THE ART OF THE DEAL

By John Greenwald

AFTER BARELY TWO YEARS OF EXIStence, NetEdge Systems is ready to cash in big. The fast-growing North Carolina company, which makes devices called edge routers that connect computers to high-speed voice and data networks over telephone lines, plans to launch an initial public offering (ipo) of its stock to raise some $40 million in the second half of this year. NetEdge already has more than 100 employees and revenues of about $25 million and expects to show a profit by the end of 1996. The public offering will finance the firm's expansion; it will also boost the value of the shares held by NetEdge executives and employees and thereby enable them to reap--or at least contemplate--the benefits of their 80-hour weeks. "Pinch me," says NetEdge founder Albert Bender, "so I can be sure that this is real."

Bender's euphoria is understandable; not all start-ups enjoy the same prospects. The IPO game can be perilous for less well-prepared entrepreneurs and for the investors who snap up their shares. For every highflyer like Netscape Communications or Pixar Animation that has enriched its owners almost beyond counting, there are dozens of losers that have dashed their founders' dreams. Smith Micro Software, for example, jumped from $12 a share to $14.50 a share amid the frenzy of the IPO market when the Aliso Viejo, California, maker of software for modems went public last Sept. 18. Since then the stock has cooled to about $7.25 a share, leaving founders William and Rhonda Smith to face the wrath of shareholders who sued the company in December over the slump in price. Investors who initially paid $7 a share in 1993 for Golden Systems, a Simi Valley, California, maker of electric-current converters for personal computers, fared even worse when Compaq Computer, the firm's biggest customer, twice rejected shipments last year because of quality-control problems. The stock virtually ceased trading in January, at 37 1/2-c- a share.

Those setbacks were not isolated incidents in the supercharged stock market that has made IPOs the hottest way to raise money in the 1990s, just as junk bonds and cheap credit fueled the stock boom of a decade ago. The junk binge left the U.S. with a colossal hangover of corporate debt, and the IPO fever inspires some worries about the country's financial and economic health. Among other things, it raises the issue of whether a casino-like mentality tends to lure investors into high-risk and even dubious new issues, or tempt start-ups to race to market before they are ready in hopes of cashing in quick.

IPO binges are hardly new. H. Ross Perot, lately a presidential aspirant, first sold stock in Electronic Data Systems, his data-processing company, in 1968 for $16.50 a share; it soared the same day to $38, which amounted to a previously unheard-of 271 times the company's annual earnings per share. (Companies traded on the New York Stock Exchange typically trade at about 16 times their earnings per share.) But never before have so many new issues rocketed to such high prices on the basis of hope rather than proven results. Take Netscape, for example. While the company managed to earn $2.4 million on sales of $40.6 million in the final quarter of 1995, it still lost $3.4 million for the year. Yet the $5 billion market value of the two-year-old company already exceeds that of Delta Airlines, General Dynamics or Bethlehem Steel.

Many Wall Street watchers are worried that the lofty prices of some IPO shares could soon plummet. "I think we've got a bubble here," says Daniel Miller, managing director of the $20 billion Putnam group of mutual funds, based in Boston. "The first things thrown out in a bad market are the newer ipos." The risks only grow when mutual-fund managers--the institutional investors who are driving much of the stock boom--find themselves with little time to evaluate new issues. Nearly 40 new companies went public the week of Dec. 10 alone, as many as might have made their debut in an entire quarter a decade ago. "When 40 IPOs are priced in a week, there is no way a money manager can properly analyze them," Miller says. "I worry about that herd mentality."

History shows that the performance of many new stock issues fails to live up to expectations after the initial enthusiasm wears off. A University of Illinois study tracked a total of 4,753 U.S. companies that went public between 1970 and 1990, comparing the performance of their stock with that of older firms. The new issues produced average annual returns of just 5.1% over five years, while better-established companies showed average gains of 11.5%. Observes Jay Ritter, a finance professor at the University of Illinois at Urbana-Champagne, who co-wrote the study: "The underperformance [of ipos] indicates how investors can become overly optimistic about a hot industry when a lot of companies are going public."

Ritter warns that such faddishness has a broader effect: it can soak up scarce investment funds that other businesses could sorely use and thereby reduce employment prospects. Established businesses can also be hurt when their talent walks out the door to join a start-up in the hopes of hitting the IPO jackpot. And some defectors may harm their old employers by cashing in on ideas conceived on company time.

