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Pricing IPOs: science or science fiction?

A look at the intricate art of taking a company public.

It's show time. After months of preparation, your company's initial public offering (IPO) will start trading this morning. You spent yesterday afternoon anxiously tracking the market. The investment bankers canvassed their institutional brokers to assess interest in your stock. The company finance and accounting staff have spent countless hours preparing for the day. The final decision: The company will sell 2 million shares at $20 each, for a total offering of $40 million.

The investment bankers say demand for your IPO looks strong, and they expect your stock to open with a "pop." That prediction proves true--the shares open at $23 and the price moves steadily higher throughout the trading day, finally closing at $25. Although the stock's strong first-day performance is gratifying, you can't shake the feeling that you might have mispriced the IPO. The calculations run through your mind: Each $1 increase in the offering price would have generated $2 million more for the company.

The thought nags you--did you sell too cheaply?

When an IPO quickly moves to a significantly higher price during its first day on the market, it's natural to wonder if the investment bankers--and the issuing company's officers--didn't misprice the deal. Although the market for IPOs has cooled recently, some offerings still post impressive first-day gains. In mid-June, for example, 6 million shares of came to market at $15 and closed at $22.375, after trading as high as $28.50. Not too long ago, Internet and technology IPOs routinely doubled in value on their first day. That kind of volatility makes it inevitable to second-guess.

The offering exemplifies the incredible demand that has existed for these issues. The company, an online financial news service, went public January 15, 1999, with an offering price of $17. It closed the day at $97.50, an increase of 474%. In another instance, went up 606%, from $9 to $63.50 on its first day, in November 1998.

These enormous price surges raise questions about whether traditional valuation methods remain valid. Not surprisingly, however, investment bankers and CFOs who have taken their companies public recently dispute the notion that IPO pricing rules have changed.


Investment bankers say the valuation process is as much an art as a science. The scientific part of the pricing equation is based on numbers: an issuer's historical and projected financial results, as well as valuations for comparable companies. The art is in the investment banker's assessment of market conditions and investors' demand for the new issue.

"Pricing an IPO is always a function of the valuation," says Charles J. Kaplan, president of Equity Analytics. "That's what you have to determine first."

Kaplan, whose company advises privately held firms wishing to go public, points to a range of valuation multiples used to estimate a company's market value. "Let's assume a food distributor or a food processing company wants to go public. We look at income before interest and dividends and put a multiple on that. If it is a relatively slow-growth industry, the multiple will be lower; if it's a fast-growing company, we'll use a higher multiple. The multiple probably won't go higher than 10 or lower than 2 or 3."

Estimating a company's value begins well in advance of the IPO date. Businesses planning to go public typically interview several investment banking firms before selecting one to underwrite the offering. The investment bankers, in turn, investigate the company to determine if they want to handle the deal. They perform a detailed review of the company's finances, the quality of its management team and the company's position in its major markets. The investment bankers also consider "comparables," which are publicly traded companies in the same industry as the IPO candidate.

Selecting the right comparables is straightforward when working with established companies in clearly defined or mature industries. It is more challenging, though, to find appropriate benchmarks for younger companies, especially those in new and rapidly changing industries. William J. Ruehle, CFO of Broadcom in Irvine, California--a broadband-communications integrated circuits manufacturer that went public in April 1998--stresses the need for flexibility in developing comparisons. "The universe of comparables is constantly changing, so you're always challenged to find the right firms," he points out. "We started with comparable communicatioris-semiconductor companies, then we broadened that to companies that have a unique franchise. The established companies have one type of multiple. As a new company, should we have a better multiple initially or perhaps a lower multiple because our track record is shorter?" Despite the tepid IPO market, Ruehle says, "I would say the current pricing practice definitely favors higher multiples for very promising new companies."

But how do you value a company--such as an Internet-related business that's pioneering a new activity--when there are no comparables? To compound the difficulty, how do you value a young business that shows losses despite rapidly growing revenues? It's a challenge, but one that Wall Street has overcome before.

"In the past, a company had to show profits and reasonable revenue growth to do an IPO," Kaplan notes. "Then the cable TV companies came along, in the 1970s and 1980s. They needed to do IPOs, but they were showing increasing losses because they had had very large capital expenditures to build and maintain their networks. Investment bankers recognized that the companies were showing large increases in revenue and the losses would dissipate over time because the companies had large customer bases that would buy the service month after month."


The solution: Change the valuation model. "Instead of valuing the cable companies traditionally, at some multiple of earnings, for example, they valued the firms based on their installed customer base," Kaplan says. "This led to a valuation multiple based on the cable company's subscribers."

