On the 25th anniversary of Microsoft's IPO, Fortune is featuring our 1986 cover story in which we followed around a young Bill Gates as he prepared to take his company public. Here's the story of the birth of a billionaire.
Editor's Note: This story was first published in the July 21, 1986 issue of Fortune. As Bro Uttal told Fortune's editor, Marshall Loeb, at the time (see Editor's Letter at the bottom of this page), "I doubt that a story like this has been published before or is likely to be done again."
By Bro Uttal, writer
Going public is one of capitalism's major sacraments, conferring instant superwealth on a few talented and lucky entrepreneurs. Of the more than 1,500 companies that have undergone this rite of passage in the past five years, few have enjoyed a more fren- zied welcome from investors than Microsoft, the Seattle-based maker of software for personal computers. Its shares, offered at $21 on March 13, zoomed to $35.50 on the over-the-counter market before settling back to a recent $31.25. Microsoft and its shareholders raised $61 million. The biggest winner was William H. Gates III, the company's co-founder and chairman. He got only $1.6 million for the shares he sold, but going public put a market value of $350 million on the 45% stake he retains. A software prodigy who helped start Microsoft while still in his teens, Gates, at 30, is probably one of the 100 richest Americans.
Gates thinks other entrepreneurs might learn from Microsoft's (MSFT) experience in crafting what some analysts called ''the deal of the year,'' so he invited FORTUNE along for a rare inside view of the arduous five-month process. Companies hardly ever allow such a close look at an offering because they fear that the Securities and Exchange Commission might charge them with touting their stock. Answers emerged to a host of fascinating questions, from how a company picks investment bankers to how the offering price is set. One surprising fact stands out from Microsoft's revelations: Instead of deferring to the priesthood of Wall Street underwriters, it took charge of the process from the start.
Bringing the road show to New York City, Microsoft Chairman Bill Gates explains the future of personal computers to institutional investors.
The wonder is that Microsoft waited so long.Founded in 1975, it is the oldest major producer of software for personal computers and, with $172.5 million in revenues over the last four quarters, the second largest after Lotus Development. Microsoft's biggest hits are the PC-DOS and MS-DOS operating systems, the basic software that runs millions of IBM personal computers and clones. The company has also struck it rich with myriad versions of computer languages and a slew of fast-selling applications programs such as spreadsheets and word-processing packages for IBM, Apple, and other personal computers.
Yet Microsoft stood pat when two of its archcompetitors, Lotus and Ashton- Tate, floated stock worth a total of $74 million in 1983. Nor did it budge in 1984 and 1985, when three other microcomputer software companies managed to sell $54 million of stock. The reasons were simple. Unlike its competitors, Microsoft was not dominated by venture capital investors hungry to harvest some of their gains. The business gushed cash. With pretax profits running as high as 34% of revenues, Microsoft needed no outside money to expand. Most important, Gates values control of his time and his company more than personal wealth.
Money has never been paramount to this unmarried scion of a leading Seattle family, whose father is a partner in a top Seattle law firm and whose mother is a regent of the University of Washington and a director of Pacific Northwest Bell. Gates, a gawky, washed-out blond, confesses to being a ''wonk,'' a bookish nerd, who focuses singlemindedly on the computer business though he masters all sorts of knowledge with astounding facility. Oddly, Gates is something of a ladies' man and a fiendishly fast driver who has racked up speeding tickets even in the sluggish Mercedes diesel he bought to restrain himself. Gates left Harvard after his sophomore year to sell personal computer makers on using a version of the Basic computer language that he had written with Paul Allen, the co-founder of Microsoft. Intensely competitive and often aloof and sarcastic, Gates threw himself into building a company dedicated to technical excellence. ''All Bill's ego goes into Microsoft,'' says a friend. ''It's his firstborn child.''
Gates feared that a public offering would distract him and his employees. ''The whole process looked like a pain,'' he recalls, ''and an ongoing pain once you're public. People get confused because the stock price doesn't reflect your financial performance. And to have a stock trader call up the chief executive and ask him questions is uneconomic -- the ball bearings shouldn't be asking the driver about the grease.''
But a public offering was just a question of time. To attract managers and virtuoso programmers, Gates had been selling them shares and granting stock options. By 1987, Microsoft estimated, over 500 people would own shares, enough to force the company to register with the SEC. Once registered, the stock in effect would have a public market, but one so narrow that trading would be difficult. Since it would have to register anyway, Microsoft might as well sell enough shares to enough investors to create a liquid market, and Gates had said that 1986 might be the year. ''A projection of stock ownership showed we'd have to make a public offering at some point,'' says Jon A. Shirley, 48, Microsoft's pipe-smoking president and chief operating officer. ''We decided to do it when we wanted to, not when we had to.''
