Understanding the IPO process

So you missed out on Twitter's meteoric first-day rise because the stock gapped up to $45 from the initial public offering price of $26 and you couldn't get in. With a market capitalization of ~$25 billion everybody is screaming bubble because the company is not profitable and only has $500 million in revenue. But who cares? Twitter has changed the way we communicate and you could have made a whopping 73 percent if you could have gotten some shares!

Outrage by the investment community quickly ensued about the preferential treatment institutions and wealthy individuals received in the IPO process. Phrases such as “The rich get richer” and “Shut out again” were commonplace. CNBC reported that 50 percent of the Twitter allocation went to only a handful of institutional investors despite thousands clamoring to own.

In this post I'd like to help explain the IPO process and clear up some misunderstandings along the way. To provide some background, I worked on placing over 100 IPOs to institutional shareholders during my 13 years on Wall Street. Most of my deals were international deals, but I was also present for U.S. deals such as Google way back in August 2004. It certainly seems like the good times are back again!

The Purpose of the IPO

When you go IPO you go public. You are selling a portion of your company to public investors who can buy your shares on a stock market exchange such as the NASDAQ or NYSE. Stock market exchanges make money through listing and trading fees, so the more companies that go public and the more volume that trades, the more money stock market exchanges make.

There are three main reasons why private companies go public.

1) To create liquidity for early investors and employees. An IPO is one of the biggest “liquidity events” a company can go through. We've learned from the 2000 dotcom bust that it's always a good idea to diversify your holdings. Venture capitalists, private equity investors, angel investors and senior management who've been with the company since day one would love to monetize some of their profits. It's generally a great sign if management announces to the public they won't sell any shares, so pay attention to this fact during the IPO process.

2) To raise money. An IPO generally issues primary shares (new shares) to the public. Primary shares dilute existing shareholders, but it's usually not enough to make a negative impact. Companies often use IPO proceeds for working capital, research & development, capital expenditure, and acquisitions to hopefully grow the company and make more money for shareholders. It's important to differentiate between primary shares and secondary shares. Secondary shares are existing shares owned by investors and employees who are cashing out as we discussed in point #1. Pre-IPO companies are generally limited to 500 investors total. Going IPO vastly expands the shareholder base.

3) To build reputation. Our financial system is built on reputation, otherwise everything falls apart. Going public on a reputable stock exchange such as the NYSE builds a company's reputation because the company is now subject to the scrutiny of the Securities & Exchange Commission (SEC) and Generally Accepted Accounting Principles (GAAP). With a better reputation, you can attract higher caliber employees, do business easier, and continue to raise money or cash out existing shareholders due to higher levels of trust. Nobody knows what goes on behind closed doors with private companies. A reputable public company will be filing quarterly reports and hosting conference calls with shareholders for the sake of transparency.

The Pricing Dynamics of an IPO

Not all IPOs are created equal. There are many factors that affect the pricing and after-market trading of an IPO. The main issue is the simple law of supply and demand.

1) Reputation outweighs IPO size. Everybody has heard of Twitter, but Twitter's IPO was relatively small at $2 billion. Let's say you were the fund manager of a $110 billion international fund. You could easily take down the entire $2 billion position with your own fund. But there are literally thousands of mutual funds, index funds, and hedge funds out there that all want a piece of the action. Then there are retail investors like you and me who'd like some shares too. You can easily see a situation where the IPO becomes multiple-times oversubscribed, and careful allocation deliberation must be put in place.

2) Pricing is based on existing comparables. The main way IPOs are priced is by comparing the firm's growth rate, profitability, size, and potential to existing publicly traded companies. Generally, there is an IPO discount relative to growth due to the lack of a trading track record. Investment banks that take companies public want to provide some cushion so investors don't get burned. At the same time, investment banks don't want to price the IPO too low and leave money on the table. There will be intense pricing discussions after the books have closed. Twitter could have raised $1.6 billion more dollars from investors by pricing the stock at $45 instead of at $26. But if they priced at $45, the chances are high the stock would have tanked on day one, thereby sullying the reputation of the bookrunners and the company.

3) The strength of the sector. IPOing telecom companies with little growth in this market is probably not going to receive a lot of demand. IPOing tech and Internet companies today will certainly receive a lot of interest because everybody is searching for the next Google, Apple, Facebook and so forth. I'm a proponent of investing in growth stocks if you are a younger investor due to time and your ability to recover from a downturn. Companies and bankers are opportunists who want to raise money when valuations are highest. But they also want to ensure that investors make some money as well. In a bull market, almost every single sector should increase in value. It then becomes a relative game of which sector is most in demand.

4) Allocation goes to a few blue-chip investors. The amount of the IPO is also called the float. The float is what's traded on the stock exchanges that reflects the entire value of the company. A company's public float is usually less than 30 percent. In Twitter's case, they floated about 10 percent of the company. By allocating the IPO to a handful of blue-chip investors, the hope is that they will be less inclined to flip the stock and cause volatility in the after market. Blue-chip investors are usually large mutual funds that also pay Wall Street the most money because they have the most assets to trade. You don't want to allocate the majority of shares to tiny, fast-money hedge funds that go in an out of stocks all day long. You also don't want to allocate all the shares to retail investors who are deemed less sophisticated than professional money managers either.

5) Only a small portion of an IPO gets allocated to retail investors. The only way you and I can get stock allocation in an IPO is usually through an online broker. The more assets we have with them, the higher the relative allocation. But the reality is we still won't get much allocation in an enormously oversubscribed deal such as Twitter. But we shouldn't blame big institutional investors for getting allocated the majority of the deal because such institutional investors are representing us. Hence, the main way to participate in an IPO is to buy a fund that plans to participate. For example, you may want to buy an Internet Fund if you like Internet IPOs.

