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How-to Become a Linux Billionaire

Feb 21, 2000, 01:22 (9 Talkback[s])
(Other stories by Tom Adelstein)

Okay, here's the secret handshake now open your Kimono

By Tom Adelstein, Bynari Inc.

[ The opinions expressed by authors on Linux Today are their own. They speak only for themselves and not for Linux Today. ]

The path to wealth has many doors. Over the last century, many people have taken the one marked IPO and walked away instant winners. Today, if you add the word "Linux" to your product line, your chances of winning increases dramatically. Traditional steps exist if you wish to make it through the door, but in today's game the room with the Linux window is still open.

Still Traditional Corporate Finance - But Not Really
Last year, we saw a company who had 15 or so employees the previous year and revenues of around $2 million wind up with a market value of $18 billion on their opening day of trading. How did they do it? Many find the whole subject mysterious and unreachable. Is it?

Now that I have your attention, I want to transfer some information so you can understand the processes involved in walking through the door marked IPO. You can use this information to add prosperity to your life or just get a handle on the game of Corporate Financial Futbol. Where do we begin and where will we wind up? Let's take a look.

First, we have to address "How they did it". When we look into this area, we see very traditional strategies. The company must prepare itself for a securities offering. Secondly, they must establish a market value in the private sector. Then, they must find an Investment Banker who will sell their shares to investors. On the way, they must file a registration statement called an S-1 with the Securities and Exchange Commission (SEC) and various State Securities Commissions. Then, they have to "time" the offering to achieve maximum value and collect the money. Let's look at the steps while realizing this isn't a sure way to wealth.

Preparing for a Securities Offering
The old saying that you need money to make money applies here. A company wanting to go public has to pass certain tests. For example, an independent CPA firm allowed to practice before the SEC must audit the company's financial statements for the previous three years. For a company that didn't have it's financials audited, that could take months. Then, if the company existed for say over five years, previous years' information must be included in the (S-1) registration statement. This usually costs hundreds of thousands of dollars.

If you plan to head for the door marked IPO, consider spending money for financial audits in advance of "having to". If you own a start-up (also called an early stage company), have your statements audited the very first year you go into business and continue each year. Also, you will need to use a CPA firm that practices before the SEC. If you don't use such a firm, the financial statements will need additional work. That can hurt your timing and cost more money.

In addition to having audited financial statements, you'll need to have all your legal work in order. Many companies file articles of incorporation and pay fees to become a corporation but forget to do the rest of their legal work. You shouldn't wait to do the additional legal work until you decide to go public. Prepare your corporate bylaws, resolutions, minutes, issue your stock formally, document meetings and have everything signed. Do this in real time not after the fact. If you hire a CPA firm to audit your financial statements, they will demand that your legal work be done and done correctly. Or, you may not pass their audit tests and the CPA firm won't issue an unqualified opinion on your statements. Call that the "blue screen of death" in the securities world.

Additionally, you will need to document your business plan from 30,000 feet in the air to ground level. That's jargon for clearly defining your vision as a company, your business initiatives, your mission and your objectives. If you don't understand what that means, then you need to find out. Buy a good book that addresses the subject of business planning and read it.

Briefly, you will need to articulate your reason for existing which is called a Vision Statement. The company vision isn't a goal. It's something that persists over time. Business schools teach the traditional example of what happens if one fails to articulate a vision. They use the Railroad Industry over and over as an example. The Railroad Industry didn't understand that it was in the transportation business. They thought the were in the railroad business. When airplanes came along, they didn't make the transition. If they had a vision, they didn't go high enough to see the whole spectrum.

Your business plan should clarify your vision differently from your mission and your goals. Your goals live in time with quantifiable aspects such as how much revenue you will generate over a given period of time. You might see a statement such as "we will generate $1 million in revenue in the second quarter of our fiscal year". Then your mission adds qualifying aspects to the goals. In a business plan, the mission statement might add something like "we will build our company on a coherent value system emphasizing low cost at the sacrifice of value".

Establish a Market Value in the Private Sector
Before a company goes public,management must establish a value for the company's stock. Traditionally, companies headed for the IPO door do this by going through "rounds of financing". Typically, early stage company management needs an "angel" for the first round. Individual investors usually provide angel financing. They put up a minimum amount of cash to get the company started.

After the angel round of financing, management must find a recognized Venture Capital Group (VC) to begin a series of financing rounds. In the past, we usually saw three series of financings. Each series typically had a name and increased the per-share value of the company. For example, a well known VC might purchase 10% of the company stock for $5 million. That would mean, a qualified commercial investment company felt your company had a worth of $50 million. We might call that round of financing, Series A.

Traditionally, financial advisors might recommend two additional rounds, Series B and C. In today's market, however, some companies by-pass additional rounds and go right to the counter with a public offering. One might wonder how they can do that. Simply, the market moves very fast and the windows of opportunity can shut quickly. Three years ago, people might not have considered financing companies this way. Today, things have changed. Information moves fast, on-line brokerage firms take shares to sell, historical evaluation methods no longer apply. Call this the "dot com" era.

