The Love of Linux Chapter 6: Taking the Company Public
Before Red Hat went public, we had spoken with several investment bankers to evaluate the interest. Our initial search led us to S. G. Cowen. We were impressed with the knowledge and maturity of the investment banker and even went so far as to sign a letter of intent. However, S.G. Cowen did not feel the company was quite ready. Taking a company public is a real balancing act. It appeared to us, that you have to go public when there is interest in the Industry you are in. In many ways, Caldera or any Linux company for that matter was not ready to go public. While revenues for Linux products were increasing, the sales were primarily based on retail. Retail sales were cyclical and based on constant turn and freshness. Linux companies were pulled into the rush of investment brought about by the dot com flurry but it was right at the end of the bubble. The window on the Linux industry was open and Caldera could not wait if we wanted to go public and pursue our strategy, especially when our competitors had already successfully completed their IPOs and were full of cash. This decision proved to be a company saving judgment call and one exciting, educational ride.
During the second round of financing, we interviewed several other investment banks to determine if there was a bank interested in taking the company public at that time. We were very pleased with the response. Robert and Stephens (known affectionately as Robbie) had the most credibility as the lead banker. The fierce competition among banks was unknown to me at first, but who you pick as a lead will determine so much of who the working group of banks, attorneys and accountants become. They also determine to a large degree how well your company will be represented to the investment community during the initial offering and, more importantly, after the IPO. Finding the banks to participate after selecting the lead bank is a unique dance. For those unfamiliar with the process of taking a company public, a representatives from three to four investment banks along with a leading accounting and legal firm forms a team called the working group” The objective of the working group is to produce a booklet called an S4. The S4 is submitted to the Securities Exchange Commission (SEC) for approval. When approved, the booklet gets printed and becomes the bible about your company to potential investors. Each of the investment banks that participate in this process and the distribution of the initial offering are listed “on the cover.” Investment bankers are very sensitive about whom they associate with and their positioning “on the cover” of the S4 as it contributes to their prestige in the investment community. Certain banks will not even be “on the cover” if they are not the lead. Others will be “on the cover” if they have only a certain percentage. I always thought that the IT industry was very competitive, until I began to interact with the investment banking industry. There is a definite, clear pecking order that appears to only change through acquisitions and mergers, one of the many reasons why the investment banks seem to change their name so frequently. Change is almost constant in the investment banking area. Consequently, my advice to anyone even considering taking a company public would be to talk to several companies that have gone through the process with the bank. Make sure that you interview companies that have just been through the process as well as those who have been public for several years and ask them how well the bank and its “analyst” represent the company in the beginning and on an on going basis. Each investment bank employs analysts who are considered experts on a given market. The analyst listen to the company earnings reports and recommend to investors whether to invest or not. They wield much power because companies in the past spoke through them to the investors to reduce risk. However, good analysts were hard to find and would often move to the highest bidder. Because of the fierce competition, the faces change rapidly and you want to be sure that the service does not change with the changing of the guard.
We asked the appropriate questions and Robbie assured us that, unlike their competing bankers, they would stick with us after the IPO. In other words, we were asking would their analyst continue to watch our company and make the necessary recommendations to investors. We did not interview companies they had taken public because we were very new to the investment game and a little naive. We were able to convince Bear Sterns, and an online banking upstart, WIT Capital to join Robbie on the cover. We took a chance on WIT because they had not done a lot of IPOs as a cover participant. They had mainly handled the “Friends and Family” or “Directed Shares” programs for other offerings. We wanted WIT involved because we knew our “Directed Share” program would be very complex because we wanted to involve many from the Linux community all around the world.
I should also explain the term “Friends and Family” or “Directed Share” program. When a company goes public, a small percentage of the stock is often reserved for the friends and family of the company or key customers and suppliers. Shares of the initial offering are set aside or directed to friends and family. Those who are identified on a list provided by the company going public are notified and are able to register and get a certain number of shares at the initial stock price the day the company goes public. The directed share program is a political hot potato. People are offended if you don’t offer them participation and people are offended if you offer them participation and they don’t make money. If the initial price goes up significantly, then those friends and family can sell the stock and make some pretty good money. If the stock goes down, after the initial offering, you will probable not have to many friends left. Family is stuck with you, but family gatherings can become more challenging. I would recommend that you investigate this option ahead of time and talk with companies who have and have not offered a directed share program and determine if it is right for your company and your employees.
