Netscape's Initial Public Offering
Executive summary
Netscape Communications Corporation was one of the big players in the dot-com era and information technology boom of the late 1990's and contributed in making the Internet and World Wide Web known to common people. On August 9, 1995, Netscape went through the initial public offering (IPO) process. Dramatically, on August 8, the day before the IPO, Netscape's lead IPO underwriters recommended to the Netscape board to increase the initial offering price to $28 per share from $14 per share, a 100% increase. At this new offering price, the Netscape's value would suddenly climb to more than $1 billion, which when held together with their 1995 revenue of some $16 million, to many seemed like a very optimistic firm value. Furthermore, the company was only 16 months old and had yet to turn a profit. The big question was: What yearly revenue growth rate is needed to support a firm value of $1 billion and an IPO price of $28 per share, and is this growth rate realistic?
To answer this question we have performed NPV analysis for the period 1995-2005 based on Netscape's income statement and balance sheet for 1994/1995 together with a number of assumptions stated later in the text. We found that a yearly revenue growth of 59.4% was necessary to justify an IPO price of $28 per share and thereby a firm value of $1 billion.

Even if Netscape was the indisputable leader of its kind in 1995 the number of competitors was on a steady rise. Microsoft, the most notable of these competitors, was only weeks away from launching their now famous Windows 1995 operating system which included an integrated and rivaling browser when Netscape went public in August 1995. Moreover, online computer service providers like America Online and Prodigy had created their own independent browser systems. Growing competition and increasing awareness of potential opportunities in the business were factors that could have a grave impact on Netscape's future revenues and make the company's shares less attractive to investors.

If we were on Netscape's board of directors we would recommend to accept the new $28 per share IPO price primarily due to the fact that the stocks were vastly oversubscribed when the underwriters proposed a total issuance of only 3.5 million shares. As a consequence, this number was raised to 5 million shares but chances are that the stock is still oversubscribed due to the hype surrounding the information technology and internet solutions industry at the given time.
Furthermore, the yearly revenue growth it takes to justify an IPO share price of $28 is 59.4% while the revenue growth rate required to justify a share price of only $14 is 49%. Both growth rates seem high but the difference between them is modest, taking into consideration that a share price of $28 obviously is twice as attractive as a share price of $14, provided that investors a willing to pay the $28 per share.

Background
Netscape Communications Corporation was founded in 1994 to provide a line of client, server and application software products for communicating and commerce on the Internet and private networks. Netscape's later success had much to do with its business model that dictated making their basic client product Netscape Navigator available free for interested customers and then generating revenue later by selling integrated application software products to make it possible for customers to communicate and conduct commerce over the Internet and over private Internet Protocol (IP) networks.

Netscape Navigator was a client-based web browser software application that enabled users to navigate the Internet and the new World Wide Web using a graphical point-and-click interface with text and images, similar to the Windows or Mac operating systems for personal computers, in short the kind of internet browsers we have now today. Back then this kind of browser was revolutionary compared with other existing browsers that had to be navigated using complex text commands only known to the initiated. Some of the easily accessible functions that made Navigator popular included web browsing, file transfers, news group communications and e-mail. By making Navigator available for free, Netscape's strategy was to gain market share quickly and build brand loyalty and recognition and making it inconvenient for users to later switch to a different similar product. All of this would hopefully stimulate demand for its server application software that was to be the revenue creating products.

For Netscape to be successful in the long run the company was facing quite a few challenges. First of all it had to turn profitable. As of August 1995, this had still not happened. However, with the release of Netscape Navigator, the company was close to completely revolutionizing the web browsing industry. To be successful in the long run, Netscape had to continuously offer new innovations in the web browsing and associated markets. Netscape's competitive position as the web browser market leader was at the time in significant risk due to competitor's entrance into the potentially very lucrative market market. The firm's primary competitor was Microsoft.

In 1995, Microsoft launched its new Windows 95 operating system for the personal computer, which came together with their free web browser Internet Explorer (IE). Microsoft also offered a long list of new software applications for common business and office tasks such as word processing, financial spreadsheet analysis, e-mail and databases. IE would be a problem for Netscape, since many laymen did not have the knowledge or the time to download and install an independent browser. Another problem for Navigator was that IE was an inseparable part of Windows 95 operating system. Most users are likely to use and get familiar with the web browser that is already on their computer once the operating system is installed instead of going out looking for a new one. To make matters worse, Microsoft was on the brink of launching its own server software and applications which would put Microsoft in a very comfortable position as a highly diversified company that could satisfy almost every need within the markets for operating systems and business and consumer software and applications. Yet another concern for Netscape was that of what web browser would be the default browser for customers of the emerging internet service providers. This would obviously be important due to the aforementioned rationale that consumers are likely to stay with the product they are first presented with and gain familiarity with.

