Inside the Red Hat IPO

In January, 1999 CEO Bob Young did not want Red Hat to go public. Today

“The computer industry
is so competitive,
people really have a
hard time getting used
to the notion that maybe sometimes you can
agree to be friends.”
– Linus Torvalds

January 1999: The Idea

Redhat Logo


Linus begins work on the Linux kernel.


Bob Young and Mark Ewing found Red Hat.

August 1997

Publisher Frank Batten Jr. becomes the largest individual shareholder, investing $2 million in exchange for 25 percent of the company.

September 1998

Intel, Netscape, and VC firms Benchmark Capital and Greylock Management announce investments in Red Hat totaling $8 million.

November 1998

Matthew Szulik hired from Relativity Technologies to serve as President.

January 1999

IPO discussions begin at Red Hat.

March 1999

Compaq, IBM, Novell, Oracle, and SAP announce equity investments in Red Hat. $7 million raised.

June 1999

Red Hat announces $96.8 million IPO plan.

August 11, 1999

Red Hat begins trading. Priced at $14 per share, the stock opens at $46 and closes at $52.06. Cumbersome SEC requirements and snafus turn an attempt to disburse shares to the open source community into a PR nightmare.

September 1999

Red Hat’s stock hits $135 per share, making the company worth $4.7 billion.

At a quarterly board of directors meeting for a small software
company in Triangle Park, North Carolina, a drama was unfolding. The
Linux distribution vendor Red Hat, Inc. was preparing for another round
of venture funding, and the board was discussing the options when
venture capital sleuth Bill Kaiser, a Red Hat board member and a partner
with Greylock Management, had just interrupted the discussion with a
startling idea.

Around the table sat Robert Young, CEO of Red Hat; 30-year-old
company founder Marc Ewing; Red Hat’s first angel investor, Frank Batten
Jr.; Benchmark Capital’s 34-year-old fortune hunter, Kevin Harvey;
Greylock’s Kaiser; and Red Hat president Matthew Szulik.

“Why don’t we just scrap this investment round, and go straight to a
public offering?” Kaiser had suggested. “Why raise several million
dollars from corporate investors, when we can make a leap and raise a
much larger number of dollars in the public markets?”

The room fell silent. Finally, Kevin Harvey spoke up. He agreed with
Kaiser: A Red Hat offering would be well-received.

Bob Young was skeptical. A 45-year-old Canadian known for his
gentle, soft-spoken manner and a propensity to analyze business events
metaphorically and in the large scheme of world history, Bob was also a
self-proclaimed entrepreneur, and he was annoyed by the assumption that
an IPO was required for any new technology to succeed in the

“What about those Horatio Alger stories of people who had started in
their garages and built great companies without outside financial
support?” Young wondered out loud to his colleagues at the meeting. What
about SAS Institute, the brilliantly successful billion-dollar corporate
software developer that was built over the past 25 years by Jim
Goodnight, just down the road from Red Hat in Cary, North Carolina?It
didn’t have any outside investment.

Young wasn’t alone in his skepticism. Forty-two-year-old Szulik, who
at that time had been president and COO of Red Hat for only 60 days, was
against the idea. And he could not be swayed. “Even if the market is
ready for us, we’re not ready for the market,” he said, bringing the
meeting back on track.

Szulik, who had been wooed away from software maker Relativity
Technologies by the idea of “revolutionizing an industry,” had helped
guide several technology companies, including MapInfo, a Troy, NY-based
maker of desktop mapping software, into the public market. Tall, with
thick, dark hair, Szulik had an easy-going manner and a talent for
communicating difficult issues in an objective way.

Though many high-tech stocks had been enjoying an unprecedented bull
run in the market, an IPO posed serious risks — especially to a company
like Red Hat, with its nontraditional, open source business model.

Szulik knew that if Red Hat did not achieve everything it claimed it
would during the IPO, investment analysts would point this out to the
market, and the value of the company’s shares might plunge. Customers
and suppliers might then be reluctant to buy from

the company out of concern that Red Hat might not be around to
support its products in the future.

