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ROSETTA STONE: PRICING THE 2009 IPO
We are changing the way the world learns languages.
—Tom Adams
Introduction
In April 2009 Rosetta Stone management was considering an initial public offering of
Rosetta Stone stock during one of the most difficult periods in market and capital-raising history.
Rosetta Stone provides an unique language-learning strategy and was a pioneer in developing a
whole new market in language-learning. Their strong financial performance allowed them to
consider going public during a difficult financial period. At the time of this case, managers are in
the process of valuing the stock using various corporate valuation strategies, and making the
decision on whether to go public.
Purpose
In development of this case, students will review the institutional aspects of the equity
issuance transaction, explore the costs and benefits associated with initial public share offerings,
develop an appreciation for the challenges of valuing unseasoned firms, develop corporate
valuation skills, specifically using market multiples, and evaluate related the financial anomaly of
IPO underpricing.
Case
It was mid-April 2009. Tom Adams, president and CEO of Rosetta Stone, Inc. (Rosetta
Stone), the language learning software company, reached for his iPhone to contact Phil Clough of
private equity fund ABS Capital. Adams and Clough had been discussing plans to take Rosetta
Stone public for some time. The wait was finally over.
In the wake of the 2008 financial crisis, the market for initial public offerings (IPOs)
evaporated. By early spring the market was showing its first encouraging signs. Just a week prior,
Chinese online videogame developer Changyou.com had listed on the NASDAQ at a price to
EBITDA of 6.5 times followed by a one-day jump of 25%, and the online college Bridgeport
Education was currently circulating its plans to go public at a range of 10 to 12 times EBITDA.
Having received preliminary approval of its registration filings with the U.S. Securities and
Exchange Commission (SEC), Rosetta Stone was authorized to sell 6.25 million shares, a 30%
stake in the company. Exhibits 1 and 2 provide financial statements from Rosetta Stone’s IPO
prospectus, required by the SEC to inform investors about the details of the equity offering. Half
of the shares were to be new shares and the other half were shares to be sold by existing
shareholders. Rosetta Stone management had circulated an estimated price range of $15 to $17 per
1
share, representing a price to EBITDA of about 8 times. Demand for the shares was strong, and
some analysts believed that Rosetta Stone was leaving money on the table. Yet with world financial
and product markets still in turmoil, there was a strong case to be made for prudence.
Economic Conditions
The previous year had been a dramatic one for the world economy. Prices on global credit
and equity markets had been in free fall. The U.S. equity market was down over 50% from its peak
in October 2007 (see Exhibit 3 for details of the recent price history of U.S. equity market returns
in total and for select industries). The collapse of world financial markets had preceded
deterioration in economic activity worldwide, including dramatic shifts in real estate values,
unemployment levels, and discretionary consumer spending. The severity of economic conditions
had prompted massive intervention by world governments with dramatic policy changes,
particularly by the U.S. federal government. The economic and political conditions were
frequently compared with those of the Great Depression of the 1930s.
In February and March of 2009, there had been some evidence of improvement in financial
and economic conditions. Wholesale inventories were in decline. New-home sales were beginning
to rise. The equity market had experienced a rally of over 20% in recent weeks. Yet many money
managers and analysts worried that such economic green shoots were only a temporary rally in a
longer-running bear market. There was strong concern that the magnitude of government spending
would spur inflation in the U.S. dollar. GDP growth was still negative, corporate bankruptcy rates
and unemployment were at historic highs, and many believed the economic void was just too big
for a quick recovery to be feasible. A Wall Street Journal survey of U.S. economists suggested
that the economy was expected to generate positive growth in the last half of 2009.1 In contrast, a
survey of U.S. corporate executives stated that less than a third of respondents expected to see an
economic upturn in 2009.2 The debate regarding the economic future of the world economy raged
on.