In the Linux industry, we wanted to offer, not only our employees, but key players in the industry the opportunity to participate. Because of Linux’s open source collaborative model, many out side the company had contributed to our success. While we could not “reward” all those who had contributed to Linux, our Directed Share offering was much larger than most. What added to the complexity beyond the size of the Directed Share offering were many of the individuals we wanted to participate live outside the U.S. We had heard that Red Hat’s directed share program did not go as well as they had hoped, so we felt that WIT might be able to help us in this endeavor as they were a leader in online directed share programs. Again, we explained our desires upfront to Robbie and the other banks and they appeased us with telling us what we wanted to hear, but when it came time to administer the program we really ran into some problems. At first, Robbie did not want to let WIT handle the program and they were not accommodating at all. Robbie agreed to let WIT handle it, but the next problem we found was WIT could not offer any shares internationally. We were able to work something out with yet another bank to offer shares in Europe.
The youth of the employees of the larger investment banks was amazing. They had some very talented young people, but the average age at Robbie was probably lower to mid twenties. Most of the investment bankers we dealt with, even the VP of the group at Robbie were not much older than my oldest son. The investment banking industry takes some of the best young talent, works them very hard and pays them very little. The good ones would get some incredible experience in a short period of time and then often go to work for one of the companies they helped take public. I have often heard that the IT industry was full of young talent, but investment banking again had us beat. You may be able to tell just how competitive an industry is by average age of the employees of the companies that compete in the industry. With IT, the youthfulness is more a result of the love for technology. In the banking industry, it appears to be part of the business strategy.
Selecting the banks who will work together is only part of a very delicate dance you must do up front. Negotiating the percentage split between the banks was like negotiating for their first-born child. The SEC, I believe, sets the total percentage of the offering that can go to the investment banks, so that each percent that one firm wants has to come from one of the other participating banks. Each percentage change had to be negotiated back and forth between each of the other participating banks. Finally, after negotiating things down to what seemed like pennies on the dollar, everyone agreed, but that did not mean we were going public. That was only the beginning. Right before we filed, First Security Van Kasper now Wells Fargo approached us and said they were a local bank and would help us if we would just put them on the cover. We met with their team and were very impressed. We were able to renegotiate a small participation fee.
The lead bank also influences to a great deal the other players on the team, the banks, the attorneys and the accountants. We were very happy with a local attorney firm in Salt Lake who had taken several local companies public. Robbie would not hear of it. We had to select between several of the top three or four California based law firms. These firms charge a premium, because of their name and associations. The attorneys, banks and accountants have a network of companies they choose to work with. In their defense, they were doing so many IPOs and so rapidly, they could not afford to have one of the “working group” to not pull its weight. Fortunately, we were using Arthur Anderson as our accountants and that met Robbie’s criteria (obviously this was before the Enron scandal). We decided to use Brobeck as our attorneys because they had an office in Denver who had some cycles they could spare. Most of the attorneys with offices in California were so busy taking other companies public, they did not have time to assist us. Brobeck did a good job for us, but it would have been a little more convenient and less expensive to use a local firm.
Just a side note on Arthur Anderson, Arthur Anderson was destroyed because of the actions of just a few. It is an absolute tragedy and only the beginning of the fall out of Enron and other disasters of moral decay in business. Our Arthur Anderson team was great through the whole IPO process and continued to serve the company well after the IPO. The tragedy of moral decay is that so many innocent people are hurt from the actions of a few. The country was in an uproar as they should be over the events of September 11th. The nation in many ways has rallied around the heroes of that day and the subsequent weeks. And there has been a reawakening of religious devotion and service. The same thing that has helped heal the nation from a terrorist attack will also heal it from the erosion of business ethics that has economically devastated the lives of thousands. There is no quick fix to terrorism or unethical behavior in business and financially it is going to leave a wake of tragedy. Fixing terrorism and moral decay in business will require a painstaking, inside out approach to fix. Unfortunately, if we try the quick fix, to legislate morality, the result will be more economic lives lost as companies will not be able to survive the bureaucratic red tape. As a country, an industry, a company or individual, we must be willing to pay the price to really fix the problem.