The Market is Very Efficient

I urge everyone to be very cautious when trying to invest in a company that goes public within the first three months. There's no trading track record and management is almost always in the “quiet period” where they cannot say anything about their business or results to the public. Sure, you can make a bet that management will say something positive in their next quarterly earnings conference call, but it's usually best to wait before the hype or the negativity settles before making an investment.

It's a reality on Wall Street and perhaps in life that the more money you have, the more attention you will get. I'm a shareholder in Apple just like Carl Icahn is a shareholder in Apple. But Carl gets to have filet mignon with CEO Tim Cook because he owns a $2.5 billion position. I can either fight for equality, or I can join the giants by investing in the giants. Just don't forget to take profits! The good times almost never last forever.

If you have any follow-up questions on the IPO process, feel free to ask! From my last post, I received feedback from a couple individuals that I should spell out everything as much as possible, given the community is not used to investing-related posts. I'm happy to clarify any terms that you have.

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Curtis@PayOffMyRentals
6 years ago

Wonderful explanation of the IPO process.
I’ve never seen it explained so simply.

Thank you!

FI Pilgrim
FI Pilgrim
6 years ago

I agree Curtis, great post Sam! I hadn’t thought about how “relative” the IPO is to existing companies, that explains a lot.

And Sam, you’re right about us newbie investors, simple = better.

Jon @MoneySmartGuides
Jon @MoneySmartGuides
6 years ago

Great post. Every time a “hot” IPO comes around, like Twitter or Facebook, my mom is asking me if she should get in on it. I try to explain to her that being the small-time investor that she is, the odds are she isn’t going to buy in until the stock goes public. I’ll have to point her this way and hope your explanation sticks!

Financial Samurai
Financial Samurai
6 years ago

Heads up, Zuckerberg just announced he plans to sell about 41.4 million shares of Facebook work about $2.3 billion dollars. Board member Marc Andreessen will also sell 1.65 million Class A shares. J.P. Morgan, BofA Merrill Lynch, Morgan Stanley and Barclays are joint bookrunners for the offering.

These shares are SECONDARY shares (existing shares) as early investors/shareholders cash out. Smart move as the stock has doubled. Why not lock in a couple billion just in case something happens right? Zuck has a big tax bill to pay anyway.

theFIREstarter
theFIREstarter
6 years ago

Ah a well timed post Sam… 😉

I take it you still have some contacts in Wall Street then?

Thanks for the explanation. Seems like the best thing to do is just ignore the hype then?!

Matt YLBody
Matt YLBody
6 years ago

Great post about IPO’s. I’m not really a fan of IPO’s, especially for the general public as for the most part, people are small investors and the majority of the money is made for the people already holding on to shares when the company goes public. Those of us who have shares may enjoy a little moment when the stock goes public and the price rises. Anyone remember Facebook?

Financial Samurai
Financial Samurai
6 years ago
Reply to  Matt YLBody

Ignoring the news like CNBC is one of the best things you can do. When the markets are up, they’ll have bullish pundits. When markets are down, they’ll have bearish pundits. There is so much noise it’s unbelievable!

But, watching how people communicate in finance is a vital skill to learn.

Alea
Alea
6 years ago

Another great example of how being informed on how you invest your money will save you money in the long run. Since I learned how IPO’s work, I know that I am not losing out on anything, and enjoy the circus on the cable news about not being able to get one’s hands on the new “Hot IPO”.

Great article.

Ryan @ Impersonal Finance
Ryan @ Impersonal Finance
6 years ago

Thanks for explaining. I like where you warn investors not to get too excited in the next new hot IPO. So, I can take it you’re a fan of the market efficieny hypothesis? (I’m not judging, just honestly curious).

Janey
Janey
6 years ago

Very help and clear explanation of the entire process! I bet a lot of people still think it’s only about the rich getting richer, but in reality, it’s simply the size of the mutual fund that represents the people that is getting a large allocation.

Beth
Beth
6 years ago

I always wondered if I was missing out on big IPOs! Thanks for a great explanation of the process. I feel better informed.

Untemplater
Untemplater
6 years ago

Very helpful explanations and insights Sam. That’s interesting about the float. I didn’t realize that before. I’ve never tried to buy into any IPOs. I remember when people started buying a bunch of shares in a company that had a ticker that looked like Twitter’s by mistake. I bet they were kicking themselves once they realized their error. Gotta be cautious when there’s a buying frenzy.

Nate
Nate
6 years ago

Really cool, “behind the scenes look” at the IPO process Sam!!

Quick question – why is the typical public float around 30%? Why was Twitter’s float 10%? What is the logic there?

Did you have fun putting any of those international deals together? I bet it was a lot of long hours!! 🙂

Cheers,

Sam
Sam
6 years ago

Hi FIREStarter,

I’ve definitely kept in touch with a lot of my clients. It’s actually really fun to hang out with them now that there’s no business involved.

Sam

Sam
Sam
6 years ago

Hi Nate,

When you issue new shares you dilute existing shareholders. That’s generally no good bc old shareholders own less of the company. But to have a public market to trade can be a very good thing for those who want to liquidate.

Due to the desire to maintain controlling shareholder/voting rights the float will generally always be less than 50%. Can you imagine the ever whimsical public owning a major corporation and making all the rules? Chaos might ensue!

Sam

Cody
Cody
6 years ago

IPO is very interesting!

Nick
Nick
6 years ago

I missed Twitter IPO but I’m waiting for the next explosive IPO where I could make a lot of money. This post has made things clearer, thanks for sharing.

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