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The Tough Go Shopping

In a volatile market, it takes a little more ingenuity to take a company public.

1Jan

Even the engineers were grinning when Steve Nill joined Sonus Networks Inc., a Westford, Massachusetts-based voice network infrastructure producer, as its first CFO in September 1999. "At first I just thought everyone was really friendly. Then I realized the grins were because they knew my arrival meant their options would finally turn into cash," says Nill half-jokingly. He, too, was looking forward to leading his second initial public offering, having done his first shortly after joining multimedia server provider VideoServer (now Ezenia Inc.) in 1994, after six years as Lotus Development Corp.'s corporate controller.

Too bad the IPO was planned for this past spring. At the S-1 filing on March 10 everything seemed fine, but the precipitous April Nasdaq drop forced Sonus management to postpone the road show. Worse, the critical last day of presentations in front of the biggest investors was scheduled for May 23, the day Nasdaq lost 200 points. "Investors kept saying to us, 'You've got a great story — so why are you doing the offering now?'" recalls Nill.

No one ever said taking a company public was easy. In fact, "the IPO market is never in equilibrium; it's always too hot or too cold," says Jay Ritter, a professor at the
University of Florida who studies the behavior of IPO markets. But the unprecedented volatility facing the 400 new issues that braved the market this past year made it tougher than ever to plan a smooth debut — and called for some extra ingenuity by issuers.

In Writing, Please

Sonus ultimately survived its May 25 debut spectacularly, opening at $9 above its offered $23 price, closing at a rich $50.50, and, unlike 60 percent of last year's offerings, trading above its IPO price as late as December, at about $36, even after a 3-for-1 split in October. One of the reasons for its success, Nill says, is that he had started the underwriter selection process by polling institutional investors, the ultimate stock buyers. Knowing them to be selective about underwriters, and ever more wary of sell-side analysts' potential biases, he wanted to find out "who they listened to, and how they distinguished one offering from another," he says.

Feedback from fund managers led to a list of about a dozen banks, with which Nill met informally for several months prior to the formal selection process, or "beauty contest." But to ensure that the "right" banks were right for Sonus, Nill asked them to respond to a written request for proposal. The RFP required answers to more than 20 specific questions about positioning, valuation, aftermarket support, and trading. Nill had developed the RFP for his first IPO with the idea of adding some objectivity to a process he had heard venture capitalists and others describe as vague and subjective. "Probably any of the banks could have gotten the deal done, but in the end, you want to establish a relationship with a firm that can help your business grow," says Nill.

According to investment bankers, Nill's technique is unusual — most beauty contest discussions are verbal and much less detailed. "If I didn't already have the highest regard for Steve, that would have convinced me," says Ryan Limaye, a Menlo Park, California-based Goldman Sachs banker who worked on the Sonus offering. "We inferred from [the RFP] that Sonus was doing a very thorough investigation and evaluation of the firms." He says the format was useful, both in helping the bank better target its presentation to Sonus and in making the competition more productive. "Some CFOs try to invite 20 or 30 firms to compete for the business, but short takes with lots of firms don't really let you differentiate," he adds.

The More the Merrier

Some finance chiefs, especially those doing their first IPOs, have discovered that entertaining a large number of banks, at least in the early stages, has helped them learn more about the process. Just ask Buddy Rogers, CFO of Plano, Texas-based specialized-semiconductor manufacturer Microtune Inc., who found himself juggling the interests of about 25 banks for more than a year and a half before the company seriously considered an offering.

Rogers says that favorable trade press and CEO Douglas Bartek's connections with bankers made the process of interviewing banks easier (although he also called banks that didn't initiate contact). But it was grueling to meet as many as 20 bankers in two weeks. So, while building relationships for the future, Rogers also used these meetings to help him gauge Microtune's readiness for the public market.

"It was a two-way street," he says, noting that "it was especially helpful to talk with them to find out what investors really want these days," given the unprecedented valuations for young, revenueless companies.

When it came time to actually choosing a banking team, Rogers was one of the key negotiators for an ambitious plan to maximize banks for the buck. Microtune wanted to use four banks to make sure the company had adequate analyst coverage, but because the proposed deal was only $57.5 million, all the bankers strongly encouraged the company to limit the number to three, says Rogers. Despite the banks' resistance, and Rogers's fears that the banks might not exert their best efforts for a lower return, he continued to press each of them to take a smaller cut of the standard 7 percent fee.

"Their first answer is always no," he says. "But then you kind of work through it, learn a little more, and try again. You can't shove something like this down their throats, but, after all, these guys wanted to do the deal." Swayed by the argument that the arrangement would make it easier for all of them when it came time to sell investors on a complicated technology, Goldman Sachs (the lead manager), Chase H&Q, SG Cowen, and Bear Stearns & Co. eventually agreed to the terms, with no concessions on Microtune's part.

Throughout the process, Rogers's relationships with about six other banks continued to be useful. When he questioned the terms the chosen banks were offering, he says, he would call the runners-up (as well as other CFOs he trusted) to find out whether he was being taken for a ride. "Of course they'll want to slam the other banks a little, but they'll usually give you a pretty good sense of what's fair," he notes, especially since he has made it clear that he would consider them for future transactions.

