What is an IPO?
An Initial Public Offering is the first time a privately held company issues stock to the public.
IPOs are one of the biggest FOMOs for investors: the Fear Of Missing Out.
And fear is a dangerous emotion, where all common sense might go out of the window!
This is the Age of the Unicorn:
tech startups worth $1 billion or more, many of which want to IPO.
Your chance to ring the opening bell on the stock market, get lots of applause, and be
the focal point of the financial and business news…. for at least a day, or maybe just
half a day depending on what else is happening in the world.
An IPO is a financial journalist’s dream: a great opportunity to sell sensation and excitement!
The narrative of a Unicorn IPO usually goes something like this.
This is the story of two guys in… let’s see… a basement, a garage or a kitchen?
Basement!
That built a disruptive… let’s see… app, product, service?
App!
After… dropping out from college, getting fired, quitting big tech… and made it into
a billion $ company.
But of course this isn’t just about a new technology or making money, it really is about
making the world a better place.
It’s a long road to the IPO.
Millions of companies are started in the world every year.
They start off with the equity that the entrepreneurs put into the company themselves, and possibly
a round of “family and friends” funding.
The majority of these startups go bankrupt, and exit stage left.
Some companies get acquired very early on in their existence, and exit stage right.
Getting acquired might bring you a lot of cash if you are the entrepreneur or one of
the early shareholders, but you might wonder for the rest of your life what could have
happened if you hadn’t sold.
Many companies simply stay in the small business phase for a long time.
A few companies make it to the next round of growth: seed capital to gain traction.
Once again, a majority of the companies exit stage left through bankruptcy, others exit
stage right getting acquired, many stay in this phase for a long time, and a few make
it to the next round of growth: Series A funding.
This is where shares are offered to external investors at the point where the startup is
likely to have a product and user base.
From there, it’s onward and onward (with continued exits stage left and stage right)
through series B and series C funding.
The valuation of the company (“how much the dream is worth”) tends to go up and
up and up during this process.
An infinitely small number of startups makes it to the IPO stage, and of these, a very
small number will be a Unicorn IPO.
Many companies take five to ten years to move through these funding stages, and it then
takes an average company between six and nine months to go public via an initial public offering.
So why does a company IPO?
According to the official language that companies include in SEC registration documents, the
principal purposes of Initial Public Offerings are to increase capitalization and financial
flexibility, create a public market for the common stock, and enable access to the public
equity markets for the company and its stockholders.
Translated: the company either wants to raise money for growth, or provide an exit opportunity
for existing shareholders, or a combination of both.
So why would an investor be interested in signing up for shares in an IPO, or buying
them on the day the company gets listed?
Very simple: the hope of the share price skyrocketing on day 1, and making lots of money quick!
Who’s the sucker in an IPO?
The bigger the hype, and the more bullish the news and investor attitude, the bigger
the chance of investors wanting to buy the IPO shares at any price.
I HAVE GOT TO HAVE THESE SHARES!
What do you do if you absolutely have to have something?
You don’t care much about the price you pay.
Investors put in a “market order” instead of a “limit order”, which means they want
their buy order executed at whatever the price is.
And who knows, maybe there’s an even bigger sucker lining up behind you, who will buy
the shares you just bought at an even higher price!
In normal conditions of the stock market, there is some match between supply (which
goes up as the price goes up) and demand (which goes down as the price goes up), which leads to a price.
If there’s good news about a company,
the demand curve moves to the right, and a new price is set.
In an IPO, supply and demand work a bit differently.
The supply or availability of shares is very limited.
If the price goes up, there are not that many more shares available.
Additionally, there is not an opportunity yet to short-sell an IPO stock on day 1.
The other reason for the limited supply is that a lot of shareholders (existing and new)
have agreed to some type of lock-up,
promising not to sell any shares for a certain amount of time.
The IPO hype moves the demand curve to the right, while the supply curve is very steep.
Bang, there’s what is known as a “first day pop” of the IPO share price!
How does a company choose a target price range for the IPO?
This is where the board of the company works very closely with the underwriting banks.
An investor “roadshow” precedes the IPO, this is where potential buyers can indicate
their interest in signing up for shares in the IPO (quantity and price).
In the case of the Twitter IPO, the initial range of $17 to $20
was increased to $23 to $25, and the IPO price finally set at $26.
In the case of the Facebook IPO, the initial range of $28 to $35 was increased to a range
of $34 to $38, and the IPO price finally set at $38.
What if the company and its underwriters get it wrong, and set the price too low?
Well, they would miss out on some of the upside, sell “too low”, but remember that companies
tend to float only around 15% of total shares in the IPO anyway, so there are plenty of
shares left to sell in a secondary offering a few months later if the share price does go up.
What if they get it wrong, and set the IPO price too high?
Well, that would be painful and possibly damaging for everyone involved!
An offering is undersubscribed when the underwriter is not able to get enough interest in the
shares for sale.
If the demand is too low, the underwriter and issuer might lower the price to attract
more subscribers.
Some IPOs are oversubscribed 5 times, 10 times, even 20 times based on investor demand.
Let’s look at the first day returns on the IPO shares of some of the big name IPOs of
the past couple of years.
An example of a big day 1 gain was Twitter in its 2013 IPO.
Up 73% at the end of day 1, after peaking during the day at more than double the IPO price.
Facebook’s 2012 IPO was up just 1% at the end of day 1, after peaking at 18% above the
IPO price during the day.
The stock struggled to stay above the IPO price for most of the day, forcing underwriters
to buy back shares to support the price.
