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The IPO Window Is Opening

 

Paul Broud
Despite the continuing stock market turmoil since the beginning of 2010, investment bankers and a few companies are trying to pry open the long-closed IPO window. If they succeed in their efforts, 2010 will bring the promise of initial public offerings for medical device and other life science companies. According to Renaissance Capital, of Greenwich, CT, which tracks IPO data, 19 companies completed IPOs through March 19 of this year. Contrast this accelerating launch rate with that of 2009, when a total of only 63 IPOs were completed and 50% of those transactions came during the fourth quarter.
 
So, should your device company try to squeeze through this window of opportunity? The answer depends on the type of enterprise. In general, the current environment favors mature, high-quality companies with meaningful revenues that are valued by investment bankers at over $500 million. Businesses still in the product development stage may find the IPO window still closed.
 
Companies go public for a variety of reasons. For most medical device companies, the primary driver is the need for substantial and ongoing capital to fund clinical trials, regulatory approvals, and the protection of the company’s intellectual property. An IPO has historically represented an exit strategy for venture capital funds and other investors. However, in the current environment the potential for future liquidity is more realistic than the opportunity for existing shareholders to sell stock in an IPO. Thus, the immediate goal of most IPOs is to raise growth capital.
 
Financing Growth
From a financial standpoint an IPO has several key elements to recommend it. Raising equity in a public offering is generally the least expensive form of capital available to a business, both in terms of the percentage of ownership sold to new investors and the control that must be given up by existing stockholders. Unlike debt, equity capital does not need to be repaid, and it does not generally subject the company to the pressure of meeting financial and other covenants on an ongoing basis. The valuation achieved in a public offering can often be 50% higher than could be obtained by selling equity to investors in a private placement, since private investors insist on a significant discount from an estimated IPO or sale price to compensate them for the illiquidity of their investment. While investors in a private placement must generally wait until a business goes public or is sold to recoup their investment, buyers in a public offering can resell their shares at any time.
 
In addition, venture capital firms and other sizable private investors generally negotiate substantial limitations on management’s operation of the company, as well as preferential voting and other rights and substantial penalties if the company fails to achieve the business plan set out by management. In contrast, stock in an IPO is generally distributed among a broad mix of institutional and retail investors, with almost no restrictions on the use of the funds raised or the operation of the business after the IPO. Because of this broad dispersion of ownership, it is often possible to control a publicly traded company while owning significantly less than a majority of the company’s stock.
 
An IPO may also provide liquidity for management and existing stockholders by enabling them to sell some of their shares, help facilitate growth by allowing the company to use stock to make acquisitions, provide the foundation for equity compensation plans to attract and retain key employees, and enhance the company’s reputation with customers, suppliers, and other third parties.
 
Management and existing private investors can use an IPO to achieve liquidity for their investment in the company without giving up control or the benefits of future growth. While most underwriters require management and significant stockholders to refrain from selling stock for at least six months after an IPO, the public offering ultimately creates a market for insiders to realize a return on their investment and diversify their personal holdings. With a more mature business, it may also be possible for insiders to sell some stock in the IPO itself, although most underwriters dislike the appearance of management’s “bailing out” while the underwriters’ customers are putting money into the company.
 
Many companies use their publicly traded stock as a currency to acquire other businesses, either to expand geographically, add complementary business units, or otherwise diversify their operations. Using stock to make acquisitions, rather than cash or debt, helps the company’s cash flow. In addition, a publicly traded, liquid security can be an attractive form of payment to acquisition targets, since acquisitions using stock can be structured to defer the seller’s tax liability until the sale of the stock received from the acquiring company.
 
Publicly traded companies can also make better use of equity compensation plans to help attract, reward, and retain key personnel. Properly designed equity plans, using options, restricted stock grants and other equity incentives, can create significant financial rewards for employees. Such equity plans often don’t involve out-of-pocket cash expense for the company, since the employee ultimately realizes the value of his or her stock by selling the shares in the public market. At the same time, equity compensation plans can be used to align the economic rewards for management and other employees with the interest of the company’s stockholders in seeing an increased stock price over time.
 
Finally, companies often find that an IPO improves credibility with customers, bankers, suppliers and other important third parties. Publicly held companies are often perceived to be more stable and substantial than private companies of similar size and capitalization. Whether or not the perception is correct may not matter, since perception can become reality. Becoming a public company can also be part of an effective branding plan for consumer product companies.
 
No Pain, No Gain
The IPO process is not completely painless. It involves substantial fees for investment banking, legal, accounting, printing, and other services. Perhaps more important, there are significant nonfinancial costs of an IPO, some of which are outlined below.
 
An IPO involves a serious commitment by the company’s management. Realistically, the IPO process takes at least six months from the time a company begins talking with investment bankers, assuming there are no company-specific problems that arise (for example, a delay in receipt of an expected patent, regulatory approval, or significant customer contract). It’s not easy to keep the business on track while meeting with investment bankers, lawyers, accountants, and prospective stockholders without a deep management team in place.
 
Companies that start down the path toward an IPO should understand that there is no guarantee of success. Market conditions can change quickly, even if the company is still on track in its business. Many of the factors that affect the success of an IPO are beyond the company’s control. These include economic downturns, market turmoil, interest rate changes, unexpected military or terrorist events, and poor performance by a competitor, which can depress investor interest in comparable companies. Therefore, it is not prudent to assume that the market or industry conditions that prevail at the beginning of the process will be the same when the company is ready to complete the IPO. Think about the different economic and political conditions that existed on March 15 and September 15, 2001, for example.
 
Public companies also face the ongoing need to respond to inquiries from stockholders, analysts, brokers, and others interested in the company’s stock. In other words, they must be willing to accept the “life-in-the-fishbowl” nature of being a public company. The SEC’s extensive disclosure requirements force managers to publicly disclose personal information about their compensation and to release business information that may be useful to competitors. Although companies may be able to keep confidential certain information, such as customer pricing terms, being a publicly held company by definition means being very public about the company’s business, whether the news is good or bad.
 
Time To Go Public?
Going public is not necessarily the right choice for every medical device or life science company that needs to raise capital or create liquidity for its shareholders. For some firms, however, it represents a viable alternative that enables the enterprise to continue growing while creating an exit vehicle for management and other shareholders—all while allowing management to retain control of the company. The valuations that can be achieved almost always exceed those that are available from private financing sources, and there are fewer strings attached. In addition, public companies that meet analysts’ and shareholders’ performance expectations can often find a receptive market for future financings if they need additional capital. For these reasons, if that window opens wide enough, a growing device manufacturer should consider an initial public offering among the options for meeting its capital needs and creating liquidity for its existing investors.

Paul Broude is a partner in Foley & Lardner LLP (Boston). He is a member of the firm’s transactional and securities group, vice-chairman of the firm’s emerging technologies practice, and a member of the firm’s life science industry team. Broude can be reached at [email protected] or 617/342-4027.

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