Today's Internet companies are forcing a similar revision. Since many show losses, investment bankers are focusing on revenue growth, industry leadership and projected profit potential to establish benchmarks. "Early profitability is not the key to value in a company like this," says Jerry Kennelly, CPA and CFO of Inktomi, San Mateo, California. "You must look at the potential of the firm's markets and its revenue growth potential in evaluating stocks like ours. It would be a disservice to our shareholders if we didn't make the right investments at this stage to gain important market share just for the sake of early profitability."

Inktomi, founded in February 1996, builds the software infrastructure for large Internet portal sites. The Inktomi IPO's offering price on June 10, 1998, was $18 per share, and the stock doubled to $36 on the first day. Kennelly reports that there was some give-and-take with the investment bankers over the benchmarks and the offering price. "You make projections and the investment bankers discount what you say by some factor that they believe is appropriate. You try to find the most authoritative market data you can."


After considering the issues relevant to each deal, the investment bankers make an initial estimate of the firm's value. The resulting offering price, which is based on that valuation, is influenced by several factors.

* "Desirable" range. Most new issues come to the market priced between $10 and $25. Stocks trading below $5 can't be traded in margin accounts, and conventional market wisdom holds that stocks priced above $25 tend to discourage individual investors.

* Percentage of company sold. Investment bankers generally recommend selling at least 25% of the outstanding shares in the IPO.

* Float. The company must sell enough shares to ensure liquidity in the market or institutional investors (such as pension plans, mutual funds) may be unable to buy the stock. Many institutions have policies that prevent them from acquiring more than 5% or 10% of a company's shares. Since institutions like to trade large blocks of stock--10,000 or more shares per transaction--it becomes necessary to offer a large number of shares.

Example: A company is valued at $225 million, and it decides to sell one-third of its equity--$75 million of stock--to the public. With a target offering price of $15 per share, it's necessary to issue 5 million shares. The $15 price is attractive to individual investors, and the 5 million shares will provide ample liquidity for institutions.


Establishing a reasonable value for the company is the critical first step, but the investment bankers must also consider the market's receptiveness toward IPOs in general and their new issue in particular. As Inktomi's Kennelly observes, "You can have the greatest story in the world, but if the market is depressed or inflated, you are either penalized or hurt by that environment, regardless."

Most IPO issuers put on a "road show"--a series of presentations to potential institutional investors--to promote the offering and gather feedback on the market's interest in the stock. "As you take the road show across the country, making presentations to many of me top money managers, you start to determine what sort of demand your stock will have," says Jack Riggs, CPA and CFO of in Dallas. "Many things play a role in that demand: the market, your story, the industry you work in and your business model."

Riggs and his investment bankers obviously did a good job telling the story. The company, which broadcasts audio and video events over the Internet, came to the market with 2.5 million shares priced at $18 that closed the same day at $62.75.

In addition to road show presentations, investment bankers use their sales forces to canvass potential investors for their price sensitivity. "The syndicate manager's objective is to put away the whole offering," Kaplan explains. "The investment banker first needs to find out the demand for this offering at various price levels, so the investment firm's institutional brokers contact their customers who might be interested in the offering. The brokers explain the offering and learn how many shares the institutions would take at various prices--like sketching out a demand curve. The firms' top retail brokers also contact their best clients to learn where the demand is with those investors."

This telephone survey reveals potential demand for the new issue, looking for people to "subscribe" to buy shares. "For example, the investment banker will know that, at $14 per share, the offering is oversubscribed 4 times; at $15, it's oversubscribed 23 1/2 times, and so on," Kaplan explains. "The objective is usually to oversubscribe the offering two to three times, which will pretty much guarantee that the whole issue can be sold on pricing day."


Although the company hires the underwriters and pays the IPO fees, the investment banker must balance the conflicting goals of several audiences. The issuer wants the highest price--within reason--for its shares, while investors want to pay the lowest price. Overpricing the issue increases the risk of a poor after-market performance, which can lead to lawsuits from disgruntled investors.

Underpricing costs the company substantial sums and can damage the investment banker's reputation. Finally, in a firm commitment offering (rather than a best-efforts deal), the investment banker agrees to buy all the shares the issuer offers. The investment bank has an incentive to sell out the entire offering quickly, otherwise it ties up its own capital in the deal.

