Chapter 2 - The Beauty Contest, February 1999 - Episode 2Listen to podcast
Someone once said that when Donna Langhorne enters a room, she sucks all the oxygen out of it. The three male bankers in the hackoff.com conference room certainly look as if they are having difficulty breathing when she walks through the door.
“You guys don’t have to dress up to come here,” says Larry Lazard. “We're casual.” He's in jeans and a hackoff polo shirt. The male bankers are in pin-striped suits with tailored shirts and yellow ties. They're all looking at Donna, who is wearing slacks and a hackoff sweatshirt.
“Next time we’ll know better," says Harvey Maklin, a Barcourt & Brotherson Vice President and would-be lead banker for the hackoff IPO. He is trying not to look at Donna but has a hard time maintaining eye contact with Larry. Barcourt is visiting hackoff as part of the “beauty contest” to choose a lead investment bank for the planned IPO.
“How was your weekend?” asks Harvey. “Did you get some golf in?”
“Let’s start the meeting,” says Larry.
“Uh … okay,” says Harvey. “Again, I’d like to thank you for considering Barcourt as the lead on this transaction. Sam Gutfreund is our chief trader. If we’re your bankers, he’ll get you opened well and make sure the after-market is orderly. John Braxton is our chief software analyst. We’ve decided that John is the right analyst to cover hackoff.com and he’s been getting up to speed on the story. He—”
“Why?” asks Larry.
“Why is he getting up to speed?”
“No. Why is he the right analyst? He’s a software analyst. We’re in the e-commerce business. I don’t think he knows squat about e-commerce.”
Harvey has a reputation for being unflappable. CEOs have been getting increasingly arrogant as their IPOs soared. “We considered whether to cover hackoff.com as an e-com or a software company. We discussed it with a few of the big funds and they think of you as software. That’s what you sell. If you were in e-com, people would always be asking ‘how many eyeballs have you got?’, ‘how many hits are you getting?’, ‘what is your website ranked?’. Hackoff grows by selling licenses, not by attracting eyeballs. That’s the software business. So we’ve asked John to cover you as a software company and he has been getting up to speed on the story, as I said—”
“And he still doesn’t know squat,” Larry interrupts.
Donna says: “John, why don’t you tell us something about how you see the company. How are you going to tell the story?”
Everyone except Larry and Harvey look relieved. Larry leans back in his chair, though, and listens.
“We have a presentation we’d like to show you,” says Harvey. “It should tell you something about us and how we see hackoff and the IPO. I think it’ll give you a good idea of our thinking.”
Larry slams the front feet of his chair back on the floor and leans forward toward Harvey who flinches before he can get himself under control. For a long moment, Larry allows an uncomfortable silence to compound. “Spare us the presentation, please,” he says with ominous softness. “We want to know what John thinks. We already know what’s in the presentation. You’re the fourth bank to come through.”
“I think you’ll find it interesting,” Harvey persists.
“Let me tell you what’s in the presentation,” says Larry. “First, the title page has the logos of Barcourt and hackoff. Then, there is a page with the logos of all the companies you’ve taken public and helped to raise money in the last year. The logos of the software companies — because you idiots think we’re a software company — will somehow be set off from the others. Then there is a graph that shows that, even though you’re really only number three or number four in terms of money raised, you’re really number one for some esoteric reason. There may be a chart showing how successful companies you’ve taken public have been in the aftermarket. Can you tell me I’m wrong?”
“Well,” Harvey says with a forced smile, “you’re not exactly WRONG but ... but that’s just the intro stuff; the stuff you may want to show your board. Then we get to the specifics of our vision for the IPO, for the positioning of hackoff — the things you were asking about. That’s what I expect you and Donna will be most interested in.”
“You’re forgetting the page with your resume and John’s resume and the trader, I forget your name,” Larry says.
“Sam, Sam Gutfreund,” says Harvey. “Yes. You’re right; there are some resumé pages. I’ve also put in the resumés of our US and International Sales VPs since they’ll be important to the transaction.”
Larry says: “So why do you want to waste our time with all this?”
“I have an idea,” Donna interjects. “I’m sure John can tell us how he sees positioning the company and telling the story without the slides. Our Board will want to see them as part of its decision, of course. We’ll take the books and look at them later.”
“Sounds good to me,” says Harvey quickly.
Larry again prolongs a silence as everyone looks at him, then nods curtly to John: “Go.”
