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February 28, 1999

M&A IMPACT: OPENIPO MAY EFFECT FEWER BUYOUTS

By CBR Staff Writer

By John Rogers

Bill Hambrecht thinks the current structure of the initial public offering market is all wrong. That’s why the founder and former CEO of veteran investment bank, Hambrecht & Quist LLC, has set up a new company which aims to leverage the power of the internet to change the way companies go public. WR Hambrecht & Co, established in January 1998, is promoting a Dutch auction system designed to break the stranglehold that powerful financial institutions have long enjoyed on new securities issues and open the door for the individual investor. Called OpenIPO, the model seeks to give virtually everyone equal access to an offering, with the market setting the price for the shares.

The current IPO model tends to keep hot new issues in the hands of only a privileged few, with the banks underwriting the IPO offering the shares to institutional clients such as mutual funds and certain favored individual investors, mostly with a view toward winning future business. Then when the shares hit the open market – often doubling or tripling in value during the opening session – those lucky enough to have had first crack at them can make an instant profit.

This model favors young companies with a perceived early growth curve but does not bode well for an IPO candidate which won’t make investors a fast buck. Companies in the latter category have therefore often chosen the M&A route as the more lucrative exit strategy. A start-up or small business can command a higher premium if it is bought by a competitor because it has a product line, customer base or particular technology expertise which is highly coveted and one for which the buyer is willing to pay dearly.

The web application server marketplace is a classic example of a group of companies that knew the road to independence would reap less rewards than a financially stable parent. WebLogic, Kiva Software and NetDynamics all postponed public offerings in anticipation of being bought. And the strategy paid off when they were bought by BEA, Netscape and Sun respectively. None of these application server companies were purchased for less than $150 million, yet at the time of takeover all three had revenues that had only just started to creep into double digits.

The OpenIPO model could change all that. It is designed to replace the accepted structure in a way that will move the offering price of a stock closer to the market level, netting more money for the company selling the shares and discouraging the day traders who often pocket most of the initial gains of an issue. Through the bidding process, investors decide what they think the company is worth and the resulting price reflects what people are truly willing to pay for the stock.

The auction system proposed by Hambrecht will have the buyers and sellers together creating a market clearing price, or the highest price at which the company can sell the total number of shares it is offering. All the bidders end up paying the same price in the end, which is equal to that of the lowest winning bid. Thus, if a million shares are being offered, all of the successful bidders will pay the same amount as the bidder whose offer was good enough to claim the millionth share – with many of those inside the winner’s circle paying substantially less than they actually bid.

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After a few weeks of secret internet bidding, the offering price will be set. Those above the offering price will essentially get all the shares they sought, while bidders at the offering price will receive at least a portion of what they were looking for. Any bidders under the offering price will be shut out completely. If the proposed system works as it is intended to, the market will set the optimal share price for both the company and the investors. A further check on the system dictates that no more than 10% of the shares can go to any single bidder, while Hambrecht reserves the right to limit the purchases of anyone who is looking to buy more than 1% of the total.

OpenIPO is a modified version of a system developed by William Vickrey, who won a Nobel Prize in Economics for his work in the area of auctions. Hambrecht says his adaptation of the model is beneficial to everyone concerned. The investors who really want the shares will have access to them, while the company will be able to sell the shares at a truer market price and – almost as important in Hambrecht’s mind – to those investors who actually want the shares and aren’t just looking to flip the stock for a quick profit. Another benefit for companies that choose the OpenIPO option is that Hambrecht intends to charge underwriting fees of only 3% to 5% of the total capital raised, compared to the 6% to 7% that are typically charged by investment banks.

On the research side, WR Hambrecht aims to cover smaller companies that aren’t well covered by the competition. Hambrecht points to the fact that out of about 450 software companies that are publicly traded, only a few are covered by big investment banks, with even those banks who claim to be committed to technology firms only covering a moderate number. Hambrecht intends to cover all of them, as lofty a goal as that may seem. The company’s partners and management, such as newly-appointed president Ian Zwicker, who was lured from his previous position as co-head of technology banking at Donaldson, Lufkin & Jenrette, say their interest in emerging companies comes from years of ferreting them out. Hambrecht and his team proudly claim to have been instrumental in making companies like Apple and Netscape household names.

For now, Hambrecht plans to focus on firms in the areas of software, the internet and consumer-branded products. The company is in the process of taking bids on its first deal, the IPO for a California-based winery, and plans to take between six and twelve companies a year public.

Hambrecht’s idea, needless to say, has not proven to be a tremendously popular one in the investment banking community – one banker recently interviewed on National Public Radio likened OpenIPO to putting the lunatics in charge of the asylum – although Hambrecht’s strong reputation and visibility could go a long way in advancing the concept. Hambrecht admits his plans were initially met with distrust on Wall Street, where the general reaction was essentially How could you do this to us? although that attitude has somewhat dissipated, as bankers resigned themselves to the fact that someone would have eventually come along with a similar plan. In fact, Hambrecht says, he is now receiving offers of cooperation as some on the Street have come to understand the efficiencies of his model, if not the inevitability of it.

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