When services-outsourcer OAO Technology Solutions Corp., in Greenbelt, Maryland, reached $50 million in estimated value late last summer, management and investors agreed the time was right to go public. After all, investors at the time still hungered for small, fast-growing technology-based stocks.
Yet just after OAO launched the offering in late October, the market entered its most turbulent period in a decade, with many broad indexes dropping more than 10 percent in a few days, rebounding, and then yo-yoing for the next three weeks. Many initial public offerings at that time were delayed to wait for calmer waters. But OAO steamed ahead, going out the door at $5 a share.
How did OAO navigate through the market mess so smoothly? Mostly thanks to Safeguard Scientifics Inc., a Wayne, Pennsylvania-based venture capital firm disguised as a corporation. When Safeguard bought a 50 percent stake in OAO in April 1996, OAO founder Cecile Barker agreed to go public through a stock rights offering to Safeguard's shareholders.
The little-used technique grants the investing company's shareholders the right to buy shares of the IPO company during a 35-day rights period, or sell the right prior to issuance for market price. In this case, Safeguard shareholders received one OAO share right for every five shares of Safeguard they owned.
That built-in market, as well as Safeguard's track record of bringing good issues out, gave both management teams confidence to go ahead with the offer. Still, there was no guarantee that aftermarket trading would push the stock higher and make the offering a success for Safeguard and its shareholders.
"We were nervous as hell because no one knew what the market would do, and most people exercise their rights at the end of the period," admits Safeguard CFO Michael Miles. "Thankfully, OAO shares traded up to $12 and stayed at around $9 a share. It proved to us once again that we don't need a good market for a rights offering to be successful."
While the run-up in share price immediately after trading began suggests deliberate underpricing, Miles insists that isn't the case. "We obtained two independent valuation opinions of the company. Then we split the stock and determined how much stock should be issued and how much of ours and the existing owners' should be sold in order to get to our target price of about $5 a share. The rights have absolutely no value when issued. Otherwise, the rights would be dividends, and taxable to our shareholders," says Miles. The run-up, he maintains, is due mainly to the market placing a higher value on the company than management and advisers did when valuing the company.
This was hardly the first time Safeguard had used this technique. The investment firm has completed more than a dozen rights offerings over the past 15 years. Big winners include software firm Novell Inc. in 1984, Cambridge Technology Partners in 1993, and Coherent Communications in 1994.
RIGHT FOR A FEW
Rights offerings aren't used more often because most corporations with spin-off candidates, says Miles, own more than 80 percent of the subsidiary and can qualify for a tax-free spin-off to shareholders to take the entity public. And others, such as Waltham, Massachusetts-based Thermo Electron Corp., use spin-outs, in which the new entity goes public in a normal, but minority, IPO.
However, a rights offering could be used by any midsized-to-large company interested in investing in private businesses and later seeing those companies go public. Using a rights offering to go public could both increase the value of the shares still held by the investing corporation and provide its shareholders with a new equity opportunity.
For the IPO candidate, the value of the rights issue option to the investing company could lower the cost of capital. Plus, the built-in shareholder base could smooth the IPO waters during a difficult market period, as it did for OAO. For this arrangement to work, however, shareholders of the investing company must either expect opportunities like rights offerings or be educated about the advantages and procedures of such offerings.
Says Miles regarding Safeguard's shareholder base and issuing process: "We think it's a great technique, but it takes time to do rights offerings well."
Ian Springsteel is an associate editor at CFO.