Snap closed up 44% in its 2017 IPO at the end of day 1, after being up 53% earlier in the day.
Lyft closed up 9% in its March 2019 IPO at the end of day 1, after popping to 23% immediately
at the start of trading.
Uber closed down 7% in its May 2019 IPO.
While this is by no means a representative sample of all possible IPOs in all markets,
three things jump out.
One: it’s very difficult (maybe even impossible) to time the buying or selling of shares on
a possibly volatile first day of trading.
Easy with the benefit of hindsight, but very nearly impossible in the heat of the battle.
Two: overall market sentiment, which can go from ecstatic one day to utterly depressed
the next day, or both of these during the same day, can significantly influence IPO performance.
Three: day 1 gains are possible, but certainly not guaranteed.
What about the day after the IPO, “day 2”?
Down 7% for Twitter, down 11% for Facebook,
up 11% for Snap, down 12% for Lyft, and down 10% for Uber.
Once again, not a statistically representative sample, but we can safely conclude that a
day 2 drop in share price is very well possible.
What about the longer term share price performance of these companies?
Once you are listed, you go through the quarterly and annual cycle of earnings releases and
updates on the outlook.
Twitter’s share price stayed above the $26 IPO price for a few years, then dropped below
it for a long time, and more recently recovered above the IPO price.
Facebook’s share price, to the frustration of a lot of shareholders, dropped very significantly
below the $38 IPO price, even to half of it!
From there started the great recovery, leading to a peak of over $200!
Snap’s share price was above the $17 IPO price for a while,
then dropped significantly below it.
Lyft’s share price had a long way down in the months after the IPO, and so did Uber.
In short: it can go either way medium or long term,
just like any other share price in the stock markets.
How can I make more informed bets as a potential IPO shareholder?
Inform thyself and use caution!
Do the same as an airline pilot who makes a round of inspection prior to the flight.
To quote Nassim Taleb: When you have skin in the game, dull things like checking the
safety of the aircraft because you may be forced to be a passenger in it, ceases to be boring.
Or in the case of investing: If you are an investor in a company, reading the footnotes
of a financial statement (where the real information is to be found),
becomes, well, almost not boring.
People are much less interested in what you are trying to show them than in what you are
trying to hide.
Information about an IPO is found in the S-1 registration statement that companies file
with the SEC as part of the IPO process.
Or even better: make sure you get the latest amended version, as this S-1 gets updated
with new information along the way to the IPO date.
These documents can be 200 to 300 pages in length, but possibly even 600 to 800 pages.
If you plan to put any significant amounts of money into IPO shares, it’s worth having a look!
In the Table Of Contents of the S-1 document, I tend to start with the prospectus summary
to get a high level understanding.
My next step is to review the section on dilution, which tells you how many shares already exist
and how many are offered in the IPO.
In this example, 475 million shares already exist in the company, which were bought over
the various funding rounds by investors for an average price of $2.21.
These investors arrived early, took a lot of risk, and are potentially looking at a big gain.
70 million new shares are to be issued in the IPO, at $24 each,
which represents 13% of the total shares outstanding.
From there, I move to the consolidated financial data (pro forma income statement, balance
sheet, cash flow statement), which tends to be limited and in some cases unaudited, and
the rest of my reading journey unfolds based on whatever I find in the financial statements,
just like I would do when reading an annual report.
The metrics used in IPOs tend to be colorful and unusual, and mostly non-GAAP.
The more exotic your metrics, the more tech you are? Maybe.
In tech companies, DAUs, Daily Active Users, and especially the growth in this number, are key.
A variation on DAUs is MAPCs, Monthly Active Platform Consumers.
These users generate revenue, measured as ARPU: Average Revenue Per Customer.
From here, it gets more financial.
Common non-GAAP metrics like Free Cash Flow and EBITDA are used often.
Or even more exotically non-GAAP: Adjusted EBITDA, Adjusted EBITDA before Growth Investments,
or Community Adjusted EBITDA.
I am not even going to try explaining these here, but make sure you read carefully how
these are defined and calculated, how they are trending over the years, and figure out
why the company thinks this is a relevant metric to share with investors.
Besides doing some reading of the IPO registration documents yourself, find some critical views
of financial journalists to help you see things in perspective.
The Financial Times tends to publish articles after reviewing the IPO prospectus,
and so does Fortune.
If you prefer to watch rather than read, CNBC summarizes their findings in videos.
Financial journalists sometimes uncover governance issues like conflicts of interest, complicated
corporate structures, or other red flags that tell prospective investors to treat the IPO
with caution.
You can go one step beyond this, to get to true independence without political correctness.
Here’s a few parts from a cynical review of a website commenter summarizing his personal
interpretation of an IPO prospectus.
We don’t make money.
We probably will never make money.
We have annoyed lots of regulators so we have lots of disputes and problems with regulators.
We don’t pay much tax and have done lots of aggressive tax planning.
We are really big and you have heard of us plus we say we are a tech disruptor so don’t
worry that we make no money it will all be great because you will be an investor.
Obviously, Unicorn Inc has a very different view of the future.
Historically, revenue has doubled and doubled, while losses also accelerated.
But once the IPO is done, sunshine and bright skies are ahead: revenue is forecast to continue
to grow, and as a result of that losses are forecast to dry up and the company will turn profitable.
Up to you to decide what to believe, and whether you want to take action buying IPO shares.
For me personally, I very rarely sign up for IPO shares, and tend to avoid the IPO rollercoaster.
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