/AIM, NYSE/AMEX or NASDAQ (each lists between 2200 and 2900).  But the aggregate value is much less (the TSX company values, altogether, are 1/10 the value of those on NYSE/AMEX, and ½ those on LSE/AIM and NSASDAQ.  (TSX:  US $1.9 trillion, LSE/AIM: $3.2 trillion, NYSE/AMEX: a whopping 11.8 trillion, and NASDAQ: $3.8 trillion).  So small businesses find a lot of comparable company there, but they are likely to get lost in the weeds created by companies that spend more to attract investor attention.

AIM is the small company branch of the London Stock Exchange (LSE).  It has such a low threshold of due diligence and disclosure that respected observers conclude that only a quarter of its companies would qualify to be on the NYSE and AMEX.  Started in 1995, it reached its peak number of companies in 2007, from which it has declined to a current number of only 1118 listings, of which about ¼ are foreign.  In one report it estimates its daily average number of shares traded in 2011 at 704 mm, but its excellent monthly reports reveal that most of those firms newly issued in March, 2012 raised no money in their inaugural month whatsoever. 

The lesson for American companies that listed abroad was taught by the absolute dearth of interest in them.  The costs they evaded in regulatory requirements in America they made up for in having to hire IR/PR firms to hawk their languishing stocks until many of them delisted themselves.   The other lesson I hope they learned is that investors are cautious about companies that so obviously choose to evade regulations designed to inform and protect investors in an inherently “caveat emptor” environment.  For an American company to list itself on these exchanges always smacked of the short kid who couldn’t make it on the team but wanted to be on the field any way he could, even as a water boy, paying for the privilege.  

Mergers & Acquisitions
Despite reports of cash rich companies ready to snap up undervalued companies around the globe, mergers and acquisition activity remains at a 5 year low, in terms of both money and number of deals.  In 2011, 725 global M&A deals were consummated.  The annual number has remained below 800 since 2008.  The value of the 2011 deals totaled $1.1 trillion, half as much as the 1184 deals concluded in 2007 ($2.2 trillion). This, too, is unlikely to change in the near term.  Why?  For one thing,  the UK passed a new Takeover Code in Sept, 2011 that protects target companies in various ways from hostile take overs that would otherwise be more popular in a market of undervalued companies and cash rich acquirers.  For another, European banks are rarely lending more than $50 mm, and there is a paucity of consortium lending of, say $250 mm by five banks to support larger deals.  Across the pond, in America, debt financing virtually shut down the second half of 2011 and banks are keeping their coffers locked up at the Fed this year, too. All this inertia remains despite the fact that large global corporations do appear to be sitting on cash reserves – the 100 biggest companies in the world appear to have 32% more cash on hand than in prior years.  Those with the largest reserves appear to be not in the US but in Brazil, Singapore, and Hong Kong.  Smaller firms are shoring up their own balance sheets, buying back stock, cutting staff or hiring younger cheaper ones, investing in efficiencies to make themselves leaner and meaner but not out buying other companies (except as mentioned below).  In the US market, M&A deals indicate prolonged due diligence phases which may reflect a game of chicken as both parties stare across a broad gulf between buyer and seller valuations.  Who will blink first?  We worked on one project for a small company in which the buyer verbally offered an attractive price for 20% of the company.  When the deal was papered, just about everything was the same except the portion of the company.  They now wanted 50% of it... for the same price.   The seller regarded this as an egregious bait and switch.  The potential acquirer explained it as the result of extensive due diligence.  The seller walked away from the table.

What About…
What is an optimistic entrepreneur of a small private company to do?  Hunker down and grow the business organically, the old fashioned way?  With cost controls and steady growth in customers?  Well, in a word, yes.  The funding frenzy from the late 1980s on fueled a generation’s expectation of easy cash and creative financing that was largely as illusive as unraided pension funds.  Industry journals highlighted the occasional brilliant success story and published unexamined press releases about pending fundings far more often than the slow and steady bootstrapping or “whatever happened to” stories (when the first tranche was paid but none of the rest).  Many sources of government funding have dried up, too, as municipalities, states, and the federal government take in less money from their tax base.  Sources like CAPCos (state credits to insurance companies that invested in businesses) are all but closed.     

The entrepreneur can also profitably spend time in self-examination as well as exploring relationships (before they are needed) with banks, investment bankers, factoring firms, suppliers, customers, competitors and larger, synergistic firms.  The financing and acquisitions I have seen in the past several years are ALL with smart money experts in a given industry, often with resources the acquired company lacked, usually a sales channel to outlets like governments, schools, hospitals or the military that would otherwise take years to develop.  Here are three examples:  One company that developed a hospital inventory management system was bought by a company that sold, guess what – hospital inventory.   Another was a small fish farming company that wanted to get into big box stores but lacked the connections.  It was acquired by a large conglomerate with other subsidiaries selling into those stores, as well as the transportation and logistics arm to facilitate delivery of such time sensitive products.  Here is an example for service providers:  A successful investment banker I know takes only back end fees, never retainers, but he only takes on clients for whom he already knows a few competing money sources interested in what the client company has to offer.  He is able to do this because he is an expert in a narrow geographic/industry niche.  He knows everyone and has an excellent reputation for honesty.  It helps, too, that since he is an expert, he can offer rapid due diligence before saying yes or no to a potential project and can thus conclude a deal faster than generalists who have to climb a learning curve on each transaction they stumble across.  The point of these examples is that a scatter shot approach is unlikely to be successful.  A company that desires to be acquired or funded needs to seek out smart money or hire industry experts who know those who need to be known, first to get a reality check on valuation and then to approach potential buyers or investors with realistic expectations.   

With profit margins and disposable income being squeezed as oil prices and regulations rise, it is only the smart money with deep knowledge that is willing to take a risk on small companies.   Small smart companies will already know who those companies and investors are in their space, whether they are looking for acquisitions, and whether the company has met the milestones those money sources want to see. Some angels may be willing to take a flyer with a portion of their money, but I'm not seeing the activity level or the enthusiasm of the past.  It seems to me that many angels are really service providers in disguise.  This is a buyer’s market.  Small companies looking for financing better put their best foot forward, and that foot should be shod in profitability with a sole of sound market (and self) analysis tied with the bow of cost containment.


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