The Public / Private Question

Joseph W. Bartlett, Founder of VC

At a recent session of the New York Business Forum , I discussed, along with two other panelists, the metrics of going private, including Rule 13(e)(3), reverse splits and odd lot tenders. The issue on the table in this Buzz is whether a public company in today's environment should consider 'going private,' and what are the pluses and minuses to this option. To dissect this question and examine its sub-parts, let us construct the following hypothetical:

The paradigm company, Newco, has 10 million shares outstanding, 20,000 shareholders of record and the stock is trading in the $2 range, indicating a notional market cap of $20 million. The IPO price was $15 a share; the stock got has high as $25 but was dragged down in the meltdown and has bumped along in single digits for over a year. The company has cash in the bank courtesy of the IPO and operates at about break even on revenues of about $15 million a year. Management, including the founder, owns about 15 percent of the outstanding shares and a couple of institutions, including the original venture capital investors, control and own another 40 percent. The stock now trades on the NASDAQ Small Cap market and the threat of delisting to the Bulletin Board/Pink Sheets is omnipresent. There is little trading activity and no analytical coverage.

Let us start with the advantages to Newco in remaining a public company. The first is its history. The company worked extremely hard to get to the stage of an IPO; the transaction was a success, in that it brought in a lot of money and a relatively fortunate valuation. Why would one want to give up a status the founders and VCs had worked so hard to achieve? The price of the stock is in the cellar, but that status might be temporary, and the company remains sound. Why not wait until the market reverses itself, equities are back in fashion and the stock price gets back to the level at which it belongs? Secondly, if the price does recover, the insiders might make some real money. Options can be issued at today's valuation, which the board fervently believes is unnaturally depressed by reason of the overall market conditions; and, when the rebound occurs, everyone makes out like bandits.

In fact, some advisers argue that public registration has intrinsic value. While I don't think the 'shell game' usually works, witness the premium prices that have been paid to acquire a public shell. Moreover, if the stock price can be rehabilitated, then the classic benefits of public registration remain: an acquisition currency, currency for compensating employees, and currency for attracting attention and interesting customers and vendors. In fact, if you want to grow your company to mammoth proportions (Bill Gates didn't get super rich by maintaining Microsoft as a private company), there are very few mammoth private companies: Cargill, Koch Industries, but not many others.

Let's turn to the opposite side of the equation. The principal benefit, as we suggested, of public company status is public currency, meaning a liquid security which trades in an efficient market reflecting the company's enterprise value. We have suggested in our hypothetical that the firm in question does not enjoy that advantage; its shares trade by appointment and, in the view of the board at least, substantially undersell the underlying values involved.

But how about the argument that that the stock can recover? Unfortunately, that rarely happens. According to at least one survey, [1] the chances of a company, whose stock has slipped into single digits in fact recovering (other than by reason of a reverse split) to respectable price levels is under 10 percent. That does not mean that no firm can or will recover; but it is a fairly ominous number.

Next, the factors most frequently cited as a detriment of public registration are not at the heart of the problem. To be sure, it is expensive to maintain public filings and relationships with public shareholders: the filing fees, increased lawyers and accountants compensation, all coupled with the threat of civil and criminal liability from the plaintiffs' bar; the SEC's newly acquired religion in these matters; activist pension fund managers; and takeover specialists. I do not deprecate the costs and the exposure. These count, and count large, in the final analysis. In fact, since the advent of Sarbanes-Oxley, the notion of criminal responsibility is both literally and figuratively life threatening for management, audit committees and boards of directors of public companies generally. It is as if the Feds had put a sign up on the cover of the '34 Act: "Abandon All Hope, Ye Who Enter Here."

