Wanted: the right investment banker.
At Starbucks Coffee Co., we had our sights set on an initial public offering for years. In 1992, when we finally decided to put the wheels in motion, we needed the best investment banker we could find to take us public. So we began our search.
Selecting an investment banker should be a thorough, deliberate process, and it's probably a mistake to select the first firm that offers its services. We met with more than 20 investment-banking firms in the 24 months before we made the final decision to go public. That was unusual, and it took a lot of time, but it was well worth the effort because we learned a great deal about the IPO process from talking with all the banks.
Through our interaction with the investment bankers, we were also able to begin shaping the perception we wanted the investment community to have of Starbucks, which sells premium coffees and beans and operates 405 stores nationwide. By communicating with so many representatives of the investment community before we went public, we were relatively well-known by the time of our IPO. This helped increase the receptiveness of the investment community to Starbucks both during and after our IPO.
WHO MAKES THE GRADE?
There are several ways to select an investment banker, all of which may work well for a company, depending on the circumstances. We've been told our approach was somewhat unusual, but it worked well for us. We reviewed the investment-banking firms we had interviewed during the 24 months prior to our decision to go public and created a short list of six firms whose capabilities appeared to best match our requirements. We then developed a thorough request for a written proposal and sent it to those firms, from which we received some outstanding responses in about two weeks. Finally, we asked each banker to do a one-hour presentation, followed by an hour of questions from two of our five board members and two representatives from our management group.
Our request for proposal asked each of the investment bankers to respond to a number of questions, which were designed to enable us to determine the bankers' capabilities in several critical areas. The list of questions allowed us to control the content of both written and oral presentations, which ensured the bankers addressed our issues. Also, the list made it easier to compare bankers.
We asked each banker to tell us when we should become a public company and what size offering it would recommend, given our capital requirements. At the time of our "beauty contest," as the investment-banker selection process is often called, we were uncertain about when to do an IPO and what size offering we should have. Essentially, we were asking the bankers to help us think through the fundamental questions of market timing and offering size. The different opinions of the six bankers on these crucial issues were helpful in our decision-making process.
In selecting a banker, the capabilities of the investment banker's corporate-finance function are critical, since this group will lead your IPO process. For some companies in some markets, almost any investment banker can take you public successfully. But in difficult markets, and you never know when this will occur, only an experienced banker with a strong reputation will get you through the process. So look for a banker that's successfully completed a number of IPOs, preferably in your industry. You should also ensure the individual assigned to your project has considerable experience in leading the IPO process. This individual is critical in any market because the IPO process and the relationships between the various players are complex and require strong leadership.
In addition, inquire about the banker's ability to act as your financial advisor after the IPO. Although it may be difficult to envision future needs during the IPO process, this is an important function, and you'd be wise to ensure the corporate-finance people have the experience to assist you in developing your business through acquisitions, joint ventures or in other ways.
The research function and especially the research analyst assigned to the IPO team is important not only for the initial pricing and distribution but also for after-market support. If your analyst is highly regarded by institutional investors, he or she will be an important addition to your road show, and the quality of that individual's research after the IPO will be crucial to your long-term success. We reviewed thoroughly the analysts who'd be assigned to us. Not only did we evaluate their reputations in the community, but we reviewed samples of their research reports and evaluated their work-loads to determine if they had time to serve us. We also asked for a commitment on the timing of the first comprehensive research report and the frequency of update reports.
Distribution capabilities also factored into our decision. What were the size and capabilities of the sales force? How much institutional vs. retail selling capability did each investment bank have? Also, we looked closely at how the bankers planned to link their research and selling abilities. For example, how would the research and help prepare the sales force during the IPO process? And because your bankers are usually your market-makers right after the IPO, we investigated how well these firms supported in the after-market the companies they took public.
An important part of our process was understanding how the investment bankers would price the issue and how we'd be involved in the pricing decision. Since there were no public companies that looked much like Starbucks, we were especially interested in knowing which companies the bankers considered most comparable to us, because this would have an important effect on our valuation. We also had each banker outline its pricing process and inform us how it would involve us at each step. We wanted to play an active role in the pricing process, and not all bankers are receptive to company participation.
AND THE WINNER IS ...
We also asked the bankers to value the company at the time of the beauty contest and to discuss how they developed their valuations. While their valuations were important to us, they were far from the most important issue. We were really more interested in what companies we were being compared to and why; how the bankers would position us relative to these companies; and other more fundamental valuation issues and approaches. Market conditions and valuations will change between your beauty contest and the effective date, so the initial valuation is far less important than the process and principles the banker applies to the pricing.
