Pipeline dreams?

Many Virginia companies prefer growing through buyouts rather than IPOs.

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Print this page by Nicole Anderson Ellis

Editor’s note: This story went to press before ADS Tactical Inc., citing adverse market conditions, withdrew its plans for an initial public offering. The web edition of this story has been updated.

It’s one version of the American dream.  Disappointed by inferior options, a man invents a better product. In the case of Allen Stoltzfus, it’s an improved way to learn languages. He taps into the intellectual and financial resources of his family. They start a company, Fairfield Language Technologies in Harrisonburg, and by its 10th birthday, the company tops $10 million in total revenue.  Four more years, and it boasts a new name and more than $91 million in revenue.  At age 17, the company goes public, selling more than 6 million shares at prices exceeding expectations. Today, the Arlington-based company trades on the New York Stock Exchange and boasts a market cap of about $300 million.

This kind of success story would have garnered headlines (and inspired startups) during almost any era.  But Rosetta Stone filed for an initial public offering with the U.S. Securities and Exchange Commission in September 2008 at the height of an international financial crisis.

“When we filed, [the financial website] Motley Fool called us one of the five dumbest moves of the week,” says Rosetta Stone CEO Tom Adams.  “September and October of ’08 were dark days.” 

NewsNowhere darker than in the IPO “pipeline” — the period between filing the Form S-1 Registration Statement with the SEC and appearing, post-approval, on a public stock exchange.  In 2007, 159 companies completed successful IPOs; nine of them were based in Virginia, according to the accounting firm Ernst & Young.  The three preceding years saw 157, 161 and 174 IPOs in the U.S., respectively. 

In 2008, that number fell to 37.  Nationwide.  That’s the driest year for IPOs since the late 1970s.  Many companies already in the pipeline withdrew their filings; others stalled out, waiting for better news.  In the third quarter of 2008, 79 companies sat in the pipeline; only four emerged. 

“The number of IPOs dropped off a cliff in 2008,” notes Rob Spicer, chair of the Securities and Corporate Finance group for Richmond-based law firm Williams Mullen.  Only one Virginia-based private company went public in 2008 — industrial manufacturer Colfax Corp. — and that was in early May. After the stock market freefall in September, IPO announcements stopped.  “No one,” says Spicer, “wanted to come out in that environment.” 

Yet as companies across the nation withdrew filings, Rosetta Stone pushed through.  Over a nine-month period — not uncommon for the SEC evaluation process — the company revised filings, addressed SEC comments and finally emerged, triumphant, in April 2009. “When we went public,” says Adams, “[the Motley Fool] called us one of the five best moves of the week.” Adams was named Ernst & Young’s Entrepreneur of the Year for 2009.

Since then, only a trickle of Virginia corporations have followed suit: one other company in 2009 and only one in 2010.  But as the nation’s IPO markets return to prerecession levels, experts question when — and if — Virginia’s IPO flow will recover.  The answer depends on how private companies in the commonwealth weigh the payoffs of public trading against the rising costs.  Are Virginia’s private companies just biding their time?  Or will new models of growth keep the IPO pipeline a lonely place for Old Dominion firms? 

Why an IPO?
There’s one primary reason private companies go public — access to cash.  Rosetta Stone’s IPO garnered $129 million.  When Booz Allen Hamilton went public in November last year, the McLean-based consulting firm, which had been one of Virginia’s largest private companies, saw proceeds topping $230 million. 

Traditionally, that cash is spent one of two ways: expansion or exodus. “The most frequently encountered reason for an IPO is to raise additional capital to grow the business,” says Susan Chaplinsky, professor of corporate financing at the University of Virginia’s Darden School of Business.  When a company reaches a certain size, each growth spurt can require more capital than the founders have at hand.  Chaplinsky points to recent examples:  professional networking site LinkedIn (which went public in May, raising more than $352 million) and Rosetta Stone.

“Rosetta Stone is the classic IPO,” says Chaplinsky.  “They had achieved a level of name recognition.  There was public interest.  And to take the company to the next step, it needed more than its investors could provide.”

