Business 16Stanford Department of Continuing EducationClass # 8, 11/16/09

Getting Liquid

Guest:

David Liu

Managing Director

Internet/Software Investment Banking, Jeffries & Co.

What the #@%&*!does that mean?

o Selling your companyo Trading stock for casho Start with “illiquid securities”o Get “liquid securities” or casho Overall spending plan

o Taking your company “public”o IPO: Initial Public Offeringo Selling your shares to the unqualified

public

Going public

o SEC (Securities & Exchange Commission) (www.sec.gov)o Heavily regulates what you can sell to “widows and orphans”

o In the days of Robber Barons, many abuses

o Now there are a huge number of laws dedicated to ensuring adherence to procedures and accurate disclosure

o As a result, going public is a pain in the #@?!%

Sounds ugly. What are the benefits of going

public?o You can raise large amounts of money from the sale of stock

o You can do it at prices (in general) cheaper than venture capital

o You can gain partial liquidity without having to lose control of your company (maybe) and continue to participate in its upside undiluted (relatively)

o Your employees can achieve the liquidity you promised

o Your stock has greater value (or at least a value) when considering acquisitions

So what are the downsides of going public?

o Very costly maintenance (at least $2M/year)o Everybody knows your businesso You have to spend a lot of time with teenage analysts. Say “hi” to your new bosses

o Maintenance of these new relationships is very time consuming

o Employee option pricing fluctuates dailyo If you miss a quarter, you are deado Long-range thinking is difficulto You will be second-guessed in every decision you make

o Everybody knows your compensationo Your stock may have less value when considering acquisitions

So how do you go public?o Ask some bankers to come by

o Develop a relationshipo Have them help you think about the viewpoint of

potential acquirerso They are driven by very different things than youo They have other constituents they answer to

o They can be helpful, even if they don’t take you publico They may have represented some of the potential

acquirers or sellers on prior transactionso So be careful…Data is valuable

o They may be in a position to make introductions even before you have to engage them

o They may know complementary/competitive companies you have never heard of

o They may help you think about likely outcomes and pricing

o They may have conferences that may lead to financings or mergers

o Ask for researcho Meet the relevant sector analysts

o You will learn a lot about what their expectations are

So how do you go public?o Have a strategic discussion with the board

o Will going public meet your valuation expectations?

o Is the “window” open?o Are you likely to be able to get an IPO done?o Understand what will happen if you succeed

o It may complicate some transactionso You can be sued for any decrease in your stock

price

o Understand what will happen if you failo Some private financings get difficult

o How have competitors fared? Is there room/interest?

o Will you have enough trading volume to achieve liquidity at a price people will be happy with?

o Do you know what performance is required to grow your valuation?

So how do you go public?o Make sure you are ready

o UNDERSTAND YOUR BUSINESSo If you miss a quarter because you didn’t really understand your

customer/sales process/competitive response, your company “will be dead to me”

o You are better off figuring this stuff out as a private company where the consequences are far less

o You are better off missing a public offering window and woodshedding than going out early and missing milestones

o Good storyo Be able to answer the question “Why do I need to own this now?”o Have milestones that matter all the time

o Revenues/earnings, growth, or sexo Complete management

o Have industrial-strength talent, esp. CFOo Start taking Valium now for when you find out your

audit/accounting costso Make sure you understand how revenue recognition will effect your

business o Board composition/governance

o Committeeso Documentation

o Get to know some buy-side peopleo See their perspectiveo “Tell me lies”o Understand their compensationo Understand how ex-colleagues got fired

So how do you go public?

o After a while, you or your banker will tired of an unconsummated relationshipo They worry that after all the favors they did for you, you will

go with someone elseo You are worried they will represent somebody else

o Invite bankers in for a “beauty contest”o They will try to show you that they know about your industry

sectoro Most really won’t

o They will try to show you that they are really well connectedo Most aren’to You need to know that they have relationships with all the senior

management in referenced companies, not junior bat boyso Better yet are people that have actually completed transactions with the

reference companieso Everything else is just talko Don’t let somebody learn on your nickel

o They pitch you about why:o They are the greatesto They have done a bunch of deals in your areao The aftermarket value of all their deals is multiples of the IPO

valuationo They claim to be able to get an astronomical valuation with their

institutional clientso They have a proprietary or trust relationship with the buy-side

So how do you go public?o Then VCs/board “add value”

o When the bankers leave, they judge the beauty contesto Poise, grace, flattery, analyst coverage and valuations

important considerationso It is easy to fake valuations, though, so understand

what they are sayingo They should give you several tables of valuation comps

to help you think of how your industry looks at companies like yourso Sometimes, the truth hurtso Your baby may actually be ugly or just average

o Also, what were the last few hot deals the bank hado What other useful industrial relationships they haveo Usually, they split the decision and invite more than one

o The banks hate thiso VCs don’t care; risk reduction

o So you sign the deal, and they get 7% of the money they raise, plus expenseso Plus, there is usually a “tail” that requires you to

use them in subsequent transactionso Make sure that you are only bound by a tail if the same

people are still employed by the banko If your banker or analyst moves on, you could end up an

orphan

So how do you go public?