On the other hand, successful new companies are a welcome source of jobs, and the point of an IPO is usually to help a firm carry out a business expansion. "All you have to do is talk to people in Silicon Valley," says Ritter, who points out that "almost all of the firms that got started there in the past 10 to 15 years" were founded by people from behemoths such as Xerox or Hewlett-Packard.

Despite the risks and the possibilities of failure, start-ups benefit the entire country, argues John Doerr, chairman of Kleiner Perkins Caulfied & Byers, a Menlo Park venture-capital firm that has helped finance dozens of new companies, including Netscape and Pixar. Doerr says Kleiner Perkins clients have created 150,000 new jobs in the past five years alone and have reinforced America's technological edge. "Some people refer to [IPOs] as a game," Doerr says. "But the notion that an entrepreneur can have a big idea and gain financial independence for his family is at the very heart of the American system of fair play." Echoing that sentiment is Dan Case, chairman of Hambrecht & Quist, a San Francisco venture-capital and investment-banking firm that helped manage the public offerings of Netscape and Pixar Animation last year. Says Case, who is the brother of America Online chairman Steve Case, another IPO millionaire: "IPOs are the fuel that entrepreneurs' job engines run on."

Hot new stock issues don't just happen. They are produced by a complex web of relations among a company's founders, backers and investment bankers and involve extended periods of hard work, discipline and innovation. Venture-capital firms like Kleiner Perkins first lay out money to get promising companies up and running, and then take seats on their boards. The nurturing often lasts for years. Silicon Video Corp., a San Jose, California, maker of flat-panel video displays that plans to go public in the second half of this year, has got some $15 million from venture capitalists since 1991. "They've been essential in helping us attract the right management and giving us the credibility we need," says Silicon Video president Robert Duboc. "And they will be critical in helping us get ready for the IPO."

A successful IPO can hit the jackpot not only for the start-up but for venture capitalists as well. Doerr and his Kleiner Perkins partners invested nearly $5 million in Netscape before it went public in return for stock now worth some $590 million. Some venture capitalists have even launched their own high-tech companies to ensure getting in on the gold rush. Kleiner Perkins joined forces with cable-TV giant TeleCommunications last year to create a firm called @Home; it plans to bring the Internet and its World Wide Web--along with programs like local news shows--to home computers via cable-TV wires at 500 times the speed of signals over conventional telephone lines. That could enable companies like Walt Disney and Time Warner to feed their movies and TV shows to computers over the Internet.

To run the firm, which plans a test in Sunnyvale, California, later this year, Doerr tapped William Randolph Hearst III, grandson of the newspaper baron and a Kleiner Perkins partner. "Today it's too complex to hook up to the Internet to get a rich, full [sound and video] experience," Hearst said in launching @Home last November. He promised that the new system would be lightning fast and easy to use.

The investment bankers select candidates for IPOs only after careful scrutiny. "We turn down many more companies than we take public," Case says. But Case had few doubts about either Pixar or Netscape, whose executives he had known for years. Hambrecht eagerly teamed with fellow bankers to buy up all the offered shares of both companies and then staged nationwide "road shows" to tout the stock to big investors like mutual funds. The tours generated so much excitement that Netscape, which had been tentatively priced at $12 to $14 a share, went public at $28. Hambrecht's profit for co-managing the offering with Morgan Stanley: $10.6 million.

As NetEdge founder Bender prepares to take his company public, he disavows any interest in the complicated stock-market gymnastics that lead to instant wealth. "An IPO is not an end in itself," he declares. "It's a vehicle to finance growth, not to make investors rich. That happens too, but it shouldn't be the goal." The real aim, Bender says, is to help founders build their companies, "something out of nothing, like an artist painting on a canvas." Perhaps so. But the public has its own ideas about the difference between art and commerce.

--Reported by Patrick E. Cole/Los Angeles, David S. Jackson/San Francisco, Stacy Perman/New York and Lisa H. Towle/Raleigh

With reporting by PATRICK E. COLE/LOS ANGELES, DAVID S. JACKSON/SAN FRANCISCO, STACY PERMAN/NEW YORK AND LISA H. TOWLE/RALEIGH