While we didn't judge the bankers solely on which one had the highest valuation, we didn't select the firm with the lowest price, either. One or two firms completely misjudged our valuation. They didn't understand our market position, and their valuations were well below the other bankers'. While they tried to persuade us the other investment-banking firms were leading us on by giving an excessive valuation, the fact was they hadn't really done their homework. The firm we selected valued us about 25 percent above the bottom of the price range and 10 percent below the top. If we'd used a firm at the low end of the range, we may never have gotten to the offering price we ultimately ended up with, and we could have been embarrassed by the difference between the offering price and the trading range on the first day.
Your investment banker's reputation and that of each team member are very important. Many investors rely on the banker's reputation and recommendation to make their decision. It's amazing how little time buy-side analysts and portfolio managers spend evaluating your offering. They get hundreds of prospectuses coming across their desks all the time, not to mention all the opportunities they have with companies that are already public. So they don't have a lot of time to spend making up their minds. Accordingly, they'll often rely on the analysts or the sales force of the firm representing you to give them direction on your opportunity.
When evaluating the team members, don't simply focus on professional experience and capabilities. You also need to consider how you'll get along with the people and what kind of excitement and energy they'll bring to your IPO. You're going to live with them very intensely for 90 days or more, and getting along with them is very important to how smoothly the process works.
You may decide, as we did, to use more than one investment banker, although each banker will usually advise you that you need only one. In fact, the investment bank we selected as number one could have done our IPO without help from a second firm, but we chose to add a second firm because we wanted more representation in the financial community, both during and after the IPO process.
By using a second bank, we got more research and market-making ability. Our second investment banker added considerable strength to our research, because it had on staff the top-rated research analyst for restaurants. The first investment banker had a very strong retail analyst, but we knew that some investment companies might regard us as more of a restaurant than a retail concept, and we wanted some way of communicating with restaurant analysts.
Although most investment bankers are becoming accustomed to two-bank structures, they don't like them because they have to split the fees. Companies sometimes use three investment bankers, and we considered doing so, but it's difficult. With three, you have to consider the size of the offering and how large the fees will be after you split them up. You may end up splitting the fees so much that it's not worthwhile for the bankers and they lose their incentive to serve you well. That's why we decided we were probably better off with two banks.
We obtained most of the information we needed to evaluate our investment-banker prospects either in their written responses to us or during their oral presentations. However, we also checked with other companies that had used these bankers and that had worked with the same members of the banking team.
The detailed data we used to evaluate the bankers' prior performance we either gathered ourselves or requested from the bankers. We collected data on such things as the filing price and the price in the first week after the effective date for every company our candidates had been involved with over the last five years to find out how accurately they were pricing their offerings. We collected similar data to investigate the banks' market-making abilities. We looked at whom they'd taken public and what proportion of the total stock the banker handled, and how this proportion compared to all other market-makers in the stock. This told us a lot about how strongly the bank supports the companies it brings public.
WHAT A BANKER WANTS FROM YOU
Bankers (and the investment community as a whole) look at a number of things when valuing a company. Some of the most critical factors are often uncontrollable, such as market size, market growth rate and competition. Nevertheless, you must be prepared to address questions in these areas in a manner that fairly presents your company's opportunities. We had a large market, we were in a segment that was growing rapidly and competition was fragmented, all favorable conditions.
Still, we spent a great deal of time discussing how to position ourselves in the market and against the competition because these are critical factors in a company's current and future valuations. Even if these basic conditions aren't as favorable in your own industry, don't despair. For a strong management with a perceptive strategy, growth opportunities exist in virtually all industries.
Your business concept or strategy is crucial to attracting investors. We have a strong but simple concept that was very easy to communicate. If your company has a complicated concept, you're going to have problems communicating it to the market, and you'll probably lose some potential investors. So learn how to express your concept clearly and cleanly. A powerful brand name or strong barriers to entry are important factors as well. If you have an opportunity to further develop your brand or other competitive advantages before you undertake an IPO, do it, because strengthening your competitive position will increase your valuation.
Bankers and investors also want to see you're well-organized to manage as a public company. Our preparation began with the organization of our board of directors. Nasdaq requires two outside directors, both of whom must serve on your audit committee. We had a board of five people, four of whom were outside directors.
Our board was strong and independent, which gave our investment bankers and the investment community confidence that Starbucks would receive strong direction and control. Further, several of our board members were invaluable in helping us through the IPO process. They'd had experience with IPOs, so they could warn us about problems we'd be likely to encounter because they really understood the pricing and distribution processes. If we hadn't had some of that support, we probably would have overlooked many issues in both areas. Look closely at the composition of your board, and try to assess what kind of assistance they'll be able to give you when it's time for you to go public.
The management team is probably the most important factor investment bankers look at when evaluating your corporate potential. Strong historical growth and sustainable growth are important, and much of that has to do with your management team. And it isn't enough to simply have strong resumes. Your team needs to have worked together for several years and to have positively influenced the company's development. We had half a dozen people in the senior-management positions with an average of three to four years' experience with Starbucks, which was probably just enough for a rapidly growing company.