Returning to the IPO process, even after putting all the time and money into drafting the S4, (we have been told that we have one of the best written “Risk” sections ever produced) there are absolutely no guarantees that the banks will take the company public. Just before we were scheduled for the “road show,” an intensive two weeks of traveling all over the country and sometimes to Europe to meet with investors, all of the banks went before their approval teams and got the green light, to take Caldera Systems public. It is not until each banker gets the approval from their respective approval boards, that a company can go public. By this time in the process, the company has spent thousands of dollars in legal and accounting fees which could be a total loss if these boards do not approve going forward and the company has no recourse. After preparation school (our bankers insisted that we take several lessons and prepping from a specialist who helped us refine our Road show presentation and presenting skills) Alan Hansen, our CFO at the time, and I began the two week road show. This process really does help polish the presentation and allow those who present a chance to say only the things of most importance in the 20 to 30 minutes that you are given in front of each investment firm.
The Robbie team kept telling us how important it was to keep up the intensity and sell these investors on our story, as they these investors will want to hold the stock. When we went public was a unique time so it may never be repeated, but we found that their claim of not selling or “flipping” the stock with in the first few days was a misrepresentation. Within two days of actually going public, I think nearly everyone who we had spoken with on the road show and had purchased shares from Robbie had “flipped” their stock. Either we were very poor salesman or there never was any intent, at least in our case, to hold and we were just characters on a stage that they had already seen which is exactly how you feel when you present to them. I do not think this is a complete representation of what happens when companies go public as our IPO was right at the tail end of what seemed to be an unstoppable flow of IPOs in the heart of the Dot com era, a unique occurrence in history that may never repeat itself.
During the two-week trip, we had three different investment bankers travel with us. The others were required to fly home to take out other companies on the road who were going public. I guess once they saw that our offering had acceptance, they wanted the more experienced team members to get the other companies started. However, because of these constant changes and misrepresentations, at the end of the whirlwind two weeks, we felt like we had gone through the meat packing plant.
Near the end of the road show, is the pricing call. Our board and the investment bank get on a phone call and determine the initial price of the shares to be offered. The price is a very political issue. The initial price is all the proceeds that the company gets from the offering. In other words, if the stock is priced at $10.00 per share, but on the first day of trading, the price goes up to $40.00 a share, the company only receives $10.00 share. The difference goes to the commercial investors who buy the stock at $10.00 and then sell it or “flip the stock” on the same day or shortly there after. What the banks will tell you is that their commercial investors want long term investments so they will hold the stock. The bank is interested in the lowest possible price so that their investors can benefit from the upside and the lower price is an easier sale. During the road show, the bank communicates with its commercial investors and monitors their commitments to buy the stock but that information is not shared directly with the company. During the road show a figure is floated but everyone knows it can go up or down depending on the “pricing” meeting. When we talked to people during the road show, we floated the price of $10.00. We were able to raise that to $12.00 per share in the pricing call. Apparently, the demand for our stock was pretty good. Although we had an incredible presentation, the interest in our stock apparently was not a reflection of their interest in our company but an interest in the hype of Linux and the hope of making a quick buck.
Just as a side note, VA Linux and Caldera did not do as well as Red Hat in being able to benefit from going public. That may sound funny to some, because VA Linux price raised so much on the first few days of trading. As mentioned above, the company does not benefit at all from the rise in price after the initial pricing of the stock. The company and its initial investors must sign a “lock up” agreement stating that they will not sell any stock for at least 6 months. The investment banks and their investors who are offered the stock are not under the same restrictions. The reason that Red Hat did so well, was that being first, Red Hat was doing a second round of financing while VA and Caldera were both just doing our first. On the second round, the company benefits much more because the market price is now established at a much higher price. Consequently, the selling price could be much higher but the percent of change in selling price is much lower. Consequently, the second round is less attractive to commercial investors that want to ride the stock price up and “flip,” so you get more serious investors as well. As a result, to do a second round, the market and interest in your stock must be very strong, or bankers will not even bother to take you on a second round tour.
