THE BOOM IN IPOs
Bond prices are surging. The stock market is on a roll. And Wall Street is bombarded almost daily by companies selling stock for the first time. The action in these initial public offerings (IPOs) dwarfs anything seen in the past quarter century. Newly minted companies are on track to raise a record-breaking $12 billion this quarter, bringing the year's total to some $29 billion. Even more impressive, approximately 2,800 private companies have harvested more than $130 billion going public since 1990, and the Standard & Poor's new-issue index is up by 538% vs. 84% for the S&P 500-stock index. Marvels Stephen G. Woodsum, managing partner at Summit Partners, a Boston-based venture-capital firm: "I don't think we've ever seen such a sustained period in which the IPO market was this good."
Entrepreneurs are raking in the coin. The IPO market is even creating a few billionaires overnight. Pixar Animation Studios, the computer animation company controlled by Steven P. Jobs, was initially to be priced at $12 to $14 a share. Demand was so strong that it went public on Nov. 29 at $22 and closed at $39. Jobs's 80% stake at the end of day one: $1.1 billion. Netscape Communications Corp., a maker of software for navigating the Internet, went public at $28 a share last August. Its stock price was up to $171 on Dec. 5, making Chairman James H. Clark a Netscape billionaire.
MAVERICKS. Is it a bubble? Hardly, although there are disturbing signs of froth in parts, and the IPO market is highly vulnerable to any abrupt shift in market sentiment. But fears over the near-term twists and turns in the market prices miss the fundamental point: The IPO market is fueling the innovations that are transforming the U.S. economy into the world's productivity powerhouse. The driving force behind the technological revolution changing the way we live and work is the maverick, the risk-taker--in other words, the entrepreneur. And backing the entrepreneur is the most sophisticated capital market in the world. "Without IPOs, you would not have any startups," says Netscape's Clark. "IPOs supply the fuel that makes these dreams go. Without it, you die."
Call it IPO capitalism. Innovators are reshaping such old-line industries as airlines, steel, and retailing, driving young industries such as software and biotechnology to new frontiers, and even building whole new industries, such as the Internet. Some high-tech adventurers are pushing the envelope in computers, software, and telecommunications, constantly building new products that raise efficiency. Other entrepreneurs pinpoint what customers really want and create better products and quality services at lower prices. "Innovation breeds more innovation," says Pixar's Jobs.
Entrepreneur-driven businesses are spreading across the country. They're no longer an important tributary of the American economy but a major part of the business mainstream. IPO capitalism is a vital force in the remarkable resurgence in U.S. competitiveness in the global economy, especially in many leading-edge industries. Says William A. Sahlman, a professor at Harvard business school: "No one else has it. Not Germany. Not Japan." Adds Stephane Garelli, professor at the International Institute for Management Development and director of the IMD's World Competitiveness Project: The U.S. IPO market is "a valuable and unique economic franchise. It's absolutely a comparative advantage for the U.S."
PRODUCTIVITY. IPO capitalism is being propelled by a series of simultaneous, self-reinforcing trends: Successful first-generation high-tech entrepreneurs are funding a new generation of innovators; technology is creating new opportunities for entrepreneurs; hordes of enterprising people are starting their own companies; and pension and mutual funds are increasingly eager to invest in emerging companies. Taken all together, money and ideas are combining at a faster and faster rate, creating new markets and new products which, in turn, replenish the IPO well. "The real gains for growth come from getting as many people as possible searching for new ideas and discovering different ways of doing business," says Paul Romer, economist at the University of California at Berkeley. "The most important thing is to have lots of people searching all over."
The state of the IPO market reflects the health of the U.S. economy. The market was dormant during the 1970s, when high inflation ravaged financial investments and fierce foreign rivals savaged America's industrial giants. The entrepreneurial revolution did not grab national attention until Apple Computer Inc., Genentech Inc., and other high-tech companies went public in the early 1980s. Each succeeding IPO wave has been bigger than its predecessor, leaving in its wake a larger, more vibrant entrepreneurial economy. And it's no coincidence that IPOs are exploding along with productivity: In the 1990s, nonfarm productivity has been rising at a 2% rate, twice the pace of the previous two decades. (Government statisticians are revising the productivity numbers, but the new figures will also display quickening productivity.)