In an effort to satisfy all parties, investment bankers have traditionally set a stock's offering price 10% to 20% below its estimated value. If the issuer's shares are worth $20, for instance, the offering price would be in the $16-to-$18-dollar range. This practice, known as "leaving something on the table," serves several purposes. It entices institutional investors to buy the issue because they are getting a bargain, and their participation is usually critical to selling out an issue. Assuming the stock's price moves up to its fair value in the after-market--the IPO price "pop"--investors earn a fast return as a reward for investing in an unseasoned issue. Underpricing also serves a defensive purpose. Should a disgruntled investor claim the issue was overpriced, the investment bank can point to its valuation method and the discount as evidence of its conservative practices.

As noted above, many recent IPOs have soared far beyond the traditional 20% discount, with some stocks doubling and tripling in value on the first day of trading. Investment bankers recognize the public's demand for new issues, so why aren't they taking advantage of the opportunity and setting IPO prices much higher? With Internet stocks, at least, Phil Skidmore, Senior Managing Director and Syndicate Manager at Advest, a Hartford, Connecticut-based brokerage firm, believes investment bankers cannot afford to focus exclusively on the short run. "We are in a bubble here, in the sense that trading interest in Internet IPOs far exceeds normal markets," Skidmore points out. "But even with a very hot issue, you want to relate the value of what you're selling to the public to some kind of market yardstick. In the long run, the prices of these securities usually come down and trade where they belong. So even if you have a huge initial pop, investment bankers must live with an IPO over the long run. Also, every buyer doesn't necessarily sell the issue immediately--you're trying to get long-term investors involved."

Of course, not all IPOs--even those with .com in their names--hit the stratosphere. Inc., an online retailer, opened at $10 per share--below its expected range of $11 to $13--and dropped below $8. AppNet Systems Inc., which provides e-commerce services to clients, opened and remained at $12, the low end of its range.

Neil Barsky runs Midtown Research Group, a research firm and investment partnership in New York that covers and invests in public companies less than four years old. He agrees with Skidmore's assessment that letting market events dictate IPO pricing would be a mistake. "In some deals where there is a frenzy, such as many of these Internet deals, the IPOs often trade much higher," Barsky observes. "It's a challenge for the underwriter to know where to price these deals. Often the company wants to price it higher because they know the demand is there. But everyone realizes the value may not be there, and they might regret the higher IPO price later. So they leave more on the table, and much of the risk is borne by the new buyer and not the underwriter."

Without exception, the CFOs interviewed for this article philosophically accepted the amounts they left on the table. "During the road show we realized that we did not want to come across as being greedy,"'s Riggs says. "We know that we might want future financing in the markets and we wanted to reward the people who believed in our stock and give them the opportunity to be involved in a successful IPO. That was our management team's philosophy."

Kennelly of Inktomi has a similar outlook. "Our stock price doubled the first day, and now we are at a multiple several times higher than the offering price less than a year later," he observes. "So the natural question is, `Didn't you leave too much on the table when you priced at $18?' You can't really price against the momentum trading that might take place immediately following an IPO. First, you don't Know if mat type of trading will happen--you can only speculate. Second, fair pricing means taking established values and ratios that the market has seen and putting them on the company. You can't put a high price on the stock just because you have a .com at the end of your name. It's not the right thing to do. The funds that are the big buyers of stock won't go for that, and they shouldn't. Your value will be proven when your stock trades in the market at a sustainable level for the months and quarters that follow the IPO, not just one week of frenzy."

As Kennelly points out, market frenzies inevitably cool at some point. The's Internet stock index fell from a high of slightly over 800 in mid-April to the 500 range by mid-June, a drop of almost 40%. The Internet stock sell-off is affecting IPOs from other sectors, as witnessed by several recent deals. Three of the four offerings that started trading on June 9 (Lintronic, Inc.; Skechers USA, Inc.; Pantry, Inc.) closed below their offering prices. Skechers USA produces casual footwear, while Pantry operates a chain of convenience stores. Although Lintronic is an Internet security firm, it also suffered from increased investor discrimination. It seems that in spite of the Internet stocks' impact on the IPO market, for many companies, the fundamentals of reasonable valuation, investor demand and market conditions are still the dominant factors.



* IPO VALUATION IS as much an art as a science. Values are based on several factors: an issuer's historical and projected financial results; valuations for comparable companies; and the investment banker's assessment of market conditions and investors' demand for the new issue.

* DESPITE INTERNET STOCKS' impact on the IPO market, for many companies the fundamentals of reasonable valuation, investor demand and market conditions are still the dominant factors.

* IN AN IPO, THE INVESTMENT BANKERS develop an offering price that is influenced by factors such as the most marketable price range, the percentage of the company being sold and the stock's market float.

* IN ADDITION TO ROAD SHOW PRESENTATIONS to potential institutional investors, investment bankers use their sales forces to canvass potential investors for their price sensitivity.