At least when our company was going through the IPO, the investment interest depended a lot on the hype of the industry or company. The investment banks utilize the hype in the industry to get the average private investor to participate. They appeared interested in only taking a company public when the company is know in the industry or the industry itself has some buzz. The commercial investors know that it is hype, but the investing public do not. The commercial investors receive blocks of stock from the bank and then as the company goes public the commercial investors and the banks sell their stock quickly as the price goes up. To avoid competition from the company and its corporate investors, the banks have them all sign lock up agreements. This insures that their commercial investors can turn a quick profit. In the stock market, the average private investor is looking for the next Apple or Microsoft. To get maximum profits, these private investors feel they have to invest on the ground floor. If there is a buzz about a company or an industry, the public will invest. Commercial investors, if the hype exists, realize it may be risky to invest long term, but they do see an opportunity to make some quick money. However, this creates a timing issue for the company who wants to raise capital in the public markets. To catch a company or industry when it is buzzing may be too soon in the typical life cycle of the company under more conservative measurements or times. For those in the industry, this timing window may be your only chance to go public and raise additional capital needed to fund growth. My speculation on this comes from the fact that many of the Dot coms that went public, had good business concepts, but they lacked the business maturity to justify their valuations. The commercial investors we talked to seemed to be very savvy and were not as interested in the business details as they were about the position in the market the company had that would insure them a lucrative market to sell their stock. Obviously, not all investors are looking for a quick turn around. The business of investment banking is very high risk. There is no guarantee that the companies stock will go up after the initial pricing. The investment bankers provide an important service with high risk and high reward and many are very legitimate. But anywhere there is “quick” money to be made; there are those who conveniently subscribe to the “end justifies the means” business ethics so prominent in our society today.
The industry was in such an IPO feeding frenzy that everyone was processing them as fast as they could. The real disappointment for Caldera was after taking us public, only two of the four bank’s analysts ever even covered the company, Robbie and First Security now Wells Fargo. Having analyst covering the company really helped stabilize the stock price. The importance of “coverage” is that the average investor does not have the time to fully investigate every company individually. They learn to listen and trust certain analysts whose job it is to know the company and make investment recommendations that they follow. This is part of the service the investment bank should provide the companies they take public, part of the benefit of being on the cover and having the initial blocks of stocks to sell, but Bear Sterns and Wit could never come up with a convenient time to begin analyst coverage in spite of numerous calls and visits by the company. Robbie’s analyst quit shortly after our IPO and they were not able to replace him for several months. We met with the new analyst and he suggested we come back after the acquisition of SCO was complete. By the time the acquisition was complete, our stock had dropped below ten dollars, partly because we did not have coverage from the analysts and partly because of market conditions, and Robbie said, “don’t call us we will call you.” When the company could have greatly benefited from analyst coverage, all of our top banks who benefited from the IPO were no where to be seen. Only First Security Van Kasper or Wells Fargo, who benefited by far the least, continued to cover the company. Knowing what I know now about the industry, if I were a commercial investor, I would do the research myself. The analyst may provide some guidance, but they were way overvalued. With recent changes by the SEC, more and more companies will begin to make their own projections directly to the investors which will reduce the industry’s dependence on analysts and investment bankers after the IPO.
To anyone interested in taking a company public, of all the banks we participated with, First Security Van Kasper (Wells Fargo) provided the best services and stuck with us for some time. It may just be that regional banks still value a customer rather than seeing them as a cog in their machinery. I do not want to appear ungrateful, nor do I want to paint the whole investment industry as completely self serving, there are just some observations that will hopefully help others keep their eyes open. We had a very successful IPO and had raised a significant amount of money. But through the process, I had learned that the ones who really made the money were the banks, the commercial investors, the attorneys and accountants and we were just a very, very small dab of grease in a very large system of financial wheels. Caldera went public during a financial hay day for the information technology that may never occur again. Some of these experiences may not be as applicable now, but the experience was extremely eye opening. I have included a memo I sent out to the IPO working group shortly after completing the IPO in hopes that it would be some constructive criticism:
Dear Working Group,
I wanted to write and thank everyone on this list for a lot of very hard work. We greatly appreciate all the effort in getting our company public. We all sincerely thank you.
I also wanted to give you our perceptions of the process in hopes that it might be beneficial to everyone in the future. I thought I would do it bank by bank.
First Security came into the process quite late, but they were extremely helpful to us personally. With very little to gain financially, they put forth genuine efforts in answering questions, critiquing our presentation and providing assistance.
Like First Security, WIT was extremely helpful during all phases of the process. They would call and answer questions as well as educate us on the entire ordeal. They gave us a lot of time and access to their top people to ensure that the process went well for us.
On the Directed Share program, they bent over backwards to meet our requests. They went out of their way to bring in Montgomery to handle our International needs. We are extremely grateful for their efforts.
The actual process for Friends and Family needs a little work. The process is just too complex for people with limited and even a lot of experience on the Internet to follow. I completed the process for one of my friends and followed each step as outlined only to have Wit tell me that I did not complete the process right. There are just too many things that can go wrong. We recognize that what we asked for was unique, but there are some things that could have been done to avoid the problems that occurred. I offer some suggestions that might have helped.