Rosetta Stone
In the 1980s, Allen Stoltzfus, an economics professor, real estate agent, and history buff,
was frustrated with his slow progress in mastering the Russian language. He was enrolled in a
conventional classroom Russian course but found it much less effective than the process he had
used to learn German while living in Germany years before. Seeking to produce a more natural
language learning method, Stoltzfus envisioned using computer technology to simulate the way
people learn their native language—with pictures and sounds in context. Rather than learning the
language by translating one language to another, his approach would be to use electronic
technology to encourage people to think in the target language from the beginning. He sought the
aid of his brother-in-law, John Fairfield, who had received graduate training in computer science.
Together they explored the concept of how a computer could be made to facilitate language
1
2
Phil Izzo, “Obama, Geithner Get Low Grades From Economists,” Wall Street Journal, March 11, 2009.
“Economic Conditions Snapshot, March 2009: McKinsey Global Survey Results,” McKinsey Quarterly, March
2009.
2
learning. Stoltzfus and Fairfield founded Fairfield Language Technologies in Harrisonburg,
Virginia, in 1992. The emergence of CD-ROM technology in the 1990s made the project feasible.
The company released its first retail language training software product in 1999 under the name
Rosetta Stone.3
The Rosetta Stone series of CD-ROMs provided users an effective way of learning new
languages. The software utilized a combination of images, text, and sound to teach various
vocabulary terms and grammatical functions intuitively by matching images with the spoken word.
Following the way children learn their first language, the company called this method of teaching
languages the Dynamic Immersion method: “dynamic” because digital technology and the teaching
method powerfully engaged the learner in an interactive learning process, and “immersion”
because learners anywhere, from any language background, started at the very beginning and
studied exclusively in the target language. A recent research study provided scientific evidence
that the language test scores of students that completed 55 hours of Rosetta Stone training
performed comparably to those who had completed an entire semester of a good quality college
language course.4 Rosetta Stone users were broadly satisfied with the experience and regularly
recommended the software to others.
After focusing initially on school and government sales, the company began aggressively
pursuing the retail market in 2001. Following the death of Stoltzfus in 2002, the company hired an
outsider, 31-year-old Tom Adams, as chief executive. Adams brought an international dimension
to the small-town, rural company: A native of Sweden who had grown up in England and France,
he was fluent in Swedish, English, and French. He had studied history at Bristol University in the
United Kingdom and had earned an MBA from INSEAD in France. Prior to arriving in
Harrisonburg, Adams had been a commodity merchant in Europe and China.
Adams got right to work by entering new markets and scaling up the current business; from
2004 to 2005, the revenues of the company nearly doubled. Acknowledging the need for capital
and professional support as the company expanded, Adams solicited a capital infusion from the
private equity market. In 2006, two firms, ABS Capital Partners and Norwest Equity Partners,
made major equity investments in the company. As part of the recapitalization, the name of the
company was changed from Fairfield Language Technologies to Rosetta Stone, Inc., to match the
signature product. Over the ensuing two years, revenue continued to expand aggressively, more
than doubling from 2006 through 2008. Since Adams’s arrival, the compound annual growth rates
of Rosetta Stone’s revenue and operating profit were at 70% and 98%, respectively, and the
company employed over 1,200 people. By early 2009, Rosetta Stone was the most recognized
language learning software brand in the world. Millions of language learners in more than 150
countries were using the Rosetta Stone software. The company offered self-study language
The name Rosetta Stone referred to a black basalt tablet discovered in 1799 by a French engineer in Napoleon’s
army near the Egyptian town of Rosetta. The tablet contained an inscription of a single text in three languages—two
Egyptian scripts (hieroglyphic and demotic) and ancient Greek—thus enabling 19th century scholars to decipher
Egyptian scripts conclusively for the first time.
4
Roumen Vesselinov, “Measuring the effectiveness of Rosetta Stone,” working paper, City University of New
York, January 2009.
3
3
learning solutions in 31 languages to its customers. (Exhibit 4 lists the language training software
currently offered by the company.) In 2008, approximately 80% of Rosetta Stone revenue was
accounted for by retail consumers, 20% by institutions. Institutional customers included
educational institutions, government and military institutions, commercial institutions, and notfor-profit institutions.
