A Successful IPO Means Your Stock Price Goes Down.
There is a lot of misunderstanding about the IPO process and the desired result. The conventional “wisdom” is that a successful IPO means the company’s stock price increases dramatically on the first day of trading. As with most things, where you sit is where you stand. From Wall Street’s perspective this may be true, but from the CEO and company’s perspective this is dead wrong.
The single most important goal of the IPO for the company is to raise cash. The higher the price it can sell its stock (assuming the same number of shares are sold), the more cash the company receives. Once the company goes public it cannot regularly issue more shares without putting downward pressure on its valuation. As a result, correctly pricing the IPO is vitally important to the company in its early stages.
Because most founders and most private company CEOs have never worked on Wall Street, they have no experience with the IPO process. Headlines from all of the major news outlets incorrectly instruct them the stock must go up on the IPO date or the IPO (and by extension their company) is a “failure.” They are inclined to follow this guidance, resulting in millions of dollars of lost value for their companies.
The CEO’s job is to maximize value capture to the company and its shareholders. Once the company is publicly traded, that means increasing the company’s valuation, as reflected in a rising stock price. For this reason, most executives are compensated with stock grants and options to align their actions and reward with investors.
The IPO is different. The IPO is one of the few times when the company sells shares for its own benefit. During this rare and very short event the ideal outcome after the sale is for the stock price to trade even or decline during the first days and weeks of trading. Why? Because this is the strongest indication that the CEO and the company have maximized their value capture in the IPO.
To understand this further we will first look more closely at the IPO process. Then we will examine two recent IPOs, Zoom and Uber, and then Facebook’s IPO to evaluate their performance from the company’s lens.
The IPO Process (In Brief)
The IPO process has essentially four key actors: the company (its executives, employees and investors); the syndicate; outside institutional investors; and the broader public (Exhibit 1).
Exhibit 1: IPO Process And Actors
When a company wants to sell its shares to the public it engages an investment bank to act as a managing underwriter. To mitigate risk, the manager will typically form a syndicate comprised of other experienced investment banks. Over the next few months, syndicate leaders and company executives will meet with institutional investors to discuss the company’s results and projections, and receive feedback on the company’s valuation. Based on that feedback, the company and the syndicate will develop an initial public offering (IPO) price range, and then set the IPO price the day before the offering. The IPO price multiplied by the number of shares sold (less fees and other compensation to the underwriters) is the cash received by the company.
The shares the company sells are not sold to the public directly but primarily to institutional investors and other privileged parties who have relationships with the banks in the syndicate and the broader selling group. These investors pay the IPO Price. When the stock begins to trade, the balance of supply and demand determines the Opening Price. The balance of supply and demand over the course of the day determines the stock’s Closing Price that day and going forward.
Thus, there are two key points of value capture in the process: (1) the sale of the shares by the company at the IPO price (“Value Capture 1"); and (2) the sale of shares by institutional investors to the broader market (“Value Capture 2”).
It should be obvious that the company’s CEO should seek to maximize the value the business receives from the IPO, i.e., Value Capture 1, which means maximizing the IPO price at which all shares in the offering can be sold. At the offering date, the company has no vested interest in the secondary market and receives no financial benefit from an increase in stock price immediately after the sale.
In contrast, it is in the best interest of the market makers, i.e., the syndicate and institutional investors, to seek a lower IPO price. From the syndicate’s perspective a lower IPO price reduces risk by ensuring that all of the shares are sold. For institutional investors, a lower IPO price creates an immediate profit opportunity by building a “value gap” into the offering, i.e., the difference between the IPO price and the anticipated opening price, Value Capture 2 in Exhibit 1. Thus, both market makers have an aligned interest in setting a lower IPO price.
Accordingly, one simple way to view the IPO process is as a competitive negotiation between the company and the market makers to capture value. On one side sits a CEO and his board who may have limited experience steering a company through an initial public offering. On the other side sits 227 years of institutional knowledge about the sale and purchase of equities (The NYSE was founded in 1792).
Who will “win” in this asymmetrical “game,” and how do we know?
The stock’s closing price is the best immediate indicator of the “winner.” If the stock doubles the first day of trading, a huge amount of value is captured by unaffiliated investors and correspondingly lost by the company. If the stock closes even with or below its offering price, the company has maximized its value capture. After the IPO, the company, the market makers and the broader public market (except for short sellers) are all aligned in pursuing an increasing stock price. Before the IPO they are not.
