IPOs out, going private in?

Investment banker Tom Taulli writes that with high-tech stocks plunging, companies may start examining whether to go private.

4 min read
During the 1980s, investment bankers got rich quick from leveraged buyouts in which management borrowed huge sums of money to buy their companies from public shareholders.

Because of the dismal 1970s, many companies were selling at valuations well below their asset values. A classic example was the leveraged buyout of Gibson Greetings in 1982. An investment fund helped management buy the company for $80 million, of which $79 million was borrowed. To pay off debt, management sold off $31 million in real estate. Within 13 months, management took the company public at a valuation of $300 million.

Historically, management buyouts have been common for brick-and-mortar companies that have predictable cash flows and assets that can be sold. Of course, many tech companies do not have these characteristics. Last year, there were only 11 tech companies that went private, according to Thomson Financial Securities Data.

But with the plunge in high-techs, the trend could change quickly. As soon as managements realize that stock prices will not recover anytime soon, they will be looking closely at going private.

But going private is no easy task. Look at Netpliance, a company that develops Internet appliances. In December 2000, the management team--which had about 52 percent ownership--decided to take the company private for 65 cents per share, which was above its current market value of 34 cents. However, investors thought the price should have been higher. The company's message boards swarmed with angry comments. There were also two shareholder lawsuits. Netpliance withdrew the offer.

Going private is probably only for a select few companies. Simply put, management must strongly believe that its company has a viable business model. If not, a company is likely to pursue the path of E-Stamp, a company that changed its business model twice--both times failing. On April 20, 2001, E-Stamp agreed to merge with Learn2.com. The key reason? Learn2.com got E-Stamp's $29 million in the bank. In return, E-Stamp got a business model.

The plunge in valuations is evidence that many upstart tech companies should not have gone public in the first place. It appears that many of the IPOs in the past few years were attempts to take advantage of the crazy markets, in which investors would pay any price. Now these companies will most likely be ignored by investors.

The example of MathSoft
One company ignored by investors--even when markets were soaring during the 1990s--was MathSoft, the developer of spreadsheet-style software for engineers and students. Since its IPO in 1993, the company has had difficulty finding analyst coverage and press attention.

In fact, the company has been consistently profitable. But that was not enough. Basically, Wall Street considered MathSoft to be a small fry, with sales of about $15.2 million in 2000.

So in early 2001, the CEO of the company, Chris Randles, decided to start the process of going private.

First, he needed to raise capital to buy out the shareholders. Randles drafted a business plan and presented it to various private investment funds. Edison Venture Fund and Spring Capital Partners thought the deal was strong and invested approximately $4 million.

The management buyout raised complex issues, though. The biggest problem was conflict of interest. In a transaction to go private, the public shareholders usually cash out at a loss, but management ends up owning a significant amount of the equity at the low valuation.

To guard against these problems, Randles hired independent counsel and financial advisers. He also established an executive committee of non-employee board members to review the transaction. The process took about six months, and the deal was closed in January 2000.

Of course, going private is not cheap. It is similar to the process of an IPO. A company can easily spend at least $500,000 on fees for lawyers, accountants and investment bankers. Then again, a private company will save the costs of being a public company, which can be substantial. For example, MathSoft was paying about $300,000 per year for securities filings, annual reports, CPAs and attorneys.

Critical for the deal, though, was employee retention. When going private, employees exchange liquid stock options with illiquid ones. This can be another showstopper.

Randles made sure that all employees were updated on the progress of the transaction and knew about the potential benefits. He also set aside about one-third of the company's equity for management and employees. Interestingly enough, the turnover rate has been cut in half since the transaction, and the company is hiring new employees.

Do not expect a return to the wild days of the 1980s, even though many managers at beaten-down tech companies will look at the option of going private, and some will take it. But before going down that path, managers need to seriously look at the many issues. As MathSoft has shown, it can be done if it's done right.