In a few short years, Rosetta Stone had successfully developed a strong brand; its kiosks
with bright yellow boxes had become an institution in U.S. airports, and its print advertising in
travel publications included a popular print ad of a young farm boy holding a Rosetta Stone box,
the copy reading, “He was a hardworking farm boy. She was an Italian supermodel. He knew he
would have just one chance to impress her.” The unaided awareness of the Rosetta Stone brand
was over seven times that of any other language learning company in the United States. Leveraging
a strong brand, steady customer base, and diverse retail network, Rosetta Stone had maintained
positive profitability in 2008 despite the severe economic downturn and, in both average orders of
bundled products and services and in units sold, even had experienced increases.
The company expanded its product line by increasing the number of languages and levels
offered and broadened the language learning experience by introducing Rosetta Studio and Rosetta
World. Rosetta Studio allowed each Rosetta Stone learner to schedule time to chat with other
learners and with a native-speaking coach to facilitate language practice, motivation, and
confidence. Rosetta World connected a virtual community of language learners to practice their
skills through a collection of games and other dynamic conversation opportunities. Adams
envisioned a substantial growth trajectory for the company with a multitude of ways to leverage
its novel learning technology and expand its geographic reach. With a fixed development cost,
Adams expected the strategy to continue to increase company operating margins and expand
revenue, but he recognized that, as the company continued to show strong profit and growth, the
incentive for competition to attempt to gain market share would intensify. Exhibit 5 provides three
video excerpts of an interview with Adams in which he describes the future of Rosetta Stone.
Industry Overview
The worldwide language learning industry was valued at more than $83 billion, of which
more than $32 billion was for self-study learning, according to a Nielsen survey. The U.S. market,
from which Rosetta Stone generated 95% of its revenue, was estimated to be more than $5 billion
for total language learning and $2 billion for self-study learning. The total language learning
market was expected to expand as proficiency in multiple languages was becoming increasingly
important due to trends in globalization and immigration. The self-study market, particularly
through electronic delivery, was expected to dominate the industry expansion given that self-study
was increasingly accepted by language learning and travel enthusiasts.
The language learning industry had historically been dominated by specialized language
schools that taught languages through conventional classroom methods. The largest player in the
market was privately held Berlitz International. Berlitz taught languages in its classrooms using
4
the Berlitz Method of Language Instruction, which advocated immersion in the target language,
among other things, and according to company literature, offered programs and services through
more than 470 centers in over 70 countries. Auralog, a French company, was another important
competitor in the industry. Both Berlitz and Auralog offered electronic software packages that
provided quality language training software.
As had the Rosetta World product, businesses such as LiveMocha, Babalah, and Palabea
had also adopted a social media approach, connecting language learners through the Internet, but
these sites tended to be secondary enrichment sources for language learners.
Major software companies with deep pockets represented the most important potential
threat. Although the novelty of Rosetta Stone’s approach shielded it from many of the existing
players in the industry, the entry of a company such as Apple or Microsoft into the language
learning market had the potential to thwart Rosetta Stone’s aspiration of dominating global
language learning.
Pricing the Rosetta Stone IPO
Adams had a preference for a strong balance sheet and cash position for the company. As
a private company, corporate investment was limited by the amount of capital the company could
borrow from private sources. With constrained resources, Adams was concerned that Rosetta
Stone was an attractive takeover target for a company with the needed resources. Led by Phil
Clough at ABS Capital, the private equity investors were anxious to recognize the gains achieved
through the Rosetta Stone investment.
In March, the board had discussed the matter and yielded the IPO decision to Adams.
Despite the uncertainty of taking a relatively young company public in the most volatile markets
in decades, Adams was inclined to move forward with the deal. The fourth quarter financials
continued to show impressive performance, with a 53% expansion in revenue despite the global
economic contraction. (Exhibit 6 details the historical financial performance of the company along
with historical internally generated values of Rosetta Stone shares.) Advisors at Morgan Stanley
had shared their view that Rosetta Stone was one of only a handful of companies that currently
had a shot at a successful IPO. Senior management had been preparing the systems and
organization of the company for public company status for years. Adams saw the IPO event as
significant opportunity to establish business credibility and build the Rosetta Stone brand in a
global marketplace. His decision was to launch.