Sure, the $29 billion in new equity that companies will raise in 1995 looks like a drop in the bucket when compared to the $6 trillion value of the stock market this year. But all that trading activity doesn't go into corporate coffers. Investors are just buying and selling existing securities in the marketplace.
In sharp contrast, an IPO is the pinnacle of a long chain of new money invested in a highly risky venture. It typically begins with an entrepreneur tapping into personal savings to develop an idea. Later, the entrepreneur persuades wealthy private investors or even a venture capitalist that the business has intriguing growth prospects, and they seed the startup with somewhere between $100,000 and $1 million. The business grows, as does its need for investment capital. The money can come from the traditional venture-capital industry, which is made up of more than 500 venture-capital funds that invest between $3 billion and $4 billion a year in some 3,000 companies or the invisible venture-capital industry, drawn from some 2 million self-made high-net-worth individuals uho conservatively invest between $10 billion and $20 billion a year in more than 30,000 ventures, says William E. Wetzel, director emeritus of the Center for Venture Research at the University of New Hampshire.
ALARMING DIPS. Many of these high-risk enterprises fail. For the ones that succeed, investors cash in on their equity stakes and raise even more capital to expand the business by either selling the company to a corporate acquirer or by selling stock in the market. Going public is the preferred route, because management remains in control of the company that it built. "IPOs are critical for the market in allocating capital to new ventures and new products," says Clifford Smith, professor of finance at the University of Rochester. "IPOs are a big part of what makes the whole capital market process possible, allows the economy to tap into entrepreneurial zeal--and we're all wealthier for it."
To be sure, at today's lofty levels, the stock market is susceptible to alarming dips. Because IPOs are typically high-risk, volatile stocks, they will fall far and hard during any market downdraft. Many market mavens fear the market is already far too euphoric. With many IPOs selling at astronomical premiums--especially anything with "Net" or "Web" attached to its name--they expect a crash any moment. Says investment banker M. William Benedetto, chairman of Benedetto, Gartland & Greene Inc.: "This is the most heated IPO market I've ever seen in 30 years. I'm very concerned."
Despite these fears, the economic fundamentals appear favorable for long-term owners of new and seasoned equity issues alike. After all, the IPO market doesn't exist in a vacuum, and a robust stock market does offer strong underlying support. Disinflation is well entrenched, and productivity growth is climbing. Investors are pouring money into the financial markets, much of it through popular tax-deferred retirement savings plans such as 401(k)s. A federal budget compromise is within reach, the Federal Reserve Board has plenty of room to ease, and bond market yields have tumbled to their lowest levels in two years. Sure, the IPO market is giddy in places, but "I'm not seeing a lot of junk," says Daniel L. Miller, a managing director at Putnam Investments, the mutual-fund giant. "We're nowhere near crazy territory."
The strong stock market is encouraging all kinds of companies to sell new issues of stock. Fast-growing consumer businesses, such as microbrewer Boston Beer, maker of Samuel Adams, and Pete's Brewing Co., maker of Pete's Wicked Ale, have gone public. So are companies of aging entrepreneurs like Estee Lauder, eager to liquefy and diversify their wealth for their heirs. In early November, the cosmetics giant Estee Lauder sold 15% of the company at $26 a share. Its stock price climbed 33% during its first day of trading. Corporate restructurings are also filling the IPO pipeline: Prudential Insurance Co. sold its reinsurance business on the open market and Kmart its Borders bookstore business. Master dealmaker Ronald O. Perelman, who has already taken several pieces of his corporate empire public in the early 1990s, is planning on an IPO of Revlon, the cosmetics company he acquired in the 1980s.
CATALYTIC EFFECT. It's no accident that a powerful takeover market and new-issue market have gone hand in hand for much of the 1990s. For one thing, a healthy stock market makes it easier for companies to strike financial deals. For another, caught in a brutal struggle for survival in a world of intense competition, many large companies are snatching up competitors at home and abroad to expand their global market share and jettisoning everything else. "The common link is that there is a rapid competitive evolution in the U.S. economy," says Bruce Steinberg, an economist at Merrill Lynch & Co. "Older sectors of the U.S. economy have too much capacity, while other new dynamic sectors are expanding, like high-tech." Indeed, it's the fast-growing entrepreneurial companies that explain why total employment is rising while large companies slice and dice their payrolls.