It's also important to have a strong financial organization and to have retained one of the large national auditing firms. We'd used a large accounting firm from the very beginning, and we had audited statements going back to the company's inception. Further, for several years before our IPO we prepared quarterly as well as monthly reports, and our accounting and reporting policies were similar to those we'd have to follow as a public company. Accordingly, we didn't have many reporting difficulties as we made the transition to a public company.
Also, we had a well-developed budget process and strong financial controls -- two areas your investment bankers will look at closely during the due-diligence process. Good financial controls give your bankers confidence in the integrity of the numbers and ease concerns about the liability they undertake when they take you public.
JUST THE FACTS
Investment bankers want you to give them realistic projections of your capabilities, not simply your unrestrained ambitions. Starbucks had a five-year forecasting process that we updated each year, and we had a record of meeting or exceeding our plans. In general, you should get used to doing realistic projections as early as possible. You can count on two or more weeks of delay to develop forecasts during the IPO process if you haven't done them before.
Every company has risks, and you should be prepared for some hard questions about them from the investment community. We went through a lot of what-if scenarios in which we tried to identify potential trouble areas (such as a coffee shortage or rising coffee prices) and formulate a corporate response. You'll get questions like these during your road show, so you'd better think about them beforehand, because you'll need a quick, clear, clean response to reduce investment-community concerns.
Once the IPO process is underway, pay close attention to the distribution issues. Typically, investment bankers will want to distribute approximately 80 percent of the stock to institutions and 20 percent to retail, a split that may or may not be in your best interests. We wanted more retail distribution than most companies because we had a loyal customer base, and many of our customers wanted to participate in our offering. We also wanted our employees to have an opportunity to participate, and we eventually managed to direct some of the offering to them. Finally, we wanted to reward investors who'd invested in the company earlier on and were able to allot part of the offering to this group. But there are limits to how much stock the company can direct to specific investors, and your bankers may legitimately argue, "Why are you doing a public offering if you're directing all the stock?"
When looking at the proportion that goes to institutions, be aware that your investment bankers may want to distribute a disproportionate share to the institutions with whom they do the most business. While this may not be bad for you, make certain this is the group you want to hold your stock. In our case, we wanted to find investors who would hold the stock for the long term rather than "flip" it after the first day or shortly thereafter. Selling the stock after a short holding period can be profitable because investment bankers will try to price your stock 15 percent below where they expect it to trade on the first day in order to reward initial investors for taking a risk on a new offering. For some institutions, a 15-percent gain is enough, and they may sell as soon as they realize this gain.
While we tried to find the long-term investors, we found it difficult to separate them from the flippers, because we finally concluded that all institutional investors were probably potential "flippers," depending on how much the stock price rose. However, we were able to make some broad distinctions and keep the stock away from most of those who were notorious short-term holders.
As the road show progresses, your investment bankers will try to gauge demand at various prices around and within the filing range. Because we wanted to actively participate in the pricing process, we asked our bankers to let us see the book that's used to record how many shares each institution has requested and the price it's willing to pay. Accordingly, we knew the size of the orders and had a sense of the pricing flexibility. There are limitations to this information, however. We had a hot IPO, and investors recognized they wouldn't be allotted their entire request. Since they were aware they'd be cut back from their request level, they asked for more than they expected to get. This makes it difficult to gauge demand.
Recognize, too, that a lot of gamesmanship happens around the pricing, and real intentions are hard to identify and record in the book. When we came out of a meeting with a potential investor, we'd try to get a flavor for the real demand and price sensitivity from the salesperson. This information is helpful, but in the final analysis, pricing is a judgment call by you and your investment banker, and there's a fair amount of risk that you'll underprice or overprice the offering. In our case, our bankers priced us well. They set the offering price at $17 per share, and pricing during the first day of trading behaved as we hoped, moving to a trading range of around $21 per share.
While it's important to get a fair price, don't go into the IPO process with the objective of getting the maximum price. You want your investors to be happy in the long-term, because you may want to return to the market. Don't burn your bridges by extracting the last little bit of price during your IPO. This is one event in what you hope will be a long financing history for your company, so it's best for you, your banker and your investors to start off with a positive experience for everyone.
CARVING UP THE STARBUCKS IPO
45% U.S. investors 35% Retail investors 15% International investors 5% Starbucks employees
Mr. Smith is president and COO (and formerly CFO) of Starbucks Coffee Co. in Seattle.
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|Title Annotation:||Starbucks Coffee Co.'s initial public offering|
|Author:||Smith, Orin C.|
|Date:||Nov 1, 1994|
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