Bitter Lessons for Wall St.’s ‘Orphans’

Not so long ago, Jim Harrer seemed like this city’s version of Bill Gates.

Sales of his award-winning software were booming, a magazine dubbed his Mustang Software Group one of America’s fastest-growing companies, and Wall Street types began courting him with dazzling offers to sell Mustang shares to the public. Once he approved, bankers boosted the amount of stock sold by 35% to more than $8 million--all because of demand from eager investors.

But quick as a country two-step, Harrer’s fortunes changed.

Since the initial public offering--known as an IPO--in 1995, Mustang’s stock has fallen more than 90% as the fast-developing Internet rendered its products obsolete.

Harrer scrambled to develop new software and reorganize from his office, an outpost surrounded by dry hills on the outskirts of Bakersfield. He laid off almost half of his work force and traded in his new Mercedes. Mustang, today, is on the verge of being kicked off the Nasdaq market because its stock recently languished for weeks below $1 a share.

“Some people advised us to wait to go public--they said we weren’t ready,” said Harrer, 39, who wears a beeper alerting him when Mustang’s stock moves. “But our investment bankers got us filled with enthusiasm about our chances. They blew us away. None of us knew our industry would disappear so quickly.”

As the nation’s stock markets continue their remarkable, and seemingly inexorable, rise, another telling story has emerged--a darker and quieter one that has received scant attention.

As glittering and alluring as the public securities markets have become, they also are particularlyunforgiving to the growing number of entrepreneurs whose small and mid-size businesses are ill-prepared for Wall Street’s harsh spotlight.

They are commonly known as the “fallen angels” or the “orphans” of the capital markets.

“It’s one of the biggest problems we have in the market today,” said Alfred E. Osborne Jr., head of the entrepreneurial studies center at UCLA’s Anderson Graduate School of Management and a director of several companies, including Times Mirror Co., owner of the Los Angeles Times.

“What could have been a perfectly good company is just destroyed by going public too early. Once the stock falls to a certain level, it’s almost impossible for it to come back.”

Clearly, becoming an orphan is all part of the risky game of Wall Street. But when bull market greed rules, it’s especially easy for eager entrepreneurs to dream too early of market riches, investment bankers to do deals they might once have sidestepped and investors to buy stock from companies they don’t begin to understand.

For all of these reasons, experts say, the number of orphaned companies is on the rise.

That’s not only because of the sheer amount of firms going public. It’s also because of a shift in ownership from individuals to trigger-finger institutional funds that can be more fickle. The problem is compounded by volatile high-tech firms becoming the darlings of the public markets.

State Leads U.S. in Public Offerings

Yet smaller companies by the hundreds continue to rush into a frothy stock market like the miners who once flocked to the California Gold Rush. But like those miners, only a few hit the mother lode with their IPOs. Others just get clobbered, their problems generally obscured from public view by the relative handful of skyrocketing IPOs such as Netscape Communications.

California, as a hotbed of entrepreneurship, has led the nation in IPOs during the 1990s, with lots of successes--and bombs.

In fact, of the more than 680 companies in California that have gone public in the past 5 1/2 years, about 45% are trading below their IPO price, according to CommScan, a New York data service. (That compares to 38% of the more than 3,550 IPOS nationwide during that period.)

Nearly 15% of those IPOs--in California and across the country--are trading at less than $3 a share, were delisted from their exchanges, went bankrupt, or are trading in the obscure over-the-counter market, CommScan said.

The number of faded stocks could increase, experts say, with a record number of companies going public in 1996, and the pace picking up in recent months.

One chronic problem is that many investors are unwilling to stay with a company that disappoints even slightly, experts say.

If a product fails, a CEO resigns, or sales slump, the large institutions such as pension and mutual funds that own the bulk of IPO stocks are usually very unforgiving. Focused on extremely short-term performance, institutions generally are unwilling to look past temporary problems to a company’s long-term potential.

“It’s swift punishment if a small company says it’s not going to make what it expected. Investors don’t take time to say: ‘Golly gee, what’s this company really saying?,’ ” said Cristina Morgan, co-head of investment banking for Hambrecht & Quist in San Francisco. “They say to their trader, ‘Get me out of here--now!’ The stock goes from $15 to $3. Not $15 to $14; it’s $15 to $3, and it is that fast.”

In turn, falling stock prices make it far harder for a company to operate, sharply limiting its ability to keep valued employees and to attract more capital to keep growing. Once the stock price drops too low and a company becomes what Wall Street calls a “single-digit midget,” it often languishes there.