When Netscape decided to go public in 1995 they did so since they were strapped for cash and running out of financing opportunities. They had been through three rounds of capital injections coming from private equity placements and venture capital agreements. Still, Netscape was in dire need for capital to support the company's rapid growth and to make sure that the company had enough liquidity to keep the company in the frontline of web browser solutions. Instead of going public Netscape of course could have obtained debt to stay afloat. Only problem was that the company was not yet profitable so it might be hard to obtain a loan. Furthermore, if the loan was granted but Netscape still was struggling to become profitable interest payments on the debt would be hard to meet and foreclosure could become a real risk. An advantage of going public is that companies do not have the threat of a bank taking over their businesses and although dividends are certainly welcomed by investors they are not mandatory the same way interest payments are. Furthermore, a broad diluted base of owners generally means more control for the managers.

Netscape's board of directors should be concerned about underpricing, since underpricing essentially means that the company could have made more money on the stock issue. At the same time though, the board should also realize that if the company is indeed underpriced seen in light of their performance and their ability to attract new investors, the firm can generate new funds with a second, more accurately priced issue.
Methodology
We have used the NPV method to determine Netscape's value. The analysis consists of two parts: First, free cash flows are calculated for year 1995 through 2005 and afterwards these FCFs are discounted back to 1996. Note, than we talk about 1995 we mean the 12 months from July 1994 to July 1995 and when we talk about 1996 we mean the 12 months from July 1995 to July 1996 and so on. The reason for this is that we have used the values on Netscape's income statement as our basis values and since the income statement doesn't cover a calendar year a compromise had to be made. In the second part of the analysis a terminal value for Netscape is calculated using a terminal growth rate. Also this value is discounted back to 1996. The sum of the two NPV contributions is the total NPV of the firm. When this number is divided by the number of shares (outstanding + new) we find the justifiable share price. The main point of the calculations is to determine how large yearly revenue growth is necessarily to support a share price of $14 and $28 respectively.
The key assumptions used to perform the analysis are listed below:
Total cost of revenues (% of total revenues) 10.4%
R&D (% of total revenues) 36.8%
Other operating expenses (% of revenues) Decline on straight-line basis from 80.9% of total revenues in 1995 to 20.9% in 2001
Capital expenditures (% of revenues) Decline on straight-line basis from 45.8% of revenue in 1995 to 10.8% of revenues in 2001
Depreciation (% of revenues) 5.5%
Changes in net working capital 0%
Long-term (or terminal) growth rate: 4%
Long-term risk-free interest rate: 6.71%
Discount rate: 12% Tax rate: 34%
Number of shares outstanding: 33,000,751
New shares: 5,000,000
Financial analysis
First we examine the yearly revenue growth rate required for the firm to support a per share IPO price of $28. Appendix 1 displays a table complete with all relevant numbers. A yearly revenue growth rate of 59.4% is required over the next 10 years for an estimated firm value of $1.064 billion to support the IPO price of $28/share.
Results for Netscape IPO analysis at $28/share are seen below:
Yearly Revenue Growth Rate 59.4%
Firm Value $1,064 billion
IPO Share Price $28
Year first profitable 2001

A similar analysis is performed for an IPO share price of $14. The resulting table is displayed in appendix 2. Here we see a yearly revenue growth rate of 49.0% is required over the next 10 years to support an IPO price of $14/share with a firm value of $532 million. Results for Netscape IPO analysis at $14/share are seen below:
Yearly Revenue Growth Rate 49.0%
Firm Value $532 million
IPO Share Price $14
Year first profitable 2001
No matter if the IPO is $14 or $28 per share we conclude that it requires a very high growth rate over the next ten years for Netscape to justify these share prices. What may surprise is the relatively small difference in yearly revenue growth (59.4% - 49% = 10.4% difference) it takes to support the two share prices when we realize that one share price is twice as high as the other.
Conclusion
If we were on Netscape's board of directors we would accept the proposed 100% increase in the IPO share prices. The two annual revenue growth rates calculated above are both high but the growth rate required to support a share price of $28 is not dramatically higher than the growth rate it takes to justify a share price of $14. Since there prior to the IPO was a high demand for the Netscape stocks which resulted in an increase in the number of shares offered from 3.5 million to 5 million we know that the interest for the Netscape stock is significant and we therefore cannot see any reason not to double the share price and thereby double the influx of capital to the company. Furthermore, the Netscape IPO came at a time where the future of the internet and all the technologies, applications and software associated with it had never looked brighter. It was by many observers already at the time of Netscape's public offering expected to be the new hot market and the place to invest, which favors of a Netscape IPO at $28/share.

Appendix 1:

Appendix 2: