We’ve talked about the risks of investing in private companies. Now let’s talk about investing in IPOs and how the IPO process works.
Taking private companies public was a big part of my job when I worked in the Equities department at a couple major banks for 13 years. Knowledge is wealth and I’m here to share my first-hand experience about the IPO process to help make you a better investor.
THE IPO PROCESS
IPO stands for Initial Public Offering, a process where private companies register with the SEC to usually sell anywhere from 5% up to 20% of their company in the form of new shares (primary) to public investors. Once the company goes public, its shares will trade on the NYSE, NASDAQ, or AMEX.
The main investors of IPOs are large mutual funds, index funds, and hedge funds. If retail investors wanted to participate in a hot IPO, they usually couldn’t, unless they bought the fund which bought the IPO. Or, the retail investor would have to wait until after the shares started trading, often times missing out on the “IPO pop.”
Over the years, more and more online brokerages offer IPO shares to their customers, but the allocations are still usually quite small.
Why would a company want to IPO?
- Raise more capital for growth.
- Liquify shareholders (cash out early investors, senior management, rank and file employee).
- To gain more publicity and prestige in order to attract more business and talent.
Because of easy access to private capital and rigorous regulation once public, over the last decade, many private companies have delayed going public. After the Enron and WorldCom scandals, Congress in 2002 gave us Sarbanes-Oxley, a federal law that set new, higher standards for publicly traded companies. As a private company, you have much more freedom to do what you want.
Why would an investment bank want to take a company public?
- Fees. Investment banks usually earn fees of 4 percent to 5 percent on IPOs of more than $1 billion, but deals from Silicon Valley tend to carry a premium. U.S. tech IPOs of at least $1 billion carried an average fee of 5.8 percent from 2000 to 2012, on average, according to Thomson Reuters data. Although Facebook was able to get investment banks to charge only 1.1%. That still amounted to $176 million in fees for the syndicate.
- Prestige. If you’re able to be the lead underwriter of the Google, Facebook, GM, or Alibaba IPO, you will win a lot of prestige and gain a lot of future business, especially if the deal goes well.
- To make both management and investors happy. If an investment bank prices a deal too low, they end up not raising an optimum amount of money from the public for the company. If an investment bank prices a deal too high, they risk losing their institutional investors money and getting egg on the faces of management. The perfectly orchestrated IPO is one in which a maximum amount of money is raised for the company, while showing a first day gain of ~5%-10%, while never breaking issue price for as long as the stock is publicly traded.
I remember working on the syndicate with my US colleagues during Google’s IPO back in 2004. We took the company public at a $23 billion market cap after raising $1.9 billion. Meanwhile, Facebook went public in 2012 at a $100 billion market cap after raising $16 billion.
Private companies are going public later due to all the private money sloshing around. But, there is still an IPO advantage if you can get in at the IPO price versus after the stock starts trading.
See the chart below that shows the performance difference if you were to buy at IPO price versus buy after the shares started trading.
WHAT TO WATCH OUT FOR IN AN IPO
1) No public operating history. Management has certainly been coached by bankers to under-promise and over-deliver on company quarterly earnings, but you just don’t know for sure how it will perform. You can read as much of the prospectus as you want. All the financial data is from the past. Wall Street analysts themselves are guessing the company’s future revenue, operating profit, and cash flow.
2) The amount of secondary shares being sold. Secondary shares are existing shares that are held by management, employees, and investors. If the company is selling a large percentage of secondary shares, this means they are cashing out at the participating pubic investor’s expense. It’s a good sign if management do not sell any shares because that signals to investors management’s long term belief in the company.
3) The lockup period duration before insiders can sell. Insiders might not sell any shares during the day of the IPO, but they might dump a boatload of stock the very first chance they get. The longer the lockup period, the better. Standard lockup duration for insiders is usually 6 – 12 months post IPO. The reality is that during any IPO, there is generally a mix between primary (new) shares and secondary (existing shares). Most of the shares offered are primary shares.