In April 1985 Gates, Shirley, and David F. Marquardt, 37, the sole venture capitalist in Microsoft (he and his firm had 6.2% of the stock), resolved to look into an offering. But Gates fretted. To forestall sticky questions from potential investors, he first wanted to launch two important products, one of them delayed over a year, and to sign a pending agreement with IBM for developing programs. He also wanted time to sound out key employees who owned stock or options and might leave once their holdings became salable on the public market. ''I'm reserving the right to say no until October,'' Gates warned. ''Don't be surprised if I call it off.''
By the board meeting of October 28, held the day after a roller-skating party for Gates's 30th birthday, the chairman had done his soundings and felt more at ease. The board decided it was time to select underwriters and gave the task to Frank Gaudette, 50, the chief financial officer, who had come aboard a year before. Gaudette was just the man to shepherd Microsoft through Wall Street. He speaks in the pungent tones of New York City, where his late father was a mailman, and prides himself on street smarts. He had already helped manage offerings for three companies, all suppliers of computer software and services.
Aspiring underwriters, sniffing millions in fees, had been stroking Microsoft for years. They had enticed the company's officers to so-called technology conferences -- bazaars where entrepreneurs, investors, and bankers look each other over. They had called regularly at Microsoft, trying to get close to Gates and Shirley. Gaudette had been sitting through an average of three sales pitches or get-acquainted dinners a month.
Gaudette proposed that since Microsoft was well established, it deserved to have a ''class Wall Street name'' as the lead underwriter. This investment firm would put together the syndicate of underwriters, which eventually was to number 114. It would also allocate the stock among underwriters and investors and pocket giant fees for its trouble. Gaudette suggested a ''technology boutique'' co-manage the offering to enhance Microsoft's appeal to investors who specialize in technology stocks.
Emerging from a pow-wow with a prospective investor in New York, Alex. Brown
Narrowing the field of boutiques was easy. Only four firms were widely known as specialists in financing technology companies: Alex. Brown & Sons of Baltimore, L.F. Rothschild Unterberg Towbin of New York, and two San Francisco outfits, Hambrecht & Quist and Robertson Colman & Stephens. Culling the list of Wall Street names took longer. Microsoft's managers concluded that some big firms, including Merrill Lynch and Shearson Lehman, had not done enough homework in high tech. The board pared the contenders to Goldman Sachs, Morgan Stanley, and Smith Barney. It also included Cable Howse & Ragen, a Seattle firm that could be a third co-manager if Gates and Shirley decided that pleasing local investors was worth the bother. ''Get on the stick,'' Shirley told Gaudette. ''Keep Bill and me out of it -- we can't spend the time. Give us a recommendation in two or three weeks.''
Early in November, Gaudette called the eight investment bankers who had survived the first cut. ''I need half a day with you,'' he said. ''Take your best shot, then wait for me to call back. I'll have a decision before Thanksgiving. But remember, it's my decision -- don't try going around me to Bill or Jon.'' Gaudette made up a list of questions, ranging from the baldly general -- ''Why should your firm be on the front cover of a Microsoft prospectus?'' -- to the probingly particular, such as, ''How would you distribute the stock, to whom, and why?''
After a whirlwind tour of New York, Baltimore, and San Francisco, Gaudette made his recommendations to Gates and Shirley on November 21. Then he took off for a ten-day vacation in Hawaii, a belated celebration of his 50th birthday in the 50th state. No decision would be announced until his return. The investment bankers turned frantic. Theirs is a who-do-you-know business, and they mobilized their clients, many of them Microsoft customers or suppliers, to besiege Gates and Shirley.
Gaudette had methodically ranked the investment houses on a scale of 1 to 5 in 19 different categories. But he also stressed that any candidate could do the deal and that the chemistry between Microsoft and the firms would finally determine the winners. Among the major houses, Gaudette had been most impressed by Goldman Sachs, which tightly links its underwriting group with its stock traders and keeps close tabs on the identity of big institutional buyers. For those reasons, Gaudette thought Goldman would be especially good at maintaining an orderly market as Microsoft employees gradually cashed in their shares.
On December 4, after conferring with Gates and Shirley, Gaudette phoned Eff W. Martin, 37, a vice president in Goldman's San Francisco office who had been calling on Microsoft for two years. ''I like you guys,'' Gaudette said, ''and Microsoft wants to give you dinner on December 11 in Seattle. Do you think you can find time to come?'' Dinner at the stuffy Rainier Club was awkward. The private room was large for the party of eight, and one wall was a sliding partition ideal for eavesdropping. Most of the party were meeting each other for the first time; how well they got along could make or break the deal. Microsoft's top dogs didn't make things easy. Gates, who had heard scare stories about investment bankers from friends like Mitchell Kapor, chairman of Lotus Development, was tired and prepared to be bored. Shirley was caustic, wanting to know exactly what Goldman imagined it could do for Microsoft.
For nearly an hour everyone stood in a semicircle as Martin and three colleagues explained their efforts to be tops in financing technology companies. An Oklahoman by birth and polite to a fault, Martin labored to kindle some rapport. But it was not until talk turned to pricing the company's stock that Gates folded his arms across his chest and started rocking to and fro, a sure sign of interest. At the end of dinner, Martin, striving to conclude on a high note, gushed that Microsoft could have the ''most visible initial public offering of 1986 -- or ever.''
