The bar has been raised.
Tougher federal regulations for businesses stemming from the Sarbanes-Oxley Act of 2002 have made it harder for smaller companies to go public.
The result: Orange County businesses that went public in 2007 were bigger than a year earlier.
OC companies that went public in 2007 had average yearly sales of about $250 million, versus about $100 million for 2006.
“SOX has chilled IPOs for companies that are smaller,” said Michael Flynn, chair of the corporate practice at Stradling Yocca Carlson & Rauth in Newport Beach. “You just don’t see as many. Those guys look for other acquisition and financing options.”
The main reason,the high cost of going and being public.
Filing for an IPO, getting into regulatory compliance and hiring consultants, accountants and lawyers eat into profits.
“It doesn’t make sense to be public if the costs are going to take a huge percentage from your pre-tax income,” said Murray Rudin, who heads the Irvine office of Los Angeles-based private equity firm Riordan, Lewis & Haden. “The effect of that has been to move the bar up for being public.”
The cutoff, according to Rudin, is around $150 million to $200 million in yearly sales. Years ago, the bar was about $75 million in annual sales, he said.
On average, companies can spend $1 million to $2 million a year on accountants, audits and other compliance-related products and services, Rudin said.
“For a modest-sized company, the ongoing cost of being public,not just the upfront stuff,is probably now at least $2.5 million a year,” he said. “So you are taking a pretty big hit in terms of valuation just to be public.”
That leaves smaller companies looking for other options.
The flood of private equity money during the past few years has made leveraged buyouts,those that use credit to finance a deal,an attractive alternative. Debt-backed buyouts have become tougher with the credit crunch, but the trend continues.
“One of the things that have really changed in the last 10 years is the incredible number of dollars associated with private equity funds that weren’t there in that sort of volume back then,” Stradling’s Flynn said. “It’s causing smaller companies to choose other ways of growing.”
A handful of OC companies have wavered in their decisions to go public in recent years.
Laguna Niguel software maker GenuTec Business Solutions Inc. filed plans for a $25 million IPO in August 2006. A year later, the company withdrew its offering, citing market conditions.
Devax Inc., a Lake Forest medical device maker, withdrew plans for its $85 million offering last month. The company, which filed the plans in May, said going public “is no longer in its best interests.”
Still in the wings is Eyeonics Inc., which filed plans to go public in July but has yet to set a date for its offering. The Aliso Viejo-based eye replacement lens maker plans to raise $86 million.
Lure of a Buyout
For some, a buyout or private equity deal comes into play, according to Mark McManigal, managing director of Newport Beach’s Barrington Associates, the investment banking arm of Wells Fargo Securities LLC that focuses on midsize companies.
“There are a number of transactions we’ve done in Orange County where the decision-making process involves looking at a merger and acquisition transaction versus an IPO,” McManigal said. “Parties tend to look at the M & A; transaction as the better choice from the standpoint of eertainty and true liquidity for the owners. They’d rather do without being subject to all the considerations of having a public security and the volatility of the public markets.”
Sarbanes-Oxley isn’t as much of an issue for big companies that go public.
“I don’t think SOX is an inhibitor for the larger cap, well-financed companies that are looking for an exit for their investors,” Flynn said. “They just look at it as a cost of doing business.”
Companies that are looking to raise roughly $100 million with post-offering market values of $300 million to $500 million usually can absorb the costs of compliance without chipping away at their bottom line, Flynn said.
“They just budget for it and they move on,” he said.
There’s one big exception to the trend, according to Rudin: Small companies with breakthrough technologies and the potential to earn a ton of cash.
“That story does not apply to companies that are potentially the next huge biotech or tech superstar,” he said. “There’s a still an IPO market for those companies if people are excited about the prospects. They are being valued on potential earnings. The cost of Sarbanes is not a factor if you’ve invented a cure for cancer.”
Run-of-the-mill companies could see a bit of a break in the next few years as the costs of staying in compliance stabilizes.
“There’s a huge amount of initial work because you have to develop documented procedures for pretty much everything your employees do,” Rudin said. “Once you have done that, it’s maintenance from then on.”
Sarbanes-Oxley isn’t likely to put a damper on the local IPO market forever, Rudin said.
“Companies will get comfortable with it and the costs won’t be quite as onerous,” he said. “I think the bar for IPOs will go down a little bit but it might not go back to where it was before.”