Over the following week or two, senior management and bankers visited prospective
investors on the east and west coasts of the United States and in Europe. The investor response
was highly enthusiastic, with investors commonly asking to “max out” their allocation in the deal.
By the end of the road show, Morgan Stanley reported that the book was more than 25 times
oversubscribed, meaning that the underwriters maintained orders for 25 shares for every Rosetta
Stone share being offered in the deal.
5
Adams was delighted that many investors appeared to share his vision of Rosetta Stone’s
unique capacity to play a substantial role in the global language learning market. Such a trajectory
implied revenue growth rates of 20% to 35% for some time. Other analysts were more skeptical,
predicting revenue growth of around 15% for the next five years and then tapering down to a longterm growth rate of 3% to 4%. Adams believed that the operating leverage in the organization
allowed margins to continue to improve for some time; others believed that competitive pressure
would soon drive margins down. (Exhibit 7 provides one view of how the financials were expected
to play out in the years to come.) In the debt market, Rosetta Stone faced a prevailing borrowing
rate of about 7.5%. The marginal corporate tax rate for the company was 38%. Exhibit 8 details
the current ownership structure of the company and details the new shares to be sold in the offering,
which would grow the total number of shares outstanding from 17.2 million to 20.3 million.5
Comparable multiples played an important role in the valuation of IPO firms. Exhibit 9
provides financial data on a broad set of industry comparable firms. Adams liked K12 Inc. as a
comparable match, but acknowledged that no other firm perfectly matched Rosetta Stone’s
business strategy, skill set, risk profile, or growth potential. Still, there was some debate regarding
whether Rosetta Stone would be positioned as a technology company or an educational company.
See Exhibit 5 for a link to video excerpts of Adams and Clough discussing this topic.
Please address the following discussion questions and hand in your solutions on April 25th.
Be sure to include names of all the group members in your file and each group only needs to
submit one copy.
1. What are the advantages and disadvantages of Rosetta Stone going public?
2. What are the steps of an initial public offering?
3. What is a roadshow? What is book-building?
4. Compute a valuation of Rosetta Stone using the market-multiples approach. Please
use the financial data in year 2008 and compute the price per share for Rosetta
Stone based on the Price/EPS of K12 Inc, the average Price/EPS of For-profit
Education industry, the average Price/EPS of Internet industry, and the average
Price/EPS of Software industry, respectively. (The market-multiples for
comparable firms are listed in Table 9)
5. Discuss the pros and cons of the market-multiples approach.
5
To avoid the dilution of the value of securities of pre-IPO investors, it was appropriate in pricing IPO shares to
divide the total premoney equity value of the firm by the premoney shares outstanding. In the case of Rosetta Stone,
the number of premoney shares outstanding was 17.19 million. Since the pre-IPO investors held claim on the ongoing
business, a valuation based on the ongoing business represented a premoney valuation. Valuations based on
postmoney shares required adding the value of the new IPO shares to the ongoing business valuation prior to dividing
by the postmoney shares.
6
6. Discuss and justify your recommended offer price for the Rosetta Stone IPO. That
is, recommend an offer price for this firm and try to justify your recommendation
based on your calculations in #4, the firm’s current and expected performance, the
market condition, and/or any other factors that you think are important to IPO
pricing.
Grading Rubrics:
Excellent
performance
Good performance
Acceptable
performance
Poor performance
Application of
theoretical
concepts (25%)
Team members
demonstrated a
thorough
understanding of key
concepts and were
able to apply them
all correctly
Team members
demonstrated a fairly
thorough
understanding of key
concepts and were
able to apply most of
them correctly
Team members’
understanding of key
concepts was uneven
or incomplete, so
several key concepts
were not applied
correctly
Team members
lacked an
understanding of key
concepts and were
unable to apply them
correctly
Interpretation of
financial data
and …
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