''Well, they didn't spill their food and they seemed like nice guys,'' Gates drawled to his colleagues afterward in the parking lot. ''I guess we should go with them.'' He and Shirley drove back to Microsoft headquarters, discussing co-managing underwriters. Gaudette leaned toward Robertson Colman & Stephens. But Alex. Brown had been cultivating Microsoft longer than any other investment banking house. ''Better the whore you know than the whore you don't,'' Shirley concluded. Three days later the board quickly blessed the selection of Goldman Sachs and Alex. Brown.
The offering formally lumbered into gear on December 17 at an ''all-hands meeting'' at Microsoft. It was the first gathering of the principal players: the company with its auditors and attorneys as well as both managing underwriters and their attorney. Some confusion crept in at first. Heavy fog, a Seattle specialty, delayed the arrival of several key people until early afternoon. One of Microsoft's high priorities was making its prospectus ''jury proof'' -- so carefully phrased that no stockholder could hope to win a lawsuit by claiming he had been misled. The company had insisted that the underwriters' counsel be Sullivan & Cromwell, a hidebound Wall Street firm. Gaudette was miffed to see that the law firm had sent only an associate, not a partner.
The 27-point agenda covered every phase of the offering. Gates said the company was contemplating a $40-million deal. Microsoft would raise $30 million by selling two million shares at an assumed price of around $15. Existing shareholders, bound by Gates's informal rule that nobody should unload more than 10% of his holdings, would collect the other $10 million for 600,000 or so shares. The underwriters, as is customary in initial public offerings, would be granted the option to sell more shares. If they exercised an option for 300,000 additional shares of stock held by the company, almost 12% of Microsoft's stock would end up in public hands, enough to create the liquid market the company wanted.
Gates had thought longest about the price. Guided by Goldman, he felt the market would accord a higher price-earnings multiple to Microsoft than to other personal computer software companies like Lotus and Ashton-Tate, which have narrower product lines. On the other hand, he figured the market would give Microsoft a lower multiple than companies that create software for mainframe computers because they generally have longer track records and more predictable revenues. A price of roughly $15, more than ten times estimated earnings for fiscal 1986, would put Microsoft's multiple right between those of personal software companies and mainframers.
A host of questions came up at the all-hands meeting. Both Shirley and Gates were concerned that going public would interfere with Microsoft's ability to conduct business. Shirley wondered whether all three of Microsoft's top officers would be needed for the ''road show,'' meetings at which company representatives would explain the offering to stockbrokers and institutional investors. Gates tried to escape the tour by saying, facetiously, ''Hey, make the stock cheap enough and you won't need us to sell it!''
Microsoft's attorney, William H. Neukom, 44, a partner at Shidler McBroom Gates & Lucas -- the Gates in the title being Bill's father, William H. Gates -- raised another matter. The company would have to tone down its public utterances, he said, lest it appear to be ''gun jumping,'' or touting the stock. Press releases could no longer refer to certain Microsoft programs as ''industry standards,'' no matter how true the phrase. Neukom would review all the company's official statements, which came to include even a preface Gates was writing for a book on new computer technologies.
The most tedious part of taking the company public was writing a prospectus. It was a task rife with contradictions. By law Microsoft's stock could be sold only on the basis of information in this document. If the SEC raised big objections to the preliminary version, Microsoft would have to circulate a heavily amended one, inviting rumors that the deal was fishy. However cheerful or gloomy the prospectus, many investors would fail to read it before buying. Then if the market price promptly fell, they would comb the text for the least hint of misrepresentation in order to sue. Still, the prospectus could not be too conservative. Like all such documents, it had to be a discreet sales tool, soft-pedaling weaknesses and stressing strengths, all the while concealing as much as possible from competitors.
Even Before Microsoft had picked its underwriters, Robert A. Eshelman, 32, an attorney at Shidler McBroom, had started drafting the prospectus. That task took all of January. ''As usual,'' says one of the investment bankers, ''it was like the Bataan death march.'' Neukom, who had just left Shidler McBroom to join Microsoft, spent the first week of 1986 with Eshelman, sketching in ideas about the company's products and business. Two days a week for the next three weeks, many of the people who had been at the all-hands meeting reconvened at Microsoft's sleek headquarters in a Seattle suburb to edit the prospectus.
At the first sessions, on January 8 and 9, the underwriters brought along their security analysts to help conduct a ''due diligence'' examination, grilling the company's managers to uncover skeletons. Gaudette was mollified that Sullivan & Cromwell had now furnished a partner from its Los Angeles office, Charles F. Rechlin, 39. Gaudette had met him years before in New York but was bowled over by how much he had changed. Rechlin was 40 pounds lighter and sported shoulder-length hair and a fierce sunburn.
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