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Raising Money in Today's Public Markets

Eric C. Jensen, Partner, Cooley Godward Kronish LLP

Entrepreneurs, their advisers, and venture capitalists raised large amounts of money in the late 1990's by going public on NASDAQ. IPOs (initial public offerings) have long been the holy grail of many an entrepreneur and remain so today for three key reasons.

Topping the list—and the most common reason for tech companies—is liquidity. An IPO gives a company's venture capital backers, other private stockholders, and employees the ability to sell their shares. The prospect of being able to sell these shares at high multiples on the public market is what motivates most venture capitalists to invest in a company and why startups offering employee stock options can often lure talented people to work for lower salaries.

A second reason for going public is to obtain financing. An IPO can provide needed cash without the burdens of debt. This makes IPOs particularly attractive to biotech companies, which require anywhere from $30 to $300 million to get U.S. Food and Drug Administration (FDA) approval before they can even market or sell their product.

Some companies with more than 500 stockholders and assets over $10 million go public because the U.S. Securities and Exchange Commission (SEC) requires such companies to file annual 10K and quarterly 10Q reports, Google being a recent example.

The third reason a company will offer its shares is to show credibility. The credibility garnered from a spot on a major exchange is especially important to companies fighting bigger competitors.

Going public is a great target for these reasons, but most companies never grow fast enough and get big enough to make an IPO on NASDAQ feasible. In the first eight months of 2005, the Venture Capital Journal reports that 153 IPOs raised $28 billion. A year later by that time, 137 IPOs had raised $26 million and forty-two companies had filed but postponed their application.

What's changed? The 2002 federal law known as Sarbanes-Oxley is the term generally used to refer to all forms of increased regulation in the wake of the dot.com bubble and the Enron scandal.

Probably the most onerous and controversial aspect of the law is the accounting rules regarding "internal controls" imposed on companies to ensure accurate financial disclosure. The SEC, seeking to restore confidence in its ability to prevent fraud, set forth a number of additional accounting, disclosure, and corporate governance rules. NASDAQ, seeking to retain investors' faith in its vetting process and compete with the New York Stock Exchange made it harder and more expensive than ever for companies to win the right to sell shares to the public.

This has led to increasing interest and growth in alternative ways to raise public money. Here are four of them:

Foreign Markets

Among the most attractive of late are foreign markets, particularly AIM based in London. Going this route, a company completely avoids Sarbanes-Oxley and SEC rules required for a U.S. listing. According to statistics, the annual cost to operate a public company on AIM is $922,000 compared with $2.3 million on NASDAQ and $1.3 million on the Toronto Stock Exchange.

AIM has done an outstanding job of marketing itself and developing a reputation as a good vehicle for smaller companies that need liquidity or are not likely ever to grow big enough to be traded on NASDAQ. The average share volume on AIM is going up, but a large percentage of companies only recently listed, making it too early to tell whether the market offers sufficient opportunities for investors to get their shares registered and achieve liquidity.

Through the Back Door

Another way companies can raise public money is by acquiring a corporate shell, also known as going public through the back door. A shell, as viewed by the SEC, is a company that is listed on a public exchange but no longer operates a business or has any assets other than the fact that it is public. When a private company merges with a shell, the public company becomes the surviving entity but the private company ends up owning the majority of tradable shares. Going through the back door, so to speak, doesn't exempt companies from the full review and scrutiny of the SEC. In fact, it results in significant regulatory review. But for companies that can't interest a major underwriter in offering their shares it can be a faster and easier way to access capital in the public market.

Private Investment in a Public Equity (PIPE)

Still, access to public markets doesn't itself provide necessary capital. When companies go the traditional IPO route, they have underwriters that provide a "firm commitment" for the issuance of new stock and approach investors with offers to sell shares. But companies that go public by acquiring a shell, as do some biotech firms, have no ready market to sell shares. Also, if the market is volatile and demand is high, any public company may also need to act quickly—more quickly than the SEC might permit. Through a PIPE, a public company can issue private stock to sophisticated investors with the proviso that the shares will be immediately registered and tradable on the public market. PIPEs provide quick access to investors in public companies, but entrepreneurs should get highly qualified advice and counsel to ensure they are structured to benefit their company.

Direct Public Offering (DPO)

A direct public offering refers to various methods in which stock is sold directly to the public without the help of an underwriter and without the registration and reporting requirements associated with traditional offerings. They are designed to provide access to capital markets for small businesses generally seeking to raise a few million dollars. The main limitation of a DPO is shareholders' limited ability to sell shares on the public market.

While debate continues regarding how best to strike a balance between cost of regulation to companies and benefit to the public, raising money through an IPO on NASDAQ in 2006 poses more challenges than ever. In the meantime, hard-charging entrepreneurs are seizing on alternatives with the potential to meet their companies' capital needs.

© 2006 Ewing Marion Kauffman Foundation. All rights reserved.

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