“The big question,” says John Braxton, senior software analyst for Barcourt & Brotherson, “is: What metric is The Street going to use to value hackoff? Since you don’t have positive earnings, it can’t be that. But that’s not too bad because no one else going public these days has positive earnings either. It’s hard to measure the dollar value of your sales since you take an equity position in so many of your customers and they don’t have any earnings either. In this new economy, it is essential to have an alternative to earnings in determining a company’s value. We have to find the metric that we teach The Street to use in valuing hackoff. IF you were an e-com company...” He carefully looks at Donna and not Larry. “IF you were an e-com company, then you’d be measured on hits or eyeballs or unique logins or something like that. Clearly, you’re not. So the obvious metric for hackoff is the quarter-end value of the stocks in your portfolio.”
“That’s easy,” says Donna. “That number shows up on our balance sheet each quarter.”
“No,” says John, “No, it doesn’t. Not the number I want to base our story on. The GAAP number is too low.”
Generally Accepted Accounting Principles are supposed to define how US companies report their financial results to securities markets. Following GAAP, hackoff values each stock in its portfolio at the value it had (or was believed to have had) on the day hackoff was paid in that particular stock. The stocks in hackoff’s portfolio have been going up, but this doesn’t show up in hackoff’s GAAP reports unless hackoff sells some of these stocks and “recognizes” profit. If some of the stocks were to go down below the initial price– not something which happens much at this time in market history, then hackoff would have to write down the value of these stocks in its portfolio to reflect current market conditions.
“We think it’s pretty good,” says Donna. “The book value of the equities we were paid in was ten mil at the end of '98. It’ll probably be around fifteen mil at the end of the first quarter and those are the numbers investors are going to see.”
“With all due respect,” says John, “these are piss-ass numbers. You’re looking for the market to value the company somewhere around five-hundred mil at the IPO. And we want it to go up quickly from there. That’s not going to happen given a portfolio value of fifteen mil. I figure the true value of the stock in your portfolio at something like thirty million at the end of '98 and more like ninety million or even a hundred million when we go on the road. That’s exciting.”
“John,” says Donna, “are you suggesting that we sell the stock in our portfolio so we can report higher values? That’s brain-dead.”
“Of course not, Donna,” says John. “Only an idiot would sell in a market like this. We know you’re smart people and certainly don’t want to do anything that would make investors think otherwise. What I’m saying is that, besides the GAAP number, which we have to report, we report a ’non-GAAP‘ number as well. This number doesn’t show up in P&L or your balance sheet but you highlight it in the text of the quarterly press release and you talk about it on the call.”
“Can we do that?” asks Donna thoughtfully.
“Of course we can.” Larry has been following intently but silently. “In fact we owe it to investors to tell them the true value of our portfolio. We owe it to them to tell them how well our equity strategy is working. How else can they make an informed investment decision? It’s not our fault that GAAP is stupid and irrelevant, invented by accountants for another universe long, long ago.”
Harvey Maklin jumps in: “We’ve checked with our attorneys. They believe you can provide this non-GAAP number. You will want the opinion of your own attorneys, of course. We’ll want that number to appear in the prospectus so if the SEC people who review that don’t barf all over it, we can feel reasonably free to keep using it in quarterly reporting.”
“John,” asks Donna, “how do you calculate the current value of the customer equity we hold? Most of our customers aren’t public yet. There isn’t any usable valuation data for them.”
“That’s the beauty,” says John. “We get to establish the value. We do it ‘conservatively’, of course, just take their potential value at IPO. For the ones that are public, we use their current stock prices. When I explain this to the fund managers, they’ll realize that I’m being very conservative because obviously stocks go up after IPO and obviously, in general, the e-com stocks will go up from here. They like a conservative story because it gives them more upside — more room to win. I always leave them room to be a little smarter than what I’m telling them, so they can earn their bonuses by having the stock go up while they hold it. Everybody wins.”
“What if NASDAQ has a down quarter?” Donna asks. “We’ll get clobbered even if we have a good quarter.”
“Good question,” says John. “Someday that may happen, of course, even in this new era. You have some protection as long as some of the companies in your portfolio go public during the quarter because those’ll get an up pop even in a down market and help the whole portfolio. It’s dangerous and could hurt us in the short term someday, but I think it’s a risk worth taking; this number lets you benefit not only from your own success but also the success of the industry and the NASDAQ stocks. And, after all, that’s really what your business plan is all about. You’re e-com squared.”
“Cubed,” says Larry. “You’re right about our business plan but it’s ‘e-com cubed’, not squared.”
“Cubed?” ask Donna and John together and then smile at each other when they realize they’ve said the word in stereo. John almost giggles when Donna smiles.