Find an Investment Banker to Sell Shares to Investors
The established VC's usually work closely with Wall Street Firms (brokers) who can deliver stock to buyers. When the VC has a winner, they bring in the brokers to begin the process of syndicating the stock. In some cases, a broker might discover an early stage company they wish to bring public. They would then shop such a business to VCs who would do a financing round or more.

By having a VC enter the game, the broker can help establish a market capitalization for the company. The VC can establish financial milestones for an early stage company to achieve which provide credibility to the offering. In either case, the broker provides a bridge between company and the investing public. All IPOs go through the broker.

In an IPO securities offering, one firm becomes the managing broker. The managing broker commits to 100 percent of the offering. They also take responsibility for "due diligence" which resembles a CPA audit. The difference in good due diligence is that the scope of the investment company's examination extends past the financial statements. Hint: Have your due diligence documentation ready and waiting before you ever get started. For a sample Due Diligence checklist go here.

Generally, the managing broker syndicates the IPO which means they have other brokers participate. For example, the managing broker might want to sell directly 20 percent of the offering. They would then offer a percentage to other firms. So, First Cambridge might be the managing broker and they would spread their risk by offering Kidding & Co., Sheerstown, and Dean Brothers each 25 percent and Sloan & Co. 5 percent. Each firm would offer part of their share to smaller firms until the offering winds up in the hands of a broad range of brokers.

Prior to the first offer to the public, the brokers will send a prospectus on the offering to their customers. The prospectus, known as a Red Herring, has no price listed and has a red line down the right side of the document. Investors can place orders for the stock, but since no price for the stock exists, the investor is not bound to buy his or her order.

Brokerage firms take orders off of Red Herrings simply to get an indication of interest which helps them determine the offering price. So, if the managing broker plans to pay your company $15 a share for your stock but gets a strong indication of interest, the price might go to $25.

The S-1 Registration Statement
The 1933 Securities Act established requirements for the filing of information to provide to the investing public. The 1934 Securities and Exchange Act created the SEC which regulates securities. If you want to go through the IPO door, you have to work with the SEC.

Once a company files for registration of stock it wishes to sell to the public, its S-1 becomes a matter of public record. For example, when Red Hat filed for its IPO, its S-1 became available for all to see. To see Red Hat's S-1, go to www.sec.gov and choose from the menu on the left that says Edgar Database. Next look down the page for the link that says Search the EDGAR Database. Next, a page will appear and you should choose the link Quick Forms Lookup.

Now, you'll have to scroll down the page and enter the company name in the appropriate box. Also choose "Entire Database Since 1994". That will take you to a page where you can select different forms such as the S-1. On this form you will find out more information than you might want to know about the company. Regardless, it's worth a good look. You may have to file such a document so be prepared.

Market Timing
Let's say you have made it all they way to the selling point. During the pre-IPO period, you'll want to do what has been called the "Road Show". Often, commitments to buy shares of stock result from the quality of the "Road Show". According to Bloomberg News, "the Securities and Exchange Commission may require companies to open their presentations about initial public offerings to individual investors, SEC Commissioner Laura S. Unger says.

"The SEC staff is preparing a proposal for submission to the commission in March or April that would widen the audience for companies' pre-IPO promotional presentations, called roadshows," Ms. Unger said. These presentations typically are restricted to analysts and institutional investors.

"It would try to provide a level playing field in terms of providing access to investors for important information," said Ms. Unger, one of five commissioners who will vote on the proposal.

"The SEC staff hasn't yet worked out how companies would give individual investors access to roadshows, but one way would be to broadcast them on the Internet, she said."

After the roadshow, the brokers will want to time the offering so economic conditions in the market appear most receptive to the offering. For example, you wouldn't want your stock brought to market during a sell off in technology stocks. You might want the market to be fairly boring so that you can create an event and make news. Or you might want to time the offering so that it coincides with other companies' successful IPOs when investors feel eager to "get in the game".

Good Advice for Linux Guys
Part of the reason for writing this article involves what I consider false inducements. Many start-ups say they're in a pre-IPO stage. If you digested this information, you can evaluate the status of pre-IPO companies. You can wade through the rhetoric and find out about the astuteness of management of your prospective employer.

Ask a few questions, such as "have you had any rounds of financing"? Or, "which round of financing will you enter, series A, B or C?" If they offer stock options, make sure that they're good even if the company doesn't IPO. For example, the company may have gone through three rounds of VC financing and then a larger company decides to buy it. You want to know if your stock options have the ability to be exercised in case of a merger or acquisition. In case you wonder if that can happen, read Sun's 10K describing the Net Dynamics, Inc. acquistion. I have a few friends who got left holding worthless paper in that one. The VC's and the founders got over $100 million. You'd think they could have shared a little!

Tom Adelstein, CPA, is the CIO/CFO of Bynari, Inc. He's the author of several books and articles on business and technology and has management, consulting and hands-on experience in the Information Technology field.