* OVERPRICING THE ISSUE increases the risk of a poor after-market performance, which can lead to lawsuits from disgruntled investors. Underpricing the issue costs the issuers substantial sums of money and can damage the investment banker's reputation.

RELATED ARTICLE: IPO Valuation Guidelines

When there are no directly comparable firms that can be used to value an IPO, investment bankers frequently rely on the following factors:

Financial Results

* Accounting policies themselves and their effect on reporting.

* Assets.

* Back orders.

* Cost of capital.

* General and administrative expenses as a percentage of sales.

* Historical and projected growth rate of sales and earnings.

* Long-term debt.

* Profit margins.

* Receivables.

* Stockholders' equity.

The Company

* Cost of production.

* Experience and quality of management.

* Growth opportunity in geographic or technological terms.

* Industry outlook.

* Regional or national?

* Market share.

* New-product development from conception to production, as opposed to the rest of the industry.

* Percentage of total sales to the largest customers.

* Raw material suppliers.

* The scope of the product line as compared to the industry leaders.

* Years in operation.

Legal Considerations

* Environmental issues.

* Liabilities and lawsuits.

* National, state or local legislation, whether positive or negative.

* Patents, trademarks or proprietary knowledge.

Source: Pricing An Initial Public Offering by Charles J. Kaplan, Equity Analytics, Ltd. ( Reproduced with permission.

RELATED ARTICLE: Advice for a Successful IPO

Although it's difficult to predict an IPO's price after the market opens, you can take steps to ensure other aspects of the offering go smoothly. Nancy Pierce, founder and CFO of Carrier Access Corp., which is based in Boulder, Colorado, took her company public last year. The company designs, develops and manufactures telecommunications and data communications equipment, and it sold roughly 3.5 million shares at $12 per share in late July 1999, just before the IPO market dried up for the summer. Her advice for CFOs falls into three categories.

Advance planning. "Set expectations going in," Pierce says. "One thing I did was provide each investment bank with a list of questions and scenarios that we asked for responses on, including a positioning report. They clearly knew our expectations going into the process, in terms of publications or ongoing support. Also, I suggest the CFO get as many blind references as possible. The investment bankers are excellent salespeople; however, being public is really about analyst coverage and the quality of investor you want to attract to your company."

Talk to your peers. "I talked to other CFOs whose companies had just gone public, so I didn't walk into the IPO process with blinders on. I think that's very helpful because there is always some delay or snag during the process, and usually they are costly snags. I think the most expensive part of the process is the amount of time the CEO and CFO spend of it. Most of us work in the business, and we don't have the luxury of taking the amount of time it can consume. Also, having a good staff internally really helped us. We hired someone from a securities firm who was very familiar with the process and we had good people to help run the business."

Take a nap. "Get your sleep now!" Pierce says. The IPO process is not that difficult--"it's just time-consuming, and you're doing your regular job at the same time."


It's easy to get wrapped up in the details as you and your staff prepare for an IPO, but keep the overall picture in sight. Christopher W. Frey, CPA, a New York-based partner of Tatum CFO Partners, LLP, offers the following suggestions for maintaining your perspective.

Relationships. Choose your advisers carefully. "You'll be bringing in people you don t know to help with the IPO process--investment bankers, attorneys. When you start talking IPO, people not only look at you, they also look at your advisers. You're hiring advisers for their knowledge, but what else can they bring to the table? Do they have a particular strength in your industry? Have they done similar deals before? The fees will be substantial in most cases, so you want to be sure that you get what you're paying for."

Risk. Evaluate all your exposures and be prepared. You face several kinds of risk, not all of which is financial. By going public you face increased regulatory and investor scrutiny and may have to answer hard questions from unfamiliar sources. Your auditors also face more risk in their work with you now, so be prepared to address their concerns in new areas. An IPO will also change the culture of the company, and when that happens you run the risk of losing people you would like to keep. Be flexible and accommodate key people where possible. These are subtle issues, but they need to be considered.

Reward. Don't overlook the intangibles. "The financial rewards are obvious and everyone wants a piece of them. But the company itself has gone through a transformation, and that's also meaningful. You've gone from the owners' start-up dream to the big leagues. Reward the finance team for their dedication and hard work, reward the employees for helping to build a business that could do an IPO, and reward the extended corporate family for making it through this process. Celebrate your success with all who made it possible!

ED McCARTHY is a freelance writers in Warwick, Rhode Island, who specializes in finance and technology topics. His e-mail address is
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Title Annotation:initial public offerings
Author:McCarthy, Ed
Publication:Journal of Accountancy
Geographic Code:1USA
Date:Sep 1, 1999
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