It's a cross between JDate, Match.com, and Tinder... Only with businesses. It's a lonely Saturday night, and a company's CEO is watching Saturday Night Live, wishing the show was funnier. Alone. If the firm were solely open to the public, there would be a blazing celebration with both red and white wine provided, this time in bottles with corks instead of screw caps, as was the case when the company was started seven years ago.
Our hypothetical firm (let's call it CouchCo) has $300 million in revenue and $100 million in operating profits, but it needs an additional $400 million to expand into China, Latin America, and Mars, as well as add Bluetooth to all of its IoT-friendly furniture lines. It's evident that this company has to "go public." It's only waiting for a right swipe from a bank.
This waggle dance can now be done in a variety of ways. "Should we SPAC?" says the narrator. “IPO?” “Sell?” All good questions, but in the majority of situations, the first step is to find the correct advisor (think: investment banker) to open doors, provide a mathematical foundation for value, and consider the numerous strategic options available to this American success tale.
Which bank, though? Which banker are you talking about? Which analyst are you talking about? How does one make a decision?
To put it another way, the larger the offering, the less the preceding matters. When Facebook went public in the mid-$50 billion area a decade ago, nearly every bank was begging Zuck for a piece of the action. Joe Bob Billy's Investment Bank and Golf Club Warehouse would have sufficed for FB. It's the lesser-known businesses that require more financial support.
Wall Street analysts worked freely and openly with their companies' investment bankers to create love bullish "sell reports" praising the excellence of whichever firm their bank was... financing. Yes, there is massive ethical conflict underlying this framework, but that has been the case for decades. (To be honest, the dot-com era's IPO-a-day culture exacerbated many of these issues.)
Investment banks in this sense are structured essentially as follows: An investment report about a firm is written by a sell-side analyst who is considered an expert in their industry. It might be one that is already trading or one that the analyst uncovered while conducting his or her routine daily research searches. That analyst creates a report, which the bank's salespeople carefully analyse — and then "market" to buyside buyers of that stock, in the belief that if the sell-side bank (brokerage) alerted the buyer to a buying opportunity, the people who delivered that report to the investor would be paid a commission for buying n million shares of that stock.
That relationship is rarely, if ever, established, and is more of a handshake relic of Wall Street's past, when fees were a dime a share or more, and the group of people inside the bank who make markets in securities trading could make a nice living on commissions. Today, though, the world is a different place. Computer matching of bids and asks substantially impacted the margins for buyers and sellers, so that currently a "fat" commission on a volume sale is around 3 cents per share. It's such a small amount of money that most banks' capital markets desk, which oversees the transaction, has gone from a profit centre to a cost centre.
When we negotiate for deals, we as venture capitalists must understand that we are not dealing with the bank's wealthy luxurious divisions. (Today, most large banks have their own proprietary hedge funds or hedge fund/investment platforms that enable entrepreneurial buyside investors to plug in and... start.) Those divisions are responsible for the majority of investment bank profits today.)
So, let's return to our IoT furniture startup. We have a complicated narrative to tell. Why would anyone be interested in yet another furniture company, albeit a high-tech one, whose furniture sniffs the phone numbers and other data of everyone who has sat on its pieces and shares it in a fancy blog days or weeks later? Their most popular epiphany has been "Tom Brady sat here on date>."
Is this company looking for a furniture analyst to cover them and act as the "axe" or "hammer" (i.e. the most powerful influencer on Wall Street's buyside)? No. Not in the least. Furniture firms are valued at 6 times EBITDA, and their investors are often terrified of their own shadows. This company is looking for a tech analyst with a track record of discovering new growth companies. Tech firms trade at far greater multiples, allowing them to raise capital more "cheaply." That example, if a firm has $100 million in operational earnings and wants to raise $400 million, but only trades at 6 times the amount, or $600 million, it will have to dramatically dilute itself to achieve that $400 million, in this case a 65 percent dilution.
However, if that company has a pre-investment money round valuation of 30 times its operating profit number, or $3 billion, it will only have to dilute itself by about 15% to raise $400 million. The gist is that a tech analyst can obtain finance for a firm for a lot less money than a typical furniture analyst. (This is a bit glib – digital businesses often develop several times quicker than traditional old-world, wood-and-fabric constructors using human labor, etc.)
But what if this analyst works for a small bank with no capital markets desk, i.e., the firm has a prestigious analyst but has shaky ties to major buy-side firms like Fidelity and Capital World? That is an issue. It means that the little bank's salespeople will have to beg and plead for meetings with the large players — and many will refuse to do business with them since, in a $100 billion fund, a fund manager must buy $1 billion in positions for given security to be a 1% stake. It's simply not worth the effort for little businesses like these. But does it make a difference? At this point, all the company wants to do is raise money. It may appear on Fidelity's radar in the future.
So perhaps hiring a prestige analyst who is well-versed in the space and the sector's hammer is the best option.
But what if there really isn’t a single hammer? In that instance, the bank with the stronger capital markets staff is more likely to obtain the transaction. That bank can "will" companies to go public and have a plethora of players trading its stock due to the sheer size of its distribution force. To put it another way, if you can't get Tom Brady, go with the team that won the Super Bowl the year before.
But hold on! There's more to come! What about the third door: a sale?
In that circumstance, we usually turn to the investment bank that has completed the most transactions with the target. MSFT went public in the early 1980s thanks to Goldman Sachs. Since then, it has sold hundreds of businesses to the company. They still have a close relationship with Microsoft today. So, if you hire GS to sell your slightly worn business to Microsoft, you can expect at least a cursory review from the MSFT Corporate Development staff.
So, how do you go about it? Or, to put it another way, what would Prime Movers Lab advise CouchCo's CEO to do in order to maximize shareholder value and serve the various stakeholders that have helped the company grow?
The correct response is the same every time. It's a diaper firm, as you might have guessed.
Yes, the correct response is... "It depends."
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