4) Any re-filing of information. Once a company’s registration statement (IPO document) is filed with the SEC, there are all sorts of rules as to what the company can or cannot say to the public during “quiet period.” All that can be said should be in the prospectus, so that investors have equal information. In 2004, Google had to delay its IPO due to an interview its founders gave to Playboy during the quiet period. There was also a snafu in 2011 when Anthony Mason, CEO of Groupon sent a charged up e-mail to employees about the IPO process which the press got hold of and disseminated it to the public during quiet period. It’s best to read the prospectus in the beginning and towards the end of the IPO because things might have changed.
5) The level of demand. The bookrunners, aka the investment banks managing the IPO, get to see with absolute clarity who is coming in, and how much demand there is for the IPO. If there is $10B in demand for a $1B IPO, then the book is 10X oversubscribed. Institutional investors know this, because they talk to their investment bank account manager who provides as much color as possible to help them make an appropriate sized investment. Books that are just covered, tend to almost always disappoint on the initial day of trading by trading sideways or down. Books that are multiple times covered have a higher chance of popping on the first days of trading, but even then, there’s no guarantee.
RETAIL INVESTOR VS INSTITUTIONAL INVESTOR
The retail investor tends to be much less diligent in analyzing an IPO before purchase. For example, a common retail investor practice is to say, “Hey! I’ve heard of GoPro and use the product. Of course I’ll buy!”
The institutional investor’s research process is much more rigorous. Here’s what generally happens:
- The institutional investor (e.g. Fidelity) will have an industry analyst (buy-side analyst) who looks at similar companies to invest in all day long take a meeting or call with the syndicate bank research analyst covering the IPO company (sell-side analyst) to go through their investment thesis, pitfalls, and financial forecasts.
- The buy-side analyst will then try to get a 1X1 meeting or conference call with the management of the IPO company when they are on the road. They will at least go to a roadshow breakfast or group lunch hosted by the lead bankers to hear management elaborate its business strategy. They should also be able to ask some questions at the end.
- The buy-side analyst will probably then cross check his/her model with the sell-side analysts on the deal once more. There are sometimes different messages conveyed by the management and the sell-side analyst that need clarification.
- Once the buy-side analyst feels comfortable with the company, s/he will make a pitch to the portfolio manager who will grill the analyst. It is the portfolio manager who ultimately makes the decision to participate or pass on the IPO.
- If a decision is made to participate by the institutional client, it is almost always the case during a hot IPO that there needs to be a rationing of shares. In other words, if a fund manager wants a $100 million allocation and the IPO is 10X oversubscribed, then all things being equal, the institutional client might only get a $10 million allocation. In other words, if institutional clients are getting scaled back, what hope do retail investors have of getting IPO shares?
BUYING AN IPO IS NOT A GUARANTEED RETURN
There are many examples of where buying shares at IPO price hasn’t turned out great. Etsy, an e-commerce platform for homemade goods, priced its IPO at $16 in April 2015. The stock is now down to $10, a 55%+ decline in six months after they missed results.
Then there are success stories such as Shake Shack, which JPMorgan priced at $21 (above the initial range of $17 – $19), which is still 140% higher today at ~$48. At one point, the stock was actually trading at $92 / share. And of course there’s Facebook, which went out at $38 in 2012 and is now trading at over $100.
It’s important to realize that during every round of fund raising (Seed, Series A, Series B, Series C, Series E, Series F, Series E, etc.. IPO), the general trend is to raise at a higher and higher valuation to more than offset the dilution. Sometimes there is a down round (raise at a lower valuation), but for the most part, by the time a private company goes public, the public investor is getting to invest in the company usually at the highest valuation in the company’s history. Therefore, it’s always a good idea to really do your due diligence before investing in an unproven public company.
Read the prospectus, watch any roadshow presentations, and listen into analyst calls. You’ve got to compare the financials and growth rates of the IPO company vs. the existing publicly traded companies. Even then, investing in an IPO is a leap of faith because you don’t know exactly what management will do once they start to report earnings.
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Updated for 2020. The IPO market is heating up with the listings of giants such as Uber and Airbnb.