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Sarbanes Oxley : Auditing : Thought Leader
Successful Private Companies Turning To Alternative Investment Strategies
Wake of Sarbanes-Oxley
By
Thomas Austin
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Thomas Austin
CFO
Arbor Networks
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In the dot-com era there were two goals for successful, privately held companies, a NASDAQ IPO or getting acquired for a healthy premium. Despite what YouTube?s co-founders might tell you, the landscape has changed considerably.
In the aftermath of the bubble, corporate scandals and more robust regulatory environment, new financing options have emerged for privately-held companies. In tandem and not surprisingly, new opportunities have also emerged for the investment banks, who no longer call CFO?s solely to pitch the wonders of a NASDAQ IPO, but their consulting services to help you better understand the myriad of new investment options.
It is remarkable how much the investment landscape has changed for private companies in the new millennium.
The law of unintended consequences
Perhaps the biggest factor in the rise of alternative investment strategies has been the hesitancy of private companies to enter the U.S. equity markets. Sarbanes-Oxley (SOX) has added considerable cost to the process, both in terms of real dollars and time required by management to deal with the mountain of paperwork. Various studies have taken a look at the costs and the consensus is that it is roughly four times as expensive to go public today. For many smaller companies, this wipes all profit off the books.
According to Hoover's IPO Scorecard, the number of U.S. initial public offerings (IPOs) decreased 50% for Q3 2006 compared to the same quarter in 2005. The third quarter represents the slowest quarter since 2003. Locally, the situation mirrors the national trend. There was not a single venture-backed company in New England to go public on a U.S. exchange in the second or third quarter.
The situation has become so dire that policy makers at the highest levels of government are looking to makes changes to Section 404 of SOX which requires time consuming and laborious business practice audits. In September, Christopher Cox, chairmen of the S.E.C. said the audits are too costly and represent "one notable exception" to the positive impact of the law, according to Bloomberg. Treasury Secretary Henry Paulson recently created a Committee on Capital Markets Regulation to look into the issue and said in a statement, ?This issue is important to the future of the American economy and a priority for me.?
Private Equity
Private equity firms are best known for investing in distressed companies that are selling for less than their intrinsic value. That is changing because of two factors; the scarcity of IPO?s has created a backlog of successful, fast growing private companies looking for alternative ways to raise capital; second, these firms have never been so flush with cash. According to Dow Jones Private Equity Analyst, they have raised $172.2 billion through the first three quarters of 2006, a 72 percent increase from this point last year. The stop sign at the IPO market is a green light for private equity firms to put their cash to use.
Essentially what private equity firms are offering is a private recapitalization at or near public company valuations, without the regulatory hassles that come with it. With a private equity investment come all the reach, resources and relationships of a multi-billion firm that can help grow the business as a private company with an eye towards a future IPO.
The downsides to private equity investments include dilution of existing shareholders, the cost of capital and the lack of liquid assets (e.g. stock) to make future acquisitions.
Alternative Investment Market
The biggest beneficiary of the move by private companies away from U.S. exchanges has been the Alternative Investment Market (AIM) in London. Created by the London Stock Exchange in 1995, more than 2,400 companies have gone public via AIM. Not surprisingly, AIM says the single biggest benefit of their exchange for smaller growth companies is, ?a regulatory environment that has been designed specifically to meet their needs.? In other words, no Sarbanes-Oxley. Another benefit of the AIM market is semi-annual financial reporting.
AIM provides an alternative way to raise capital, in a less burdensome regulatory environment. However, the amount raised through an AIM offering is not anywhere near what can be raised on a domestic exchange. It?s a trade off many companies are willing to make. Protonex CEO Scott Pearson recently told Mass High Tech that while they raised less than they hoped, "It still gives us enough money to execute our plans. It covers us for a number of years."
Listing on the AIM market does not close off the U.S. equity market as a future option. It simply gives companies the capital and time they need to grow their business.
Special Purpose Acquisition Vehicles (SPACs)
Another option is a SPAC or Special Purpose Acquisition Corporation. SPACs are shell companies that go public on the OTC market with the sole purpose of acquiring private companies in a specific industry. Typically, a SPAC will look to acquire an anchor company and complement that with several smaller acquisitions.
The benefits for the acquired company are immediate access to capital, eliminating the cost and burdens of the registration process, as well liquidity (e.g. stock) to make future acquisitions.
SPACs bring with them many things to carefully consider. Post-acquisition comes all of the SOX requirements as well as the three-month lifecycle associated with quarterly earnings reports. Assuming the new entity meets the listing requirements, it can move to either the NASDAQ or NYSE. The management of the anchor company usually succeeds the original investors and runs the newly formed entity. However, this is not without risk, as SPAC investors can still have influence over day-to-day business decisions such as product strategy and how and when to allocate capital. Other problems include difficulty in getting adequate research coverage and dilution from the original investors taking a significant piece of equity in the new entity.
Similar to the AIM market, companies can raise significant capital to grow their business, but certainly not as much as through a straight NASDAQ listing.
Conclusion:
All of these alternative investment strategies have one thing in common, they give fast growing private companies the opportunity to raise capital and execute on their business plan. The ultimate goal remains the same today as it was in 1999, a NASDAQ IPO.
The reality of the marketplace today is that companies need to be of a certain size and scale in order to make the IPO and life as a public company an attractive option. These alternative strategies buy time for companies to work towards that goal. Each offers unique risks and rewards and requires extensive investigation and research. They may not be appropriate for every company, but they are worth a look.
Thomas Austin
CFO
Arbor Networks
Thomas Austin is chief financial officer of Arbor Networks, a provider of core-to-core network security and operational performance for global business networks headquartered in Lexington, MA. Arbor Networks was recently named by Deloitte as one of the twenty fastest growing private companies in North America.
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