“There are more companies than ever before entering death spirals in the public markets,” said Jay Ritter, a University of Florida economist and IPO specialist. “A company is either a big winner or a loser, rather than sustaining any longtime period of steady growth.”

AccelGraphics, a San Jose graphics software maker, went public in April. Its sales more than quadrupled to $18 million in 1996, from $3.8 million the previous year.

Although some investment bankers warned that the 2-year-old company wasn’t ready for prime-time Wall Street, the entrepreneurs at Accel found other bankers more eager.

“We believed that it was a good time to go public,” said Jeffrey Dunn, CEO of Accel. “I don’t ever look back.”

IPOs Are Lucrative --for Bankers

Companies go public to raise capital for growth and provide an exit strategy for current owners. Many entrepreneurs think the combination of their company’s rising sales and a rising bull market are reasons enough to make the move. Often when IPOs in industries similar to theirs do well, owners figure it’s a good time to go to Wall Street as well.

Accel went public, raising more than $23 million through the sale of 2.6 million shares at $9 a share. By early May, analysts at the company’s underwriters, Cowen & Co. in New York and San Francisco-based Robertson Stephens & Co., were recommending Accel with a “buy” rating, and the stock reached its all-time high of $14.25 a share.

Then in June, Accel warned publicly that disappointing sales would hurt earnings and its quarterly results would not be as promised. The reaction was swift and brutal: The stock, already in decline, plunged $3.81 to $5.25 a share--a 42% free fall that made it the day’s biggest percentage loser in U.S. markets. (The stock has since rebounded to $8.38 but still is under its IPO price.)

No matter how Accel stock performs, the investment bankers who took the firm public still pocket their fees.

And these fees can be very, very lucrative.

Typically, a firm gets about 7.3% of the total value of shares sold in an IPO, according to Securities Data Corp. a New Jersey data firm, but some make more. That means on a $30-million IPO, almost $3 million goes to the underwriters. In fact, last year Wall Street earned more than $2.6 billion in fees from IPOs, part of the reason why competition for such deals remains so fierce.

“There are these slick firms that come along and say ‘Hello there, good-looking, want to raise $5 million?’ ” said James Stancil a finance professor at USC. “The whole thing is greed. They’re happening too fast. They’re not waiting three to four years until a company is ready, but the market just seems to gobble them up anyway.”

There are investment bankers who, in theory, provide support when investors flee and an IPO runs into trouble. But finance specialists say that many lose genuine interest in a company once the initial batch of stock is sold and the fees have been paid.

“There’s great pressure on the investment banks to maximize their underwriting fees--they have such high overhead,” said Samuel L. Hayes III, a Harvard professor and Wall Street historian.

“They are, therefore, being less discriminating in the quality of deals they are agreeing to underwrite. Investment bankers now are adopting a hit-and-run philosophy. It used to be that bank put its reputation and backing behind a company and its IPO.”

In fact, in the case of Mustang, the individual investment bankers who worked on the deal are no longer with the stock’s underwriter, Irvine-based Cruttenden Roth Inc. Neither is the analyst who initially followed the company’s stock.

Byron Roth, president of Cruttenden, said he recently hired some high-quality people and acknowledges there has been high turnover. Mustang had all the right products at the time of its IPO, he said, noting that consumer software is a very volatile industry.

“There’s no doubt we’ve made mistakes. Those things happen. But in our American free-enterprise system, you never know where the next Microsoft might be.”

Not All Firms Are Suited for IPOs

At the same time bankers are pulling in big-time fees, some individual investors are sucked into the IPO game with little understanding of what they’re investing in or the risks involved.

“The problem is the investing public gets caught up in IPO fever, especially in technology,” said Deborah Stapleton, who surveys IPOs done by Silicon Valley’s high-tech companies to see how successful their offerings were. “They invest in things they don’t understand.”

While a few companies now choose to sell their first stock issues directly over the Internet, most still use investment bankers and traditional stock exchanges.

In a recent survey of 200 technology companies that went public last year, Stapleton found 81% said they wished they had taken more time in selecting an investment banker. Most said their biggest concerns were finding long-term investors and investment bankers who would support them following the IPO.

One Southern California company that found out the hard way that its business was not well-suited for Wall Street was Chatsworth-based Leslie’s Poolmart, the largest national supplier of pool supplies.

It went public through Montgomery Securities in 1991 at $11 a share. But bankers and company owners hadn’t considered how Wall Street would react to the wide fluctuations in sales, the pool supply business being very seasonal. A few wet winters and late summers hurt sales, which slammed the stock. The share price generally would rise in the spring and summer, then drop.