“Cubed,” says Larry. “The more e-com flourishes, the more licenses we sell; that’s one dimension. Then, as you said, the higher our licensees’ stocks go, the greater the value of what we got paid. So that’s another dimension and brings us to squared. But we know that this is a market that feeds on success, so, as we succeed in the first two dimensions, our stock will trade at a higher multiple of our portfolio value — that’s the third dimension. You’re not as dumb as you look. I’m beginning to like this.”
“You ought to be a securities analyst,” says Harvey Maklin. “But, if I may: a word of advice.”
“Go ahead,” says Larry now preening and good-natured.
“Just do the squared bit on the roadshow; don’t talk about ‘cubed’ with the investors you’ll be presenting to.”
“Why not?” asks Larry, suddenly not as genial.
“It’s better for us to do it than you,” John Braxton explains. “Investors want management to talk about the company and not about the stock. That’s what they expect even though they really only care about the stock. Then WE talk to them about the stock. Many of them’ll call me after you do your pitch. Then I can tell them, if they liked e-com squared, they’re really getting e-com cubed. That’ll hunt with the ones who are quants…”
“I get it,” says Larry, “what’s a ‘quant’, though?”
“The quantitative ones, the ones that like numbers,” John says. “some like people — they want to know all about the management team; some like technology; and some like numbers. Part of a good pitch is telling them apart and putting the right spin on the story for who you’re pitching. Our sales team will help with that; they know these guys pretty well. And you’ll get good at it, too. They ask questions in the areas they’re comfortable with. The quants always ask number questions; the techies always ask technology questions.”
“Okay,” says Larry, “but be sure that you do it.”
“Do what?” asks John.
“Tell them about ‘cubed’ if I’m only talking ‘squared’,” says Larry. “I’m counting on you.”
“Trust me,” says John. “This is a good strategy; this dog’ll hunt. We want hackoff priced at a multiple of the value of its portfolio. One problem, though, is that we won’t be able to use the portfolio value for the whisper number.”
“What the fuck’s a ‘whisper number’?” asks Larry.
“It’s a number higher than the number you gave in guidance that analysts tell their clients you are actually going to make for the quarter. It helps us with our clients to give them the inside scoop, but it’s very bad if you don’t deliver what we promise. So you’ve got to help us figure out what the whisper number should be and then you’ve got to beat it slightly or we’re all in deep doo-doo and the stock is in the toilet.”
“Why don’t we beat it by a lot?” asks Larry.
“Because then we lose credibility and it looks like you’re sandbagging and The Street will make really inflated estimates for you and you’ll miss them and everyone loses,” explains John.
“So what is this metric?” asks Donna. “I understand that it can’t be the portfolio value because we won’t give guidance on that and you won’t want to guess what it’ll be at the end of the quarter a quarter in advance.”
“Smart woman,” says John. “The portfolio value is too volatile to predict, so we need something else. We don’t want to use earnings — both because you aren’t yet profitable and because the number is too small. It misses the increasing value of the stock in your portfolio.” He glances at Harvey. “We think the right number to use is the number of sites using your software; this is the first dimension of your e-com cubed or squared story so it all fits in. And it’s a number that should always go up, which is important for the whisper number. Of course, this doesn’t correlate to earnings or even revenues, but nothing does these days and that’s no problem. The fund managers will understand that this number can keep growing forever since the number of e-com sites keeps increasing and so the stock will always have growth potential as it tracks this number.”
“Won’t work,” says Donna. “A lot of flaky sites come and go. They license from us and then they’re gone. In a summer quarter when there are fewer startups and more failures, the number of active licenses could actually go down. It happened last summer; it may happen this summer while we’re selling the deal.”
“That’s easy,” says John. “Don’t count the licenses that disappear. Do like McDonalds: so many sold. It’s a number that has to keep going up. You will have to condition The Street for seasonality; it won’t go up as much in the summer as in the winter but they’ll understand that. The important thing is that you be able to give good public guidance. You also need to give us good guidance on what the whisper number should be and then keep beating it. That’s what successful companies do. Look at Microsoft. Every quarter they talk about why things can’t keep being as good. Every quarter they give a lowball estimate. Every quarter the whisper number is a penny or two over what the company has indicated. Every quarter they beat the whisper number by a penny or two. That’s the way a company should be run.”