Even one successful IPO can have a catalytic effect on the economy, forcing everyone to sit up and take notice. For instance, by the late 1970s, medical researchers and academic scientists had made great strides in genetic science. Yet it was unclear whether or not a biotechnology industry was a sustainable business proposition. In 1980, the tremendous market reception given Genentech's IPO unlocked financial purse strings and persuaded many scientists to start up companies. Similarly, the Netscape IPO helped propel the Internet and the World Wide Web to the forefront of the computer industry, forcing such established software companies as Microsoft to respond quickly to the emerging threat.
In the world of IPO capitalism, success feeds on success, and the pool of sophisticated investment money is growing fast. Jim Clark, one of the principal founders of Silicon Graphics Inc., which went public in 1986, used some of his gains to invest $4 million in Netscape. Steve Jobs put $60 million into Pixar. Paul G. Allen, a co-founder of Microsoft Corp., has funded such companies as Asymetrix Corp., a software-tools maker in Bellevue, Wash., and Starwave Corp., a multimedia and online software player. A.C. "Mike" Markkula Jr., another Apple founder, is financing Echelon Corp., an industrial automation company, and Volant Ski Corp., a high-tech stainless-steel ski equipment maker.
The entrepreneurial multiplier effect is powerful. Case in point: William M. Haney III, the 33-year-old chairman and chief executive of Molten Metal Technology. He started his first environmental business while an undergraduate at Harvard University and reaped about $15 million at age 26 by selling his stock after the company went public. Haney invested his profits into two startups: One, Energy BioSystems, is a Texas company pioneering the use of bacteria to actually eat sulfur in high-sulfur oil. The other is Molten Metal, a startup trying to dispose of hazardous wastes in an environmentally friendly process. He has been cashing in his stake in Energy Biosystems, recycling the money into two new startups, one in software and the other in energy-efficiency technology. Molten, which went public in 1993, has a market capitalization of about $900 million and employs 280 people, with plans to have 550 workers by this time next year.
The Puget Sound area has become a fertile spawning ground for startups, thanks to lucrative employee stock options at Microsoft, McCaw Cellular, Aldus, and other high-tech companies. After Aldus, the desktop publishing software developer, went public in 1987, employees Jeremy Jaech and Ted Johnson used stock options as seed money to start Visio, a graphics software company, in 1990. Visio went public on Nov. 9 at $16 a share and now trades at $25. Microsoft alumnus James N. Phillips joined Microsoft in 1990, and in 1994, along with his partner, David J. Steckler, cashed in stock options to found Nobeltec, which produces navigation software for boats. Susan Lammers worked at Microsoft for six years and Gates-owned Corbis for three years before using her Microsoft options to start Headbone Interactive, a multimedia company.
HIGH-RISK DEALS. Institutional investors are jumping into the market. More pension funds are trying to boost their long-term returns by doing high-risk private equity deals, including venture-capital partnerships and leveraged buyout funds. Big institutional investors account for much of the new money flowing into venture-capital partnerships.
At the same time, mutual funds are major buyers of new equity issues. Three years ago, mutual-fund company Putnam had about $6 billion to invest in IPOs and other emerging-growth stocks. Today, mainly because of the huge cash inflows generated by 401(k) and other retirement savings plans, Putnam has about $18 billion to invest. "We are tending to buy more IPOs because we have more assets under management," says Daniel Miller. Adds Joel Tillinghast, manager of Fidelity's Low-Priced Stock Fund: "My desk is littered with prospectuses."
The rise of big institutional money in the entrepreneurial game is a mixed blessing. In order to tempt the big boys, many venture capital firms find they have to focus on well-seasoned, larger enterprises in need of large infusions of capital. So some smaller companies can find it a lot harder to raise seed money. Similarly, the typical IPO is microscopic compared with the size of the typical mutual fund, and its buying power can send stock prices way out of whack with the fundamentals. Still, the overall quality of entrepreneurial companies is generally higher than before and they include a wider range of industries. One reason is that pension funds and other institutional investors have become savvier in evaluating deals over the past decade, says Josh Lerner, professor at the Harvard business school.