Having said that, however, the cost and exposure issues, overlapping and interrelated, are not necessarily the primary drivers of the 'going private' equation. In our hypothetical, let us further assume that the share price of Newco's common stock has been languishing in the doldrums for a couple of years without much in the way of trading activity. Civil liability under these circumstances is not highly likely. The plaintiffs' bar is not generally attracted to companies without much in the way of trading activity and/or recent sudden stock movements; the reason is obvious ... there are not a lot of members of the class with substantial damages as a result of their trading activities. [2] Furthermore, the targets of government prosecutors are the big fish; the occupants of the "orphanage" are not likely to be singled out, absent egregious fraud, for enforcement action. And, finally, if you keep the books right and obey the rules scrupulously, by definition the risks can be managed ... particularly since it is likely that the rule makers will come to the senses, once the hue and cry has died down, and adjust and explain the rules so that they can in fact adhered to by people acting in good faith.

To me, the principal reasons for going private are more economic than legal. First, for occupants of the orphanage, it is unlikely that the disclosure statements are read in any detail by investors and, more particularly, potential investors. Wading through the verbiage required in disclosure statements now is a superhuman task, particularly for the non-professional. Obviously driven by the heightened risks of failure to disclose, a recent ATT proxy statement was 800 pages long, meaning that it was in effect unreadable by the targets of the SEC's expressed policy concerns ... the average investor. If an analyst is not in place to read and interpret current disclosure statements, then the risk is that we have public companies with no genuine disclosure to the stock market as a practical matter. There are, however, two audiences which will read with great interest portions of the disclosure statement ... competitors and customers. Customers want to know how much the company is making so that they can negotiate a reduction in prices (vendors, perhaps as well, so they can negotiate an increase in prices). One of the reasons not to go public in the first instance is to avoid letting your customers know your margins; the good news you trumpet to investors is bad news if the reader is a price sensitive customer. Secondly, of course, the company's competitors can be counted to go over certain portions of the periodic disclosures with a fine tooth comb. What better way to find out what moves your competitor is making, in order to checkmate the same?

A more serious problem is the practical inability of the company to finance on-going and enhanced activities. If the stock price is $1.50 and the board genuinely believes that the non-dilutive price is $10, then the stock is useless currency. Moreover, if there is an acquisition in the cards, there are only two ways to pay for it (absent 100% seller financing) ... stock and cash. If the company for some reason has ample cash on hand, then maybe the acquisition can be financed with a combination of funded debt and equity. However, if (as is usually the case) the company needs to obtain equity from the market place, then a PIPES transaction is the only feasible way to proceed. And, as most of us are aware, there is a lot of hair on PIPES transactions in today's marketplace. Leaving toxic PIPES aside, it is difficult to put together an attractive PIPES tranche if there is no realistic possibility of floating restricted stock, or indeed dribbling it out, in the public markets at a price which approximates genuine underlying values.

There are a number of other reasons for going private, most of which are derivative of the foregoing. For example, what qualified person would want to be a board member of a public company in today's climate. However, given the current climate and the issues raised herein, there are compelling reasons for many currently publicly traded companies to consider going private.

[1] A study by Thomas W. Watts, Internet infrastructure analyst at Merrill Lynch. Going back to 1985, Mr. Watts studied the trading of 1,900 publicly held companies spanning the technology sector. He found that of those companies whose stocks had fallen to single digits, only 3.4 percent rebounded to $15 or higher within the next year. Most of those that didn't bounce back in the first year never did." Morgenson, Market Watch, N.Y. Times Business 16 (Apr. 8, 2001).

[2] There is one other exposure item which cannot be ignored. It is likely or at least plausible, that the SEC and the Congress will change the world so that public companies are subjected to a continual duty to update ... to announce fast breaking developments as they occur At the present time, and barring special circumstances, a company can coast from one reporting period to another, relying on disclosures in the periodic SEC reports filed as of a mandated date to inform the public on current developments. If there is a duty currently to update, the problem is that the management and the boards will have to guess at the date when the report should be filed ... neither too early (perhaps taking into account the contingent nature of an event, such as a merger in the formative stages) or too late. This opens a whole new avenue for the plaintiffs' bar because, in hindsight there is at least a 50 percent chance that the company's educated guess at the appropriate date for the announcement will prove to have been wrong. "You should have told us about the possibility of an oil discovery when the first geological report was sent from Nigeria indicating the possible presence of a pool." "You should have not have announced the merger at the handshake stage because you should have known it would collapse."