The stock hovered around $14 a share, even though sales increased from $96.3 million in 1992 to $191.6 million in 1996 as profits also rose.

Brian McDermott, CEO of Leslie’s, which has 278 stores in 27 states, says part of the problem was that his was a small company with a small amount of stock outstanding, since about 30% of the company remained privately held.

“It caused us some frustration. There was very little incentive for the market to spend time getting to know us,” said McDermott. “We all felt there were some issues of incompatibility between our company and the market,” he said.

With increased sales, new stores and, more important, profitability, Leslie’s expected more recognition from Wall Street. It didn’t get it. Since Leslie’s didn’t need more capital, its owners considered going private again.

“We weren’t getting the benefit of being the public company,” McDermott said. “We decided we wanted an environment that did not include the glare, if you will, of the public market.”

Now, Leslie’s is privately held. Leonard Green & Partners, a buyout firm in Los Angeles, this summer purchased a more-than-50% stake in the firm. It has plans for the company to grow to 500 stores.

“The market grinds on you over a long period of time,” McDermott said. “I don’t think you can fully appreciate that until you’ve gone through it.”

Harrer can appreciate it. The day Mustang went public, its investment bankers were there in full force. They took him out to celebrate, then to the Mercedes dealer, where a salesman had a new car ready to drive off the lot in 10 minutes.

“It was stupid,” said Harrer, who now has a Toyota.

Indeed, the euphoria didn’t last. Harrer’s company started to flounder because the software it designed to run old-time, dial-up bulletin boards was made obsolete. He’s laid off almost half of his nearly 100 workers.

Whether Mustang would have done better if it had remained private is open to question. On one hand, the $8.1 million in additional capital has made it easier to stay afloat, but handling the incessant demands of investors has given Harrer less time to focus on new products, he says.

While he defends his decision to go public, he does admit that he really was not prepared for it. Among the more jolting adjustments were:

* The shift to short-term managerial style.

Monday-afternoon managers’ meetings that once centered on product development and sales became forums to discuss details of company finances and what would be attractive to investors. “We used to talk about what we were doing and rarely about the numbers,” said Harrer. “Now, when we had a product, the first thing we began worrying about was the release date.”

* Learning the language of Wall Street.

Harrer had to make sure he wasn’t making any promises to analysts. “You can’t say, ‘This product will kick ass,’ ” said Harrer. “You have to say, ‘Management expects this product will kick ass.’ It just doesn’t sound the same.”

* Shareholder relations.

Once Mustang stock began dropping, investors began calling to find out why. Again, unusual for a CEO, the conscientious Harrer began taking some of the calls.

“I would talk to some 50-year-old grandmother whose son-in-law had told her to buy our stock, and she didn’t even know how to turn on a computer,” said Harrer. “And you have to be careful talking to them, because they’re asking, ‘Should I buy more stock?’ ”

Harrer is planning the comeback of the company he founded at age 28. He and his team of managers are developing new products, including an Internet Message Center. He has reduced monthly expenses to $200,000 from $560,000 through layoffs and other cuts, such as reducing promotion of its toll-free 800 number.

“I’m going to turn this thing around--there’s no doubt in my mind,” said Harrer, who planned to meet with investors this month. “We’re like a start-up again.”

Whether the company can recover ultimately depends on its new products.

“It’s a tough road,” said Roth, the company’s investment banker. “There’s not a lot we can do for them. They have to come up with a good product so they can come back.”

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Definition of Terms

* Initial public offering, or IPO: A corporation’s first offering of stock to the public. Through an IPO, a company goes from being privately held to publicly owned, often with large institutions, such as mutual funds owning a large stake in the company. Individual investors also can buy IPO stocks.

* Listed/delisted securities: Stocks that have been accepted for trading by one of the organized and registered securities exchanges, such as the New York Stock Exchange, are considered listed. Each exchange has different rules that must be met before a security can be listed and traded. A company is delisted, or removed from an exchange, if a company does not meet those rules or its stock price falls too low.

* Investment bankers: The firm, acting as an underwriter, is the intermediary between the investing public and a company selling securities for the first time. Bankers also will give a company advice on how to structure its IPO. Afterward, the firm’s analyst will write reports to keep investors informed of a company’s progress.

Source: Los Angeles Times

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ON THEIR OWN

Many companies aren’t getting needed post-IPO support from underwriters, experts say. D1