IPO Is False Exit Strategy for Entrepreneurs

San Diego Business Journal, Feb 14, 2000 by Valerio L. Giannini

Stocks Reflect Wealth, Not Buying Power

Every week we read about another crop of multimillionaires created by the latest initial public offering of some new high-tech company.

But the truth is that these seemingly rich entrepreneurs are often no more than the King Midases of our age; they can read about their wealth in the newspapers, but they can't spend it -- at least not for a while.

Contrary to what a surprising number of entrepreneurs believe, an IPO is not an exit strategy. A company founder who wants to turn equity into cash should sell the company, not take it public.

Here's why. The purpose of an IPO is not to turn founders' ownership into dollars but to raise additional capital to grow. Investors don't put money into an IPO to make the founders rich; they invest to make themselves rich. That's why underwriters typically forbid founders and private investors from selling any stock for a specific time; this lock-up period can extend to several years.

The underwriters' rationale is persuasive: They want existing management to remain in place and to share the ultimate goal of new investors, i.e., the maximization of the value of the shares.

OK, so just when can the founders and early investors in a newly public corporation reap their just rewards?

* Offering Additional Stock Delays Monetary Rewards

Well, not soon. If a newly public company does well, it can offer additional stock a few years after the IPO. Again, the primary purpose is to raise growth capital, but this time 20 to 25 percent of the shares offered might be owned by founders, management, or early investors. But these shares seldom amount to more than 20 percent of any single individual's holdings.

Even so, these insiders have options. After the lock-up period, venture capital firms that have invested in a company might distribute shares to their partners, who in turn may be able to sell them in the open market.

If so, founders, management and early investors can also sell unregistered shares -- 1 percent of the total shares outstanding every 90 days under an exemption granted by the SEC's infamous Rule 144.

If you do this, make sure your investor relations program is running smoothly. Rule 144 sales become public information, which means an immediate announcement (i.e., explanation) is needed lest the stock price collapses.

Clearly, an IPO is not the answer if near-term liquidity is the question. A sale -- even disguised as a merger -- is the only viable route, but it has its problems.

Buyers almost always want immediate control, but they usually insist on sellers waiting for some or all of the purchase price, which typically is contingent on future performance.

In addition, a buyer may require management to remain for several years.

* Private Company Leaders Can Minimize Contingencies

As a founder or manager of a private company, you can minimize such contingencies and still obtain the maximum value for your company. The key is to start preparing years in advance with respect to those issues that matter most to prospective buyers: consistent growth of sales and profits, audited financial statements, long tenure of professional management, an attractive public profile, and the absence -- utter, total and complete -- of commingled personal and business expenses and assets.

In short, go public if you need capital to grow; sell the company if you and your colleagues want ready cash.

Giannini is a principal in the Irvine office of NewCap Partners, a private investment banking firm that has represented many Orange County companies.