o Now you start the “drafting sessions”o Usually at the lawyers’ officeso The bankers show upo So does senior managemento So do the lawyers (bankers’ and company’s)o You draft a “red herring”

o Prospectuso Sanitized

o Risks such as the Leonid meteor shower are included

o No forward looking statement that can’t be justified

o It all goes to the SEC for comment & approval

So how do you go public?

o By now, the SEC has made their comments, and the company replies to these questions/comments and waits for a response back. And waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits and waits

o When you have answered all of their questions, the company is legally ready to “go effective”

So how do you go public?

o Next, your investment banker and your senior company management travel around the world (NY, Chicago, London, Geneva, Hoboken, etc) to meet potential buyers of your stocko These people are called the “buy side” of

the transactiono Your banker is taking their temperature

throughput the meetings, usually at hotels local to the buyer for breakfast, lunch and dinner

o These buy-side people are from investment firms (like Fidelity, T Rowe Price), insurance companies (like Allstate), and many small and large funds (Deerfield)

So how do you go public?

o In the process, your bankers (the “Book Runners”) start filling “the Book”o They ask how much stock buyers want and

at what priceo They get some idea as to price

elasticityo When they are several times

oversubscribed, they are ready to price & “go effective”

So how do you go public?

o The night before the IPO, there is a “pricing meeting”o The bankers claim that despite their best efforts, last minute changes in the market/government/Israeli Palestinian peace agreement/chicken entrails mean that they could only get you 1/2 the price that you wanted

o The VCs start crying “I thought you said you loved me?”

o The bankers start crying “I know what I said. But my buy-side friends…I’m so confused”

o A price is agreed ono The VCs think the bankers are lying scumo The bankers think the VCs are lying scum

So how do you go public?o The company goes public

o The buyers pay their cash to the bankers, who then give 90% of the money to the company

o Shares start tradingo The bankers have priced the shares at a discount to get somebody to buy themo A lot of these guys are momentum playerso They wait for the price to rise high enough to screw other momentum players

o Everybody wants long-term holderso The VCs own a big piece of the company, can’t sell for 6 months

o They watch the price skyrocket, then miraculously a few days before the VCs can sell, crater

o Insiders can sell, but only in certain windows, and even then you can get sued

Selling your company: M&Ao Having an M&A alternative to an IPO is essential

o IPO windows come and goo Hopefully, you considered the strategic fit

between your company and others when you wrote your first business plan. If you didn’t, you get an F

o You need to go out of your way to meet the senior management at these potential acquirerso This is a good reason to establish a banking

relationshipo Your potential banker should know all the senior

management at your targeted companieso Not ”Yeah, I used to know a guy in shipping there. But

he’s gone now.”o He should be willing to make an introduction

o If he’s not, he is telling you somethingo You need to understand what drives the valuation

of a potential acquisition for each acquirero Compare multipleso DCFo Strategic valuation and changes in acquirer’s

valuation after an announcemento A banker can be a lot of help here, even before you

commit

Selling your company: M&Ao You need to understand what drives the valuation

and the attractiveness of a potential acquisition for each acquirero Look for holes in product lines

o Often, this is a make vs. buy decisiono Look for a history of making acquisitions

o A firm with no history is unlikely to start with youo Compare multiples

o You may be able to trade your crappy multiple for the better multiple of an acquirer

o This may pay for your acquisitiono DCF

o Consider assumptions about the discount rate, and number of years out in their model

o Strategic valuation and changes in acquirer’s valuation after an announcement

o Can your acquirer afford it?o Does your acquisition need to be accretive?o Cash or stock?o Have they filed a shelf registration?o Will they need to stage it based on milestones?o Will there be an earn out?

o A history of successful earn outs is essentialo A banker can be a lot of help here, even before you

commit

Selling your company: M&A

o Sometimes, that strategic fit may not be apparent to a potential buyer or the sellero If you see the fit, it may be up to you to make

the caseo Assume they will not do any work

o Start by talking about a smaller relationship

o Get to know as many potential acquirers on your own as possible, as early as possible

o YOU NEED AN AUCTIONo At some point, you may need to hire a banker

to make introductions for youo Having a go-between can preserve your future

working relationshipo You don’t want to get sold; you want someone

to buy you

Selling your company

o Understand the purpose of a bankero They give you plausible deniabilityo They preserve your relationships with your

potential future employero They create a level of opacity required for a

good auctiono They also create a level of opacity that

prevents a buyer from poaching your employeeso Many times these same bankers have been on the

buyer’s side of the table, so they know what is realistic

o That means they may also be conflicted o Understand what that implies, and assume whatever

you say goes directly to your potential acquirero Be judicious in your discussions on valuation

o They can help you think about relevant business metrics

Selling your company

o A banker can rarely do anything for you that you have not already thought through yourself

o They can help you mature a process at a pace that maximizes the chance of multiple bidders

o They set up a “data room” that allows you to see who is actually looking through your stuff

o They help you manage all of these relationships and minimizing pissing anybody off

o They have usually have minimums (usually $1-2M)

Dividendizizing/annuitizing (?!?) your

companyo In many companies (restaurants, machine shops, hair dressers), a natural acquirer is not obvious

o Liquidity in these kinds of small businesses can occur by distributing the profits in cash at the end of each year

o There are lots of tax implications in how you do this, so make sure you have competent tax/accounting advice

o Your lawyer should be able to help you with this

o A track record of large dividends may actually help you find an acquirer where none was obvious