That next step, according to its SEC filing, will take Rosetta Stone around the world.  “Over 90 percent of the $83 billion spent in 2007 on consumer language learning products and services worldwide was spent outside the United States,” reads the company’s S-1 statement. Yet foreign sales accounted for only 5 percent of Rosetta Stone’s revenue that year.  “There is a significant opportunity for us to expand our business internationally.” By the end of 2010, international sales had risen to roughly 18 percent of total revenue.
IPOs can also serve as an escape hatch for founders or investors who want to get out.

This is the second most common reason companies file IPOs, says Chaplinsky: founders want to get a big return for the business they built. “If you want to cash in and take off for the Caribbean,” she explains, “you need to find someone willing to buy your stake in the company.”  Willing, and also able.  When a successful private company is owned by a handful of people, it becomes increasingly difficult to find anyone capable of buying out a single investor. 

Booz Allen Hamilton struggled with this challenge for years.  In 2008, roughly 70 percent of its revenue was generated by the government division, which represented only one-third of the partners, says Kevin Cook, senior vice president and corporate controller.  “The 100 or so government partners couldn’t borrow enough to buy out the commercial folks.” 

They looked for a strategic buyer, but with $4 billion in revenue the nearly century-old company was too big to be bought by another company.  “Our only option,” says Cook, “was private equity.”

That’s how it’s done these days, according to Amy Dorfmeister, who runs Ernst & Young’s East Central Area IPO group.  “The companies that Virginia has taken public in the last two years and those that are currently in the pipeline are following the national trend: They’re private equity-backed.” 

Rosetta Stone partnered with the private equity firms ABS Capital and Norwest Equity Partners.  Booz Allen Hamilton chose the Carlyle Group.  In August 2008, after incurring $223 million in new debt to finance the move, Booz Allen Hamilton split from its commercial division, now the independent Booz & Co.  That same month, the leaner, more profitable Booz Allen Hamilton sold a majority share to Carlyle.  Private equity firms are known to maximize their investment by cutting fat and otherwise remodeling corporate structure, but from the onset Carlyle announced its intention to let Booz Allen Hamilton continue its charted course.  “In our case, we weren’t broke,” says Cook.  “So they didn’t try to fix us.”

Instead they began planning the IPO.  “When you’re owned by private equity,” explains Cook, “at some point they’ll need an exit strategy.  We were bought as an investment, so it was just a matter of time.”  (Rob Spicer suggests the 2008 buyout of Richmond-based Performance Food Group, then a publicly traded Fortune 500 company, by private equity firms Blackstone Group and Wellspring Capital also may result in an IPO.  “That’s often the end game,” says Spicer.  Performance Food Group declined to comment.)

At Rosetta Stone, a private equity-backed IPO proved an ideal way for the remaining family founders to collect on capital they’d produced.  In January 2006, four years after the death of company creator Allen Stoltzfus, brother Eugene Stoltzfus and brother-in-law John Fairfield finalized a management buyout by ABS Capital and Norwest. By the latter half of the year, the company was preparing for an IPO, thus settling what CEO Adams calls the “sell or go public” debate. 

Notes Adams, “It’s much more exciting to go public.”

IPOs make headlines. So dependably that publicity is a major benefit to going public. LinkedIn’s public offering is credited with boosting use of the professional network, improving name recognition and generally strengthening the brand. 

Even after initial talk fades, inclusion on a major stock exchange projects an air of success and stability, announcing a company has arrived. 

But there’s the downside of fame: no more hiding weaknesses and flaws. Transparency is sacred at the SEC, and it can catch corporations unprepared.

“You jump from the private side, where no one’s looking, to the public side, where there’s much more scrutiny from the shareholders and the press,” says Spicer.  “If you’re large enough, you’ll have analysts following you. It’s a whole other world.”

Mandated disclosure begins immediately, with the filing of the weighty S-1. CEOs of private corporations might hyperventilate at the idea of publishing documents labeled “Risk Factors,” “Executive Compensation” and “Description of Indebtedness.”  Public scrutiny of this data starts the minute a company enters the pipeline.

Only one Virginia company has entered the pipeline so far in 2011, Virginia Beach-based contractor ADS Tactical Inc., which withdrew its IPO in late July based on adverse market conditions. 