Perhaps most important, the lure of a big score in the IPO market is attracting good people, which should keep the quality of future deals high. Says Rodney L. Goldstein, managing partner at Frontenac Co., a Chicago-based venture-capital firm: "It wasn't that long ago that the best and brightest migrated to large companies. It's now axiomatic that they will migrate to emerging companies." Five years ago in the Boston area, the majority of entrepreneurs seeking venture funding were laid-off managers from the likes of Digital Equipment Corp., Wang Laboratories Inc., and other high-tech companies. Today, many have good jobs and plenty of options in the corporate world yet are determined to strike out on their own. "The psychological impact of this IPO market goes far beyond the dollars and cents of the particular deals getting done. It creates a lot of excitement in would-be entrepreneurs," says Gordon B. Baty, a partner in Zero Stage Capital, a venture-capital firm based in Cambridge, Mass.
Going public offers many competitive advantages beyond the money raised or the fortunes made. Customers feel more secure doing business with a public company because its balance sheet is an open book, says Jim Clark of Netscape. Moreover, savvy entrepreneurs can use their IPO currency to buy other companies and expand their franchise. And being a public company makes takeovers easier to negotiate. "As a private company you argue what you are worth as well as what the buyout candidate is worth," says Visio's Jaech.
TRANSITION WOES. Take America Online Inc. It went public in March, 1992, at $11 a share; after adjusting for stock splits, its stock is at $352. The online service has sold shares to the public three times, raising more than $215 million. Founded in 1985, AOL grew at a modest pace. Since its 1992 IPO, it has expanded at a heady pace. The company went from 350,000 subscribers in early 1993 to roughly 4 million currently, while revenues went from $38.7 million to more than $1 billion, and the number of employees has risen from 200 to 2,700. AOL also used a combination of cash and stock to make acquisitions.
Of course, many entrepreneurs find the transition from running a private company to a public one daunting. Just putting together an IPO is a time-consuming process that can divert management energy and attention. Security Dynamics Technologies Inc., a company with 150 employees that supplies products and services for guarding access to networks, went public in December, 1994. CEO Charles R. Stuckey recalls that he devoted 40% of his time over a period of six months to the IPO; now he spends about 10% of his time dealing with the demands of being a public company.
Thus far, Shikhar Ghosh, chairman of Open Market Inc., a Cambridge company selling software for performing electronic commerce on the Web, feels his company doesn't have the basic earnings engine in place to go public. "The biggest management trade-off [in going public] is that when you are at an unpredictable stage of the company's growth, you're forced to predict" your earnings and revenue growth, he says. "If you miss a few percent on your revenues and profits, you can see the stock fall 20% or more. It's a public execution."
Rising IPO prices can sometimes generate too much enthusiasm, and there are signs that some investors are growing wary. For instance, Pericom Semiconductor had to postpone its 2 million-share IPO.
Yet disappointment is an integral part of this market. And at least from a macroeconomic point of view, that's all for the good. Sure, some investors will get burned and some entrepreneur dreams will be dashed. In so many businesses, especially those at the technological frontier, it is highly uncertain which management vision, organizational setup, or newfangled product is the right one. Finding out what does not work is as important as discovering what does work. "Two years from now, many of these IPOs will be down, but some will be up--way up," says Greg Jarrell, finance economist at the University of Rochester. "That's very desirable for the economy because it indicates the market is doing what it's supposed to do--winnowing out the losers and rewarding the winners."
It's also striking how failure is not a badge of dishonor in the entrepreneurial community. It's part of the learning process. "And the ones who fail will give us a new generation of entrepreneurs who have learned from their failures and those that want to try again will do so," says Timothy Bresnahan, economist at Stanford University.
In the rest of the industrial world, small companies don't fail--because few come to market. In Europe and Japan, where banks play a key role in financing companies, risk capital is scarce. Entrepreneurs are hamstrung by regulations designed to limit competition and preserve cozy business relations. True, the London and Paris stock markets recently began listing small-cap stocks on alternative markets designed for startup companies. Still, "there are a lot of companies with brilliant ideas and brilliant technology that will never take off because we don't have the risk capital for that," says IMD's Garelli.
Risk-takers are being rewarded by IPO capitalism like never before. That's all to the good. It will ensure continued innovation and stronger economic growth.By Christopher Farrell in New York, with Kathy Rebello and Robert D. Hof in San Francisco, Mark Maremont in Boston, and bureau reports