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How to Read an IPO Prospectus, Part 1

Read over my shoulder while I dissect a promising offering from the current crop.

The initial public offering pipeline at every investment banking firm I talk to is jammed full. There are deals galore out there -- some interesting, some outlandish, some scandalous -- but all of them should be considered.

First of all, I can guarantee you are not getting a lot of stock on these deals. Everyone is going to complain about his or her allocation on these IPOs;


usually gets the largest allocation, which consists of at most a measly 50,000 shares, relative to its hundreds of billions of dollars in assets.

So, if you want to own one of these companies -- and I mean really own it, not rent it for a quick flip -- you'd better be prepared to read the prospectus, the so-called red herring. It is the only legal document describing the company during its transition from a private company to a public one. Unfortunately, a prospectus is written by lawyers for lawyers, teams of lawyers who obsess over every word for hidden meaning. Most people don't read prospectuses, but I strongly suggest you do because they contain a wealth of information that can help you decide if a company is a keeper in your portfolio.

But you have to know the language, so read over my shoulder. Given that the stack of red herrings in my office is almost two feet high, let's pick out an interesting one that doesn't sell dog food over the Internet -- perhaps something like

Extreme Networks

, whose symbol will be EXTR and whose business is actually capable of being analyzed. I'll walk you through how I do the analysis, but as always, read the prospectus yourself to decide if you actually want to own the company.



Morgan Stanley Dean Witter

is the lead investment banker, so its name comes first and on the left. Good sign. Morgan Stanley does quality tech deals. Something must be going right here.

BancBoston Robertson Stephens

is in the middle, also a good sign, as it is connected in techland and knows how to sell.

Dain Rauscher Wessels

is third. The name is a mouthful, but the emphasis is on Wessels, who is known as having the best networking equipment research. So far, so good.

An underwriter puts its name on a deal as a Good Housekeeping Seal of Approval, as if to say, "We are behind this company 110%." But I tend to look at things the opposite way: The underwriter can be a future predictor of a company's performance.

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Put another way, Morgan Stanley brings out great companies. A few stinkers, sure, but for the most part, a Morgan-backed name does well over a period of years, not weeks.

Goldman Sachs

is in that league;

Credit Suisse First Boston

is close behind with its

Frank Quattrone

-led uber bankers.

Then there is a whole middle tier: BancBoston Robertson Stephens,

Hambrecht & Quist

and many, many others. The ones you have to be the most careful of are the deals lead-managed by the next bracket of underwriters:

Piper Jaffray


Prudential Securities



. These should be approached on a strictly

caveat emptor


I am not saying that an underwriter's name is the most important determinant of an IPO's success, but because it is on the cover, it can save you time by helping you to avoid reading bad prospectuses. This one will keep me reading.


Without hurting my brain too much, I probably want to figure out what the company actually does. Inside the front and back covers are usually color pictures and diagrams. There's a nice, er, foldout, showing some enterprise LAN infrastructure, purple boxes, end-to-end switching solution, high performance, yadda-yadda, I get it, enterprise switching, layer 4, gigabit speeds. This is the next wave of enterprise networking products.

Note to self (I hate people who say that, but I really need a mental note here): This is


(CSCO) - Get Cisco Systems, Inc. Report

sweet spot. I


dig deeper.


All right, let's crack this open to see if Extreme can work. The first thing I need to figure out is if the management team is any good, as management is the single largest determinant of success.

The management section is always near the end, but don't let that fool you. (By the way, every prospectus has a table of contents, sometimes on the back cover. Morgan Stanley puts the table of contents inside; in this one, it is on page 3, and the management section is on page 46.)

Let's see. Gordon Stitt, CEO: He's not only CEO, but president, chairman and co-founder, which raises a small yellow flag because it shows he owns a lot and has lots of power. He's got good credentials: an engineer turned


MBA. He founded another public company, as I recall, but oops, it's

Network Peripherals


, which is selling below its June 1994 IPO price.

I'll have to check if he takes the fall for NPIX, but a quick look at a chart shows that it peaked in May 1996, which happens to be when Stitt founded Extreme. The chief technology officer, the vice president of engineering and the vice president of corporate development are also formerly of Network Peripherals, making it sound like a midnight raid of the old place.

The CFO just started at Extreme and used to work at



Bay Networks

. The marketing guy is out of

Fore Systems





. So far the team shows competence, but not brilliance.

But very often, after the CEO, the sales guy is the key, and Harry Silverglide, vice president of sales, has been there a couple of years. He ran Western Region Sales at Bay and was head of sales at start-up

Centillion Networks

, which was bought by Bay, and before that at


. This guy sounds like a keeper and can probably keep driving growth.

The Board

Management runs companies, but often for the benefit of management, not shareholders. In techland, of course, most managers are also large shareholders, but a checks-and-balances system is still necessary.

Because I am coming in as an outside shareholder -- and an anonymous shareholder at that -- I have to ask who is going to watch out for me. Luckily, I do have a seat at the table, so to speak: In theory, the outside directors on the board are supposed to represent my interests. In reality, they are typically the venture capitalists who funded the company and are interested in taking the company public -- making it big and valuable so they can distribute it to their limited partners and collect their incentive fees. Despite this drawback, they are the best representatives I have at the table.

At Extreme, there are four outside directors. One, Carinalli, is the CEO of


, a wireless broadband access company, which sounds both complementary and useful to Extreme. The other three are all venture capitalists, from

Norwest Venture Partners


Trinity Ventures


AVI Capital Management

. Good solid VCs -- not the current hot group of

Kleiner Perkins Caufield & Byers


Sequoia Capital


Benchmark Capital

, but good, solid citizens who can help this company.

Principal Shareholders

It is always informative to see who owns what. A caution flag goes up if just one guy owns 70% to 90% of the company, because then it is that guy's company -- not the public's. On the flip side, it is also a danger if the VCs own too much.

With Extreme, VCs will own just under 50% of the company post-IPO, which is just about right. (Kleiner Perkins is an investor but has no board seat.) Top management owns about 15%, with the CEO Stitt at 5.4% and the sales guy Silverglide owning 1.4%.

Either way, the ownership numbers look fine, perhaps a little light on management ownership, but managers will award themselves options going forward to make up for it. Of course, there will still be a waterfall of stock 180 days after the deal, once the lockup of the shares expires. With the IPO only selling 10% of the company, there is surely lots more to come, either via a secondary offering, or block by block on Morgan Stanley's trading desk.

On Wednesday, I will look at what this company actually does, its competition, financials and valuation.

Andy Kessler is a partner at Velocity Capital and runs a technology and communications fund out of Palo Alto, Calif. This column is not meant as a solicitation for transactions; it is instead meant to provide insight into the methods of venture capital, technology and investing. At time of publication, Kessler's firm, Velocity Capital, has requested an allocation in the Extreme Networks IPO. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Kessler appreciates your feedback at

As originally published, the disclosure on this column was incorrect. Please see

Corrections and Clarifications.