The privately owned contractor reported $1.3 billion in revenue in 2010 by streamlining equipment procurement, mostly for the Department of Homeland Security and Department of Defense. In February, 14 years after its founding, ADS filed for an IPO. The company planned to sell 12 million shares, and use the estimated proceeds of $142.3 million to retire debt. The company implied it would monitor market conditions for future financing opportunities.

“Filing for an IPO can be a clever way to get attention and how you’re ready for major change,” says Chaplinsky. “It might be a for-sale sign.”

“I tend to agree,” adds Dorfmeister, from Ernst & Young. “We’ve seen companies that have filed and subsequently been bought.”

“I’m sure that happens,” says Booz Allen Hamilton’s Kevin Cook. “But there are a lot of other ways to announce that a company is in play.” A lot of cheaper, easier ways.

Virginia’s stalled IPO flow?
Launching an IPO requires hefty investments of money and time.  Preparing an S-1 filing takes as much a year, says Spicer.  That’s once a company has its financial ducks in a row.  Rosetta Stone started “preparing to be ready” in the latter half of 2006, says Adams.  Two years later, the roughly 200-page S-1 was filed.  Before the first public shares were sold the company had filed six amendments.

At Booz Allen Hamilton, IPO-prep began with new hires to shore up its expertise on SEC reporting.  That’s before hiring an outside auditor, as required since the 2002 passage of Sarbanes-Oxley Act’s reforms.

Motivated by a slew of corporate scandals, most famously, the collapse of Enron, Sarbanes-Oxley sought to curb “creative” accounting, while shifting ultimate responsibility to company leadership. An unintended side-effect was a jump in the price of going public. In addition to IPO expenses, companies pay ongoing accounting, auditing and legal fees preparing quarterly and annual SEC reports. The level of public accountability will be further tightened after implementation of 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act (responsibility for specific rules and implementation rest with the SEC, and are pending).

Not surprisingly, both laws drew criticism as well as suggestions they slowed the IPO market, says Bruce Johnsen, professor of securities regulation at George Mason University School of Law and former senior research scholar at the SEC.  “You have to submit to all sorts of crazy regulations,” says Johnsen.  “Sarbanes-Oxley, all by itself, some say, reduced the benefits of going public.”

Yet the reforms also draw praise. “Before Sarbanes-Oxley, folks didn’t know where the goal line was,” notes Cook, who credits the legislation with helping Booz Allen Hamilton increase record-keeping efficiency.

This acceptance is widespread, says Dorfmeister.  Whatever anxiety Sarbanes-Oxley raised has settled.  “Companies know to adopt and follow the regulations. I really don’t see it as a hurdle today.”

So what is stymieing Virginia’s IPO market?  National IPO levels have returned to pre-recession health, with an 81 percent boost in filings in 2009 and 143 percent in 2010.  Is what Dorfmeister calls “Virginia’s rich history of IPO” now history?

Likely so, says Chaplinsky. But it isn’t sign of illness; it’s evolution. 

“There’s been a change in the growth model,” she explains.  “The trend in Virginia is startup incubators, particularly in the growing high-tech and biotech fields. If you talk to these guys, they don’t have a goal of going public. They’re serial entrepreneurs.”

So where once a startup might have gone public, now they’ll sell to a bigger company, says Chaplinsky; among them, some of the splashiest IPOs of the 1990s.  “The Googles.  The Amazons.”  Plenty of companies are sitting on record amounts of cash, she notes, and they’re looking for ways to grow. 

Recent examples include ZyGEM Corp.’s 2010 purchase of Charlottesville-based biotech startup MicroLab Diagnostics and GXS’s acquisition of McLean-based software startup RollStream, in March.

Virginia still will see IPOs, says Chaplinsky, but it is unlikely to return to its once-steady flow.  “Not as many people are choosing to do it, or qualifying for it. I don’t see a lot of Rosetta Stones on the horizon.” 

Rosetta Stone CEO Adams agrees.  “I do think the private company buyout is going to continue to grow.” But he stresses the need for IPOs as well. “What grew the U.S. in the ‘90s was access to capital via public markets. That drove innovation. I think that’s vital.” 

As for when ADS might emerge from the pipeline, or be joined inside, no one is guessing.  Notes Johnsen, “Economists can’t see into the future any better than anyone else.” 


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