After the registration deadline was past, a report could have been generated to indicate all of the participants who did not complete the process correctly. We could have compared lists and resolved many of the problems then. We would have had an exact numbers of participants and then allocated the shares appropriately. As it turned out, there were many people internationally that received far more shares then our domestic participants. No letter should have been sent out stating that a random number generator had kicked them out. We agreed at the beginning that everyone in the program should receive shares and we were going to allocate them across the board.
We appreciate Bear’s help during the financial due diligence, but in hindsight, we are left with the feeling that it was not to help our company as much as cover Bear’s exposure. We felt that there was little contribution made for the amount of the deal that Bear received. We spoke only one time with a senior Bear representative and that was to discuss the economics and Bears percentage of the IPO. We would have liked to offer more to WIT and First Security if we had it all to do over.
We appreciate the many hours put into our transaction by Robertson. There were many things done to help, like finding 4,500 shares to help with the problems that occurred with the directed share program. Clearly, with Robbie being the lead, the likelihood of finding more concerns is much higher as they have done more work. At the end of the process, we were left with many unanswered questions and were treated at different stages with almost contempt. For example, the directed share people were almost rude in there responses to our requests. There was no apparent attempt to even consider our needs even though they were explained in detail before Robbie was selected as the lead. The investment banking team on our deal was extremely helpful and professional, but they were very young and lacked considerable experience when compared to the representatives from even the co-managing banks.
Many things were not explained to us. We had never taken a company public and many things were left unsaid which could have been very helpful. For example, during the pricing meeting, we indicated that we would like to see 20% of the deal go to retail. We were told that including the directed share program, 20% of the deal was going to retail. I have been informed subsequently, that typical deals are 20% excluding directed shares. We were also led to believe that institutional investors were better because Robbie sales force would work with them to insure that they would hold the shares. With 90% of the deal going (excluding directed shares) to institutional investors, we should not have seen such high trading volumes if a significant amount of the investors did not flip.
The impression we are left with is that we were used to grease the hands of Robbie’s true clients, the institutional investors. The retail demand was very high, which would have increased the value of the stock if the institutional investors had not flipped in such quantities. We are very anxious to see your final report on who flipped and who held the stock.
During the road show, we did not have a constant representative with us. We kept changing people in and out. We recognize that this is a very busy time, but we could not help but come away from the entire process and feel somewhat used, like we were just a cog in Robbie’s IPO machine. We do not believe you intended for us to have that experience. Anna, Nimesh and Peter are terrific, they are just overworked. Our requests to stay in less expensive, yet quality hotels were ignored. The airlines we would have rather flown were not even considered. The schedule could have been better organized to prevent flying back and forth between cities in the same day. We did not need to drive in stretch limos. Most of these issues are a direct result of trying to make it as easy as possible on those doing the scheduling because of over scheduling. Again, the impression it leaves on the company is that it is just a cog in the wheel.
We offer these insights not to complain, but to provide feedback. Our IPO is over and it was a success. We did not want a repeat of VA because it leaves so many of the investors hanging, but the price could have been higher if there had not been so many shares sold. We can now get on to our business. However, you all must continue to provide these services to other companies. I just hope you do not forget that for many of them, there will never be another time and they are depending upon you to be the experts. This is one of the most important events in a company’s history and much of it is in your control. You have an obligation to represent all of the facts to ensure that the right decisions are made. We do not feel that we were intentionally mistreated. In many cases, you are clearly trying to do too much and thus your overall service is suffering. We hope this is helpful.
Please understand that we are very grateful for the long hours spent in our behalf. Our purpose in writing this is to provide you full and honest feedback in hopes that you can improve the service that you are providing other companies in this process. We are grateful for the success that we did achieve.
We would also be amiss if we did not thank Brobeck, Cooley and Arthur Andersen for many long hours. They did an outstanding job. We could not have done it without their efforts in our behalf. Thank you.
All of the feeding frenzy is gone in the public markets and it may never return, but my advice is to visit with the bank’s customers and find out if they are satisfied with the service or not. Do not take the banks word alone. Spend the time to meet with several recent and not so recent customers and have them evaluate the bank. This is particularly important of your lead bank, but has direct application for the other banks and even attorneys and accountants. The process is incredibly expensive. Make sure you get your money’s worth.
With the IPO completed, we knew that we would need to use our new currency and funds to expand our business through acquisition. We felt that we could not take the time to grow organically.