Companies without a strong and experienced management team
that’s prepared for these pressures frequently suffer dramatically at the
hands of a skeptical investing public, Szulik warned. Successful
companies are the ones that are both well prepared and that use their
public offering as a springboard to greater success.

Red Hat Outside
GROUND ZERO:Red Hat’s Durham, NC

Szulik felt Red Hat had to have more support from the industry. It
could not go public until it had a much more tangible set of commitments
from industry leaders. If it was going to have a shot at convincing the
capital markets that the company was more than just a hacker’s commune,
what Red Hat needed was not just endorsements for itself, but for the
open source software-development model.

Young may have been doubtful, but the seed was planted. Red Hat’s
CEO’s idealism about his company doing everything on its own slowly
began shifting during the series of meetings that began with this
January 1999 gathering of the board. By April of that year, Young had
completely reversed his position on the IPO issue.

March 1999: The Build-up

As it turned out, that next round
of venture funding, which
occurred in March of 1999, put the company in very good shape for its
later IPO. A parade of industry giants would soon become a part of the
open source uprising, and heavy hitters IBM, Compaq, Dell, Novell,
Oracle, and SAP all lined up to invest in Red Hat. Red Hat executives
worked closely with these companies to determine exactly what they and
their customers wanted from an alternative operating-system supplier.

What Red Hat learned from partnering with these giants was that
although it was giving away a complete state-of-the-art operating system
under a free license, the best business model turned out to be exactly
the same as that of a proprietary software company. “Most computer
users do not want to take full and ongoing responsibility for the
technology they are using,” Young said. “In effect, most customers don’t
want to buy technology at all…If they could get away with it, they’d
still be using quill and ink.”

Red Hat Front Desk
HOME OF THE HAT: Red Hat’s lobby.

Red Hat’s Linux product-development team, testing, quality-control,
and documentation teams, were enabling it to supply superior software,
but it needed to build its customer support and services teams.

To upgrade its own internal management-information systems, Red Hat
turned to Oracle, whom they asked to “push the notion of Internet time,”
said Young. “The Internet was allowing companies to operate much faster
than was previously possible in ‘normal time.’ We had always recognized
that to take on companies as large as Microsoft, we were going to have
to move faster than they did. We could not operate on normal time, nor
even in Internet time, but at a pace we called ‘Linux time.’”

Linux time required that Oracle install its software so that Red Hat
would be able to run its business within 30 days. At first, Oracle
executives laughed at the idea. But in the end, they made it happen in
37 days, one of the fastest implementations Oracle had ever

The new system enabled Red Hat to track all of its customers as
individuals so that, for example, it could offer credits to customers
for volume purchases. “This is the kind of thing that Amazon.com does
every day,” Young said. “However, it had a four-year head start on that
level of sophistication, which in large part was made possible through
funding from capital markets. Amazon has been able to take what it does
and translate that on a very large scale. That’s the kind of scale we
have to operate at if we’re going to begin competing with Microsoft for
major accounts.”

Spring 1999: The Climate

For any company, the purpose of a public offering is to gain access
to the resources that the capital markets represent. Having come out of
the computer-leasing business, Young understood finance well enough to
recognize that for Red Hat to succeed in the marketplace, particularly
against companies as well funded as Microsoft, it needed to have allies
with very deep pockets.

There are no guidelines for weighing the right time to go public.
Gauging this means understanding what resources are needed for greater
success in the marketplace, and whether the application of those
resources benefits the company in the short run. Equally important is
determining how to raise the capital.

When a company needs to raise money, it can issue notes or bonds
(known as debt securities) or stock (known as equity securities). In Red
Hat’s case, the capital markets were receptive to funding a new business
model of the sort that Red Hat’s open source strategy represented.

Red Hat Ewing

At the core of Red Hat’s business was a development model that had
fueled the explosion of the Internet itself. The company had tapped into
resources that were at the heart of what computer users really wanted
and needed, and had nothing to do with control by a single company.
What’s more, the Justice Department’s ongoing antitrust case against
Microsoft was making corporations and software developers alike believe
that there was finally a chance to work with an alternative operating
system supplier, without fear of retribution. The time was right for the
market to be receptive to Red Hat. If the company had attempted an IPO
only two years earlier, the reaction would have been completely

Moreover, a Red Hat IPO would represent the first opportunity for
the capital market to weigh in on whether the open source movement was
for real.

Red Hat had reason to believe that the markets would be receptive.
By April, the company was going gangbusters and executives were busy
preparing for its “bake-off,” the ritual of selecting an underwriting
team from the various investment-bank suitors. With all the publicity
that Linux and the open source movement had received, major investment
banks had been lobbying Red Hat aggressively for its business. Way in
advance, starting in 1998, numerous investment banks had assumed that
Red Hat would eventually be filing an IPO and wanted to make sure they
had the inside track. Young was so besieged by bankers that he began to
discourage them from calling.

May 1999: The Bankers

In May 1999, the Double Tree Inn in Raleigh, North Carolina, just
down the road from Red Hat’s offices, was beginning to fill up with a
gaggle of suits. The top investment bankers in the world had

Only a week had passed since Red Hat had placed a call to Goldman
Sachs and Morgan Stanley Dean Witter & Co. They had both eagerly
agreed to compete for Red Hat’s business as the lead underwriter for
company’s IPO. The Goldman Sachs and Morgan Stanley teams each flew in
on separate corporate jets, and the executives stepping off those planes
that day represented a veritable Who’s Who of Wall Street.

Red Hat Young

Goldman Sachs was a most hallowed name. It had handled Yahoo’s
stunning IPO in 1996. When Goldman Sachs took Yahoo public, it was
almost an object of ridicule. At the time of the IPO, Yahoo’s market
capitalization was about $300 million. Today it’s about $30 billion.
Since then, Goldman Sachs had underwritten 11 Internet IPOs worth $986

Morgan Stanley’s team was equally strong. Even though it was ranked
fifth in IPO volume since 1996, it had underwritten several of the
Internet market’s largest secondary offerings, including those of
Netscape and America Online.

By the time both companies had departed, Red Hat’s choice was clear.
Goldman Sachs would lead the IPO.

In the ensuing weeks, Goldman Sachs’ Managing Director Lawton Fitt
and others worked on setting the offering price with Red Hat executives.
Setting this price may be best described as a kind of artistic balancing
act. If the price is set too low, the stock could go through the roof in
the public market. In such a case, privileged investors — who got in at
the offering price — make out like bandits. However, the company that’s
going public receives only a small fraction of the proceeds it might
otherwise have had. If the price is set too
high, the company takes home a
lot of money, but its stock could quickly plummet below the offering
price as trading continues, resulting in negative publicity and unhappy

For years underwriters have used a general rule of thumb: Value the
deal so that the stock will jump about 15 percent on the first day of
trading. However, in recent years with the hot IPO markets, underwriters
had been known to set prices low and let stocks leap 50 percent and
sometimes even double.

Red Hat Szulik

Red Hat hoped to raise about $96.8 million in its first investment
round, which would put about 10 percent of the company on the block. By
comparison, in its private rounds of funding, it raised an initial $2
million from investor Frank Batten Jr., followed by $8 million raised in
September 1998 with the investments from Greylock, Benchmark, Intel, and
Netscape. The third round raised another $7 million in March of 1999
from Compaq, IBM, Dell, Novell, and Oracle.

In May of 1999, Goldman pegged Red Hat’s valuation somewhere between
$800 million and $1.2 billion dollars. The market capitalization would
be based on the IPO price. Red Hat had a total of about 35 million
shares outstanding and was proposing initially to sell roughly another
3.5 million shares at approximately $25 a share. During the fall, it
forecast, it was likely to do a stock split and end up with 70 million
shares that sell for about $12.50 each.

The company had pondered the risks involved in doing the deal, and
decided there were few. Goldman Sachs and Red Hat executives determined
it wasn’t likely that the capital markets would cool in general toward
technology stocks.

“We did not foresee much bad news in Internet stocks between June
and the end of July. If the market did cool, our valuation might be
reduced slightly, but it would not eliminate the offering,” Young said.

He noted, however, that as an exercise, he and other Red Hat
executives did consider what Microsoft could do to torpedo the company
and its IPO. They conducted a worst-case-scenario discussion prior to
the IPO, asking themselves what would happen if, say, a week before
registering for the IPO, Microsoft were either to launch or somehow back
a lawsuit claiming ownership of some little piece of Red Hat Linux.

That could scare some investors who might believe that such lawsuits
had some merit. “Of course, it would be an unbelievably bad public
relations move for Microsoft, unless it conducted such activity via one
of its stealth campaigns,” noted Young.

In fact, Microsoft has yet to really flash its competitive teeth at
Red Hat, and last spring the Linux company did not really expect much of
a fight in the upcoming quarters.

“Ironically, as long as the Justice Department has Microsoft in the
spotlight, it needs a competitor,” Young noted. “They need to be able to
go to Judge [Thomas Penfield] Jackson and say this has no merit because
we’re not a monopolist. If Red Hat went public at a billion dollar
market capitalization, it would imply that there is some competition
occurring in the marketplace.”

Of course, even going public at a billion dollars would mean that
Red Hat had only a tiny fraction of Microsoft’s approximately $500
billion market capitalization.

June 1999: The Book

By the summer of 1999, Red Hat was ready for its road show.
Everything appeared to be going smoothly with the Securities and
Exchange Commission (SEC), and Goldman Sachs was ready to make its pitch
to the public.

On road shows, company executives give presentations and get
responses from prospective investors in a “book.” This book is carried
around by the lead underwriter throughout the road show. As the company
meets with institutional money managers, their “indications of interest”
are noted in the book. For an IPO to be considered viable, the
indications of interest must be larger than the shares available to fill
them by a ratio of at least three to one. This ensures that there will
continue to be interest in the stock after the initial offering. Hot
stocks will be more than three times oversubscribed.

An underwriter has two customers: the company it is taking public
and its investor clients. Of the two relationships, the latter is
arguably more important (which may, in the long term,also be in the best
interest of the company going public, since it represents the view of
the market). Even though it will earn a substantial commission from
doing so, an underwriter will take a company public only once. However,
it counts on institutional investors to buy its issues on an ongoing

Looking back, CEO Young now says, “A word of warning for anyone
considering an IPO. Don’t.” Young, whose stake in Red Hat is worth close
to $1 billion, is only partly kidding. “It reminds me of nothing so much
as one of those multilevel video games with hidden dangers and Byzantine
rules. It is also very hard work,” he explains.

Young wishes that the company had been able to avoid some of the
pitfalls that inevitably come up in the IPO process. “The best example
of these challenges is our experience trying to get some of the shares
we were selling in the IPO to the programming community who had helped
build many of the tools we were using in Red Hat Linux,” he says.

July 1999: The Community

It was clear that Red Hat wanted all the open source developers who
had made its success possible to participate in its public offering. Red
Hat would be nowhere without the hackers, and the company knew it.

The First Day —
Breaking IPO History

Red Hat ended its first day on Wall Street with stock worth $3.5
billion on the open market. Priced at $14 per share shortly after 9
a.m., shares started trading after noon. Demand for the stock was heavy,
and the underwriters, who bought the shares from Red Hat at $14 each,
turned around and sold them for much more; the first trade came in at
$46 per share.

When it closed at $52.0625 per share, Red Hat enjoyed a first-day gain
of 272 percent, the eighth-biggest first-day gain in Wall Street

Executives at the company were barred from making comments publicly
about their stellar first day, seeing that they were still restricted by
the SEC-imposed “quiet period.” Indeed, all was quiet at Red Hat’s
office at 2600 Meridian Parkway, but the lobby was decorated with an
enormous arrangement of red flowers, red and gold balloons, and a chest
of gold coins made of chocolate. A local real-estate agent had sent them
to congratulate the company.

Red Hat Director of Technical Projects Donnie Barnes spent three
weeks scouring the Internet, digging up all the contributor lists to all
the open source projects he could find. Red Hat then had to craft a
letter to this list of developers. The SEC has a complex set of rules
about what companies can and cannot say when they offer shares to the
public. If a company doesn’t stay well within the rules, the SEC can –
and regularly does — withhold permission to proceed with an IPO.

“I’m sure they have very important and well-researched reasons for
implementing each and every one of these rules,” Young said. “But to the
companies who have to negotiate these rules on their way to a public
offering, they appear designed solely for the purpose of ensuring the
mental collapse of anyone who attempts to navigate through them.”

For example, the SEC-imposed quiet period “was one of the more
bizarre notions to a salesman like me,” Young said. “How can you sell
shares in your company if you are not allowed to promote your company
for three months before your IPO or for a further month after your IPO?
This letter to developers could describe the offer, but not mention any
reason why anyone should want to accept the offer. That would be
promoting the shares in the quiet period — a big no-no according to the
rules.” Red Hat ended up with a letter which, while legally acceptable,
was “sufficiently badly worded to end up alienating a significant
percentage of the developers we mailed it to,” Young said.

The SEC has a set of rules governing who is eligible to purchase
shares in an IPO. First, you must be a U.S.-based taxpayer to buy IPO
shares that are listed on an American exchange. This eliminated about
half of the developers on the list from participating in the offer,
according to Red Hat.

The SEC also has a set of rules designed to protect the public from
scam artists who use public stock offers to con inexperienced investors
out of their money.

“In effect the SEC deems IPO offers to be extremely high-risk
investments, and therefore buyers of shares in IPOs must prove that they
are experienced investors who can afford to lose the money they are
being asked to invest,” Young said.

Unfortunately a significant percentage — about 15 percent — of the
developers to whom Red Hat offered shares were either students or
otherwise inexperienced investors by the SEC’s standards.

“And of course this offer was not being made by the SEC — it was
being made by Red Hat and E*TRADE. So when members of the development
community that we had extended the offer to found themselves declared
ineligible, they initially naturally blamed Red Hat and E*TRADE,” Young

The final result was that well over one-fifth of the developers on
the list were interested, eligible, and able to participate in the Red
Hat IPO.

Fall 1999: Public

Will going public influence
Red Hat’s commitment to
the open source model? “Keep in mind that it’s our customers who
influence us the most,” Young said. “That’s where our commitment to open
source comes from. Our shareholders to date have all invested in Red Hat
because they
believed in what we were doing with open source, not despite it. Their
investments are enabling us to do more of the same.”

Young and his original partner Marc Ewing are still shaking their
heads in disbelief. In a little over four years, they’d gone from
selling Linux out of their homes (“to avoid getting real jobs,” Young
says, “with few ambitions for great financial success”) to being fought
over by the world’s two largest investment banks.

Clearly, the Linux and open source arenas are in their infancy.
Selling free software has gone from an activity that labeled Red Hat’s
founders as unrealistic dreamers to one that now casts them as industry

“What a ride,” Young said. “And the remarkable part of it is that
it’s just beginning.”

Wendy Goldman Rohm is Editor at Large for Linux Magazine. She
is the author of the best-selling book
The Microsoft File: The
Secret Case Against Bill Gates, published by Random House in
September 1998. Her new book,
Under the Radar, written with Red
Hat CEO Bob Young, was published in September 1999. She can be reached at

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