After a harrowing July road show, the stock finally priced at $16 on August 4, slightly above its $13-to-$15 filing range, netting $66.8 million for the company. Three months after the issue, as the stock dropped from a high of 60 in September to a low of 147/8 in November, having an "extra" bank has paid off. "Each of these banks has its own group of high-quality investors," says Rogers. "We've seen a lot of value in their ability to get in front of these accounts and convince them we're still a viable alternative."

The Pricing Campaign

Of course, banks' close relationships with investors can be a two-edged sword. "You have to counteract their natural bias to keep a good relationship with the investors at the expense of the company's valuation," says Anne Stuart, CFO of optical network provider Corvis Corp. Stuart joined the Columbia, Maryland-based company in January 1999, after a 13-year career in various finance positions at Marriott International and Forum Group, confident about leading her first IPO after previously working on the initial stages of a secondary offering (ultimately canceled) at Forum.

On the face of it, Corvis seems to have fallen prey to this very bias: the company left more money on the table than it took home during its July offering. On the other hand, during the road show the offering more than tripled in price, to the maximum increase allowed by the Securities and Exchange Commission. It also broke all records for start-up technology companies, bringing in $1.1 billion (the 15th largest IPO of the year) on July 28, a day when Nasdaq lost 5 percent.

So how did Stuart do it? Much of the credit goes to the team, inspired by CEO and founder David Huber's "broad and breathtaking technology vision," according to lead banker Jake Peters of Credit Suisse First Boston (CSFB). But undoubtedly the pre-IPO financing strategy also helped. Stuart had devoted her first year on the job to eight private rounds of venture capital to "dial up the implicit valuation of the company" from less than $100 million in the first round to $2.2 billion in the last.

Stuart also led an aggressive pricing campaign, based on a strategy she, Huber, and the board developed to keep pricing tightly linked to subscription rates. "We asked ourselves, 'Where can we posture with our bankers to get them comfortable in being aggressive in valuation?'" she says. After CSFB was chosen as the lead, Stuart and the bankers verbally agreed to a formula for deciding when price increases would kick in, based on subscription rates, "to preempt that jockeying for position that banks might take," says Stuart, who was a mathematics major in college.

While there were no ironclad pricing promises, Stuart says the formulaic approach helped the company later, "in the heat of battle." Going into the road show, the price range was $13 to $15, geared toward a cash intake of 17 to 19.8 times projected 2001 earnings, according to CSFB calculations. By the end of the presentations, the range had jumped to $28 to $30, a huge increase.

Corvis management wanted more. The bankers tried to keep the price at an 18 percent increase over the doubled price, rather than upping it to the 20 percent the SEC allows (without refiling). At that point, Stuart returned to her original formula, and argued effectively for the full 20 percent on the grounds that the issue was 20 times oversubscribed. Corvis eventually priced at $36, with its opening trade at $92. In early December, it was trading around $40.

How to explain, then, the $1.2 billion Corvis left on the table compared with the $1.1 billion it took home? While Corvis wasn't inherently interested in aftermarket appreciation, and wanted to preserve value for existing shareholders, Stuart says she knew that for new investors to be induced to buy in, they needed to be able to look forward to a gain. So part of the pricing equation involved the bankers' estimates of investor sentiment toward future price levels, and working with the spreads they were looking for, says Stuart. "We felt we struck the balance perfectly," she notes. "You're always navigating between two extremes."

Alix Nyberg is a staff writer at CFO.

A Simple Quiz for Underwriters

Sonus Networks CFO Steve Nill shares the RFP he sent out to underwriters.

Positioning
1. How would you position the company in relation to the market and the competition?
2. What are the central positioning issues?

Valuation
1. In your view, which are the most directly comparable companies from a valuation standpoint? How do you value our company and why?
2. Propose your pricing strategy for the Sonus transaction (market cap upon filing, pricing, end of day 1, fully distributed) and contrast it with at least four other recent high-profile communications/technology IPOs that you have managed or co-managed.
3. What are the key factors that could influence a higher or lower valuation at the time of the filing and final pricing versus your current assessment?

Aftermarket Support
1. What philosophy and plan will you follow in providing research coverage?
2. Who will actually write the research and who will cover the company on a daily basis?
3. What is your coverage of companies that could be potential business partners with this company?
4. When can we expect our first major written research report post-deal?
5. What can we expect the frequency of research reports to be during the two years following the offering? Present examples of frequency of your research for other IPOs in the last two years. Also, present examples of theme pieces or other research products that you believe demonstrate the breadth and depth of the research we can expect.
6. Under what circumstances could we expect you to drop coverage of the company? Have you dropped coverage of any companies you have taken public in the last three years?
7. What can we expect in terms of conferences, private buy-side meetings, and road trips? Please provide one or two case examples.

Trading
Please prepare a table that demonstrates your trading performance post-IPO for five or six high-profile communications IPOs that you have managed in the last 12 to 18 months. The table should show quarterly performance.

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