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November 25, 2005

Public Company – The Beauty Contest

So you and your Board have decided to take your company public.  The market window is open; you don’t want your competitors to beat you to the money; you’ve always wanted to run a public company.  Whatever.  You’ve made the decision.  Now it’s time to pick the bankers for your IPO.  That process is called “the beauty contest.”

Typically, there’s one lead bank and two or three co-brokers.  The name of the lead bank appears on the left side of the cover of the prospectus and the co-brokers appear on the right.  It is important to bankers to be “on the left” and most of your effort goes into selecting the lead.  The major banker firms may not be willing to be “on the right” for your small potatoes company; so, if you want Morgan Stanley or CIBC in your deal, it may be as lead or nowhere.

When the market is receptive to IPOs as it was in 1997 to 2000 period, bankers are eager to do them.  They are prestigious when successful.  They are very profitable for more reasons than just the commissions they generate.  If the time is right for going public and your company fits whatever is the current definition is of IPO-ready, you’ll probably have your choice.

If your company was VC-funded, your VCs can be very helpful during the beauty contest.  Not only may your VCs know which banks (or individual bankers) to avoid; but VCs are also gatekeepers for bankers.  If your VC firm has a good track record, then banks want more of their “product.”  The banks will deals with your VC firm on many IPOs. They’ll deal with you at best (or worse) just a few times in your career as an entrepreneur. During the process of the ITXC IPO, we sometimes asked Fred Wilson then of Flatiron Fund and now of Union Square Ventures or Bill Collatos then and now at Spectrum Equity to intercede with Lehman Brothers, our lead banker.  Usually Lehman listened to them.

The beauty contest is fun.  The bankers all come trooping in with their presentations.  In those days they all felt they had to wear suits on their first visit to the company so you could always put them somewhat ill at ease by dressing down.  Not sure if they still come to high tech firms in suits. They bring spiral bound presentations with their logo and your logo prominently co-featured on the cover and usually every inside page as well. There are always some pages that show the logos of all the companies they’ve taken public.  There are impressive graphs showing that the bank you are talking to is the leader in some category relevant to you even if they are not the world’s most successful underwriter.

Trouble is the presentation are pretty much all the same so how do you choose?

Not on price, it turns out.  Unless you’re Google, you don’t have enough bargaining power.  In my novel hackoff.com, CEO Larry Lazard asks VC and Board Member Franklin Adams: “So how do they compete?  I thought the bastards all charge the same commission.”

“They do,” says Franklin. “They’ve got that part figured out. What we REALLY care about is how well they're gonna sell the deal and cover the company afterwards. It's very important that their sell-side analyst — the analyst they're going to have cover us — really understands the company and its story and is well enough respected to sell it. He or she is gonna have a lot to do with the success of the IPO and then with the success of the stock in the aftermarket. We WANNA hear from the VP who’s gonna own the deal. We’ll check our sources for you, that’s part of VC value-add,…”

“We’ll find out if the VP’s got a big enough dick in the firm to make things happen. There are a lot of deals going on now and we have to do what we can to make sure OUR deal’s gonna get enough attention. We may hear from one of their senior sales guys, but that’s not too important because they all say the same thing — they’re sales guys.  They tell you they're closer to Fidelity and Semper [nb. A fictional firm] and Janus and all the big funds than anyone else and that they’ll get the best set of appointments.

“We may hear from the trading guy, too. They all run pretty good desks but it’s worth listening to those guys to see if you like ’em. The stock’s in their hands once trading opens. They also count the orders during the roadshow so they can give us a handle on what’s going on.”

You do want to get a major firm on the left; on the right, too, if you can.  The major firms command more attention at the funds and it’s the funds who buy or don’t buy the stock in your IPO (more on that in a future post).  After that it all comes down to people.  Individual bankers vary greatly within firms.  You need a banker you can get along with.  More important, you need a banker who understands your business and can explain what it is that makes you a great investment. You want a banker who has a track record of success WITH COMPANIES LIKE YOURS.  Success in another industry hardly counts at all.

That being said, it is hard to know during the beauty contest exactly who your banker will be.  A VP comes in and leads the pitch.  He’s (or she’s) the senior person who’ll own your IPO and makes resource allocation decisions.  But she or he probably won’t have much to do with the actual preparation of your roadshow and won’t accompany you on most of the roadshow.  Very important that you find out which junior bankers will be doing the work and going with you.

In Bubble 1.0 many analysts were outright shills for the companies their firms took public.  The banks touted the success of their analysts as touts when competing for business.  Some banks and analysts got in trouble for that.  The SEC is stricter now on how analysts are compensated and the walls between the analysts who write “objective opinions” of your company and the bankers who earn commission dollars have been reinforced.

Nevertheless, you know that you are going to get analyst coverage from the firms that participate in your IPO and, at least until your company or your stock is successful, you won’t get much coverage from anyone else.  You also know that institutional investors, as much as they may distrust sell-side analysts, also don’t like to buy stock in companies that don’t have analyst coverage.

Let’s assume that the coverage will be objective (it’s too soon in Bubble 2.0 to know); you still have an interest in making sure it’s competent.  Analysts have to work much harder these days than they used to.  Regulation FD makes it clearly illegal for companies to give the analysts the same kind of  non-public guidance that used to form the basis of much so-called analysis; and so the analysts have a lot of work to do to figure out a new company in an new field.  You need analysts at your banks, particularly at your lead bank, who are willing to work hard and who UNDERSTAND YOUR SEGMENT AND YOUR BUSINESS MODEL.

Your analysts will be writing about your company quarter after quarter once you’re public.  They’ll be predicting your sales and earnings.  They’ll be adjusting their firms’ buy, hold, or sell recommendation on your company’s stock.  People will listen to them.  It’s really a good thing for investment in the US that analysts have to do their own work and now run a lot of risk if they’re just shills.  You can’t tell them what to say; but, if your analyst is lazy or incompetent, you can bet that won’t be good for your company.

The right choice of banks in the beauty contest comes down to the right choice of people.  Good luck.

This post and this one are about Reg FD and predicting earnings.

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