“But that’s real fucking earnings,” says Larry. “That’s not some made-up metric as a proxy for earnings. That’s why we can’t be covered as a software business; we’re not Microsoft; no one will believe we are. We’re an e-commerce company; look at Amazon’s price — they’re a book store that doesn’t make money; look at Yahoo — they’re mostly a free service. We’ve got to be an eâ€‘commerce company. This has to be an e-commerce story. You just agreed that we’re e-com cubed and now you want to talk about us like a fucking software company.”
“In many ways Microsoft is an old fashioned company,” says Harvey, shielding John from Larry’s vehemence. “You’re the software company of the future. All Microsoft gets is a little revenue each time a customer buys a product; they get a nice share of the revenue stream of the computer manufacturers through Windows and Office royalties; but they don’t actually get a piece of their customers the way that hackoff does. That’s the beauty of your story.”
“Tell us the new software story, John,” says Donna. “Tell us this new bedtime story.”
John drops a beat at Donna’s mention of bed but goes on: “Okay. The key metrics for hackoff.com are the value of its portfolio and the cumulative number of sites that have licensed the software. Obviously, the bankers are going to have to build those into the PowerPoint presentation they put together for the roadshow. I’ll build my spreadsheet model based on those metrics. Of course, I still have to come up with an argument about what multiple of the portfolio value you should trade at based on your growth rate in licenses. This is tough because there are no real comparables so we can’t just compare you to some other company in the same business. So I’ll put together a model that relates the number of licenses you’ve sold so far to the value of the equity you hold PLUS the present value of the revenue streams you’ll get. That part hardly matters but it does generate the cash you need to operate so you don’t have to keep going back to The Street and diluting everybody’s equity.”
“But we WANT to go back to The Street, “says Donna. “We WANT to do a secondary offering. That’s when we get the really high value and that’s when the VCs and founders get to take some cash off the table.”
“Of course you do, “says Harvey. “We want to handle your secondary, too. We want you to go out many times, collect all the money you can — it’s a sin not to. But no one wants you to do a secondary because you have to; you get a lousy price if you need the money. You do a secondary because you can; because The Street WANTS you to; because The Street loves your story and NEEDS to have more of your stock to trade.”
“As long as that’s understood,” says Donna.
“Understood,” says John, “trust me. So we establish a ratio between licenses sold and equity value acquired. Over time, equity per license goes up, obviously, as e-com companies continue to grow and you get further market power and can demand a better share. So there’s a double upside, the growth in the number of licenses and the growth in the equity from all licenses past, present and future. And cash needs are taken care of by the cash licenses. Smart fund managers will realize that, over time, you’ll spin out or sell some of the equity and further enhance cash flow — but we won’t complicate it with that now. In fact, the only thing wrong with the story is that it’s complicated. We’re going to have to work hard to dumb it down for the roadshow. Fund managers and buy-side analysts don’t think a lot; they don’t have time to. They go to eight or nine pitches a day. They’re only half listening unless something catches their interest and they’ll make up their mind before you leave the room. They have to make sure they get the hot issues or they’ll be out-performed by other funds and that’s the way to the door for them.”
“Of course,” Harvey picks up smoothly, “when you come in with Barcourt & Brotherson, they know you’re a good story and that you’re worth paying attention to. And, even if they can’t focus that day — problem with the wife, losers in the portfolio, too much partying the night before — they’re still likely to buy because of their relationship with Barcourt. Even if they don’t like the particular company, they value their relationship with us and want to take a piece of almost everything we bring them because then they know we’ll give them a piece of the really hot deals.”
“So the pitch doesn’t matter?” asks Donna. “There going to buy us because we’re with you?”
“The pitch matters,” Harvey says. “It all has to do with the aftermarket. One, we want them to want more stock than we’re willing to allocate them. That has to be, or they won’t buy in the aftermarket. A good pitch’ll make them greedy. Two, we don’t want them to dump on the initial run-up; that’s no way to start trading for the stock. If they don’t even hear the story, they’ll buy for the initial kick and then flip the stock. Of course, if they flip too often or don’t give us aftermarket support, then they don’t get any more allocations from us. But that’s a different story.”
“I have an idea,” says Larry. “Investors are going to buy the stock partly because of the number of licenses we sell. So they should get reminded about our licenses. We let websites that license from us put the hackmenot logo on their websites; no, we MAKE them do it. Then every fucking site becomes an ad for our stock…”
“That will help more with retail investors than the funds…” John begins.
“Good idea, Larry,” Harvey interrupts. “Very good idea. I thought you were technical, not marketing.”
“Sam, you haven’t said anything,” says Larry, not responding to the compliment. “Did you come all the way here just to listen to all this bullshit?”
“I have nothing to say,” says Sam the Trader.
“Isn’t the great trading desk you run the real reason we should use Barcourt for our IPO?” asks Larry. “All the other traders tell us that.”
“Sounds like you already know that,” says Sam, smiling slightly.
“Sam, tell them what the trading desk can do for them,” says Harvey.
“They already know,” says Sam. “The trading desk gets the stock opened right. The toughest part is the first hours and the first days when volumes are enormous and the stock is getting a lot of attention but hasn’t found a level or a pattern yet. Yada yada yada — I’m sure the other traders all told you that. The difference is that my trading desk is the best at doing this. Most of them will give you a trader part-time right after you open, then quickly lump you in with a bunch of other stocks. You get lost. The stock gets lost. It wanders around. It gets a bad rep.
“I give you a dedicated trader, a GOOD dedicated trader for the first couple of days. And I keep you with a select group of stocks as long as I have to. That way your stock gets a good reputation. That’s important because all the funds you’ve sold to are trying to figure out whether to flip or not. If they see an orderly stock moving up in a good way, they stick with us. If they see a stock flopping around, they get spooked and they pull the trigger and sell. They’ve already got their profit. It’s important to keep them during that first week. They get used to you and keep you in the portfolio for a while ... if you don’t screw up.”
“Whaddaya mean ‘if we don’t screw up’?” asks Larry. His tone is harsh.
“He means…” Harvey starts to interject.
“Let HIM answer.”
“There’s nothing I can do if you don’t deliver your numbers,” says Sam. “Nothing at all. You heard that stuff about the whisper number: you put out a number, you get John to put out a number, and you miss it, you’re toast. Stock drops like a rock. I try to keep it orderly, but the truth is there’s nothing much we can do. Or even TRY to do — don’t want to get rope burn. We don’t stop you if you screw up and fall.”
“But Sam can help…” Harvey again interjects.
“He’s telling me the truth and you’re trying to bullshit me. Stop!” commands Larry.
Harvey starts to say something and then thinks better of it. The silence is uncomfortable and continues until Donna asks: “You guys ready for the tour?”
“Yes, Thank you very much for your attention. We’re looking forward to learning more about hackoff and we’d very much like your business. We want to do this transaction. We want to do your secondary. We want help with every liquidity event you and the company have,” says Harvey obviously relieved. “Here are the books.” He hands over perfect-bound books with the hackoff and Barcourt logos on the cover. “We covered most of this and I’m sure your Board will find them helpful.”
“If you make the short list, we’ll be sure the Board gets them,” says Larry. He stands up to shake hands with Harvey but doesn’t smile.
He says, “Remember, ‘cubed’,” to John Braxton as he shakes hands with him.
“You play poker?” he asks Sam Gutfreund in a friendly tone.
“Not anymore; too much like my day job,” says Sam.
“Thought so,” says Larry. “See ya.”
Donna’s goodbyes and handshakes are all warm but she holds John’s hands slightly longer than the others. “Thanks for coming,” she says. “I like the way you tell the story.”
“You got the hots for Braxton?” Larry asks Donna when the bankers have been escorted off by Eve Gross from marketing for their tour of hackoff.
“All CFOs have the hots for their analysts,” says Donna. “What really turns me on is actually doing this IPO and then the secondary and getting filthy rich. It’s a B-School wet dream.”
“Down girl,” says Larry. “Don’t overheat. We’re not there yet. The market could always tank and we’d have to go back to making money the old-fashioned way. And who says Braxton’s our analyst? We haven’t chosen Barcourt. Maklin is an asshole. I like the trader, Sam, though.”
“You just told him he was our banker, Lar. You told him not to forget ‘cubed’. Talk about the hots; I thought you were going to come in your pants when they started the ‘squared’ stuff and then you told them it was ‘cubed’. What happened to the old poker face?”
“I didn’t promise them shit. We still gotta listen to three more of these pitches; then tell the Board what we want to do. And, seriously, I’m worried about Maklin. He has no cajones; how can we believe he has the big dick we need in the firm?”
“You did give him the patented Larry Lazard test for balls,” says Donna.
“At least I didn’t rub them like you did with Braxton.”
“They’re both good tests,” she says. “We’ll get the Board to check him out.”
“Yeah, maybe we can get Joanne Ankers to use her contacts to check him out,” says Larry mischievously.
“Yeah, once she gets out of her training bra, she might be useful,” responds Donna. “I’ll e-mail Windaw and Adams and see what they know.”
“Sexist,” says Larry.
They both seem very pleased with themselves.