Let’s consider two recent IPOs — Zoom and Uber — in this context.
Zoom (ZM) IPO (April 18, 2019)
By the media’s account, Zoom’s IPO on April 19th was an unmitigated success. Forbes declared that “Zoom’s IPO wowed Wall Street,” called it the “standout deal” of the year, and supported its assertions with the usual adrenaline-infused language: Zoom “launched its offering and the stock rocketed by 72% on its first day of trading.”
Let’s take a closer look.
In its IPO Zoom offered 9.9 million of its shares at a price of $36 per share. Zoom therefore raised $357 million in gross proceeds (Exhibit 2). The stock proceeded to soar in the secondary market, closing at $62. At that price those same shares represented a value of $615 million. Who captured that additional value? Not Zoom. It was captured by unaffiliated outside investors. These investors did not contribute one penny to Zoom’s business or success, yet captured nearly $258 million of value within hours of its public offering. This is cash that should be in the company’s bank account to grow the business. Instead, it’s going toward a banker’s new G650.
Exhibit 2: Zoom IPO Value Capture
Zoom’s venture investors were similarly impacted by the mis-pricing. They sold approximately 11 million shares in the IPO (over 1 million more than the company itself). Like the company, they also received the IPO price, generating $394 million in cash. At the end of the day these shares were worth $679 million. Outside investors captured another $285 million in value from this mis-priced trade.
In summary, the large pricing gap between Zoom’s IPO price — reflecting its incorrect perception of market value — and its closing price — reflecting the actual market value — cost Zoom and its investors $543 million in value ($258MM + $285MM). For whom exactly was the IPO a success?
Uber (UBER) IPO (May 10, 2019)
The perception of Uber’s debut on Friday was the exact opposite. On Saturday, Fortune declared “Uber Is One of the Worst Performing IPOs Ever” above a picture of a glum-looking Mr. Khosrowshahi. Gizmodo’s headline was even more dire: “Congratulations to Uber, the Worst Performing IPO in U.S. Stock Market History.” Bloomberg’s headline on Monday evening was: “Uber’s Losses Reach Double Digital in IPO Debut Debacle.”
Yowzer.
In its IPO Uber sold 180 million of its shares at a price of $45 per share. Uber therefore raised $8.1 billion in gross proceeds (Exhibit 3). Uber’s first trade executed at $42.00 and the stock finished the day at $41.57, a decrease of 7.6%. At close these same shares were worth $7.48 billion. The fact that outside investors lost $620 million in value on the first day should be of no concern to Uber or its CEO because this has no bearing on the company and no bearing on those investor’s total future return.
Despite the headlines, and provided Uber’s stock price trends even or down for the few weeks or so, one can reasonably conclude that unlike Zoom, Uber maximized its value capture during the IPO. It has an incremental $8.1 billion in cash in the bank (less fees) and outside investors did not generate huge profits by underpricing the IPO. Well done Mr. Khosrowshahi.
Exhibit 3: Uber IPO Value Capture
Facebook IPO (May 18, 2012)
The nice thing about looking back on the Faceook IPO is that it provides a longer-term perspective. Facebook’s IPO was the most anticipated public offering in the technology sector since Google when public in 2004 (Disclosure: I covered Google in 2004 and 2005 when I worked on Wall Street). Demand for Facebook’s stock was so high that the company increased both the range of its share price (from $28-$35 to $34-$38) and number of shares it planned to sell (by 25%) just days before the IPO. These last minute decisions increased the company’s cash receipts an astounding $5 billion (+51%) versus the original plan.
What happened?
The IPO price was $38 and the stock opened at $42.05. It then trended down, finishing at $38.23, nearly identical to the IPO price. In contrast to Uber, the IPO was not summarily declared a failure. Over the next weeks and months, Facebook’s valuation compression continued, with the stock troughing in mid-October under $20, a decrease of over 52% versus the open (Exhibit 4).
Exhibit 4: Facebook IPO Performance (5/18/12–10/12/12)
And since then?
Despite recent troubles, Facebook has outperformed the broader NASDAQ exchange by approximately 200% (Exhibit 5). Many of Facebook’s initial employees — all of Facebook’s early investors — have made hundreds of millions (and in some cases billions) from the company’s success.
Exhibit 5: Facebook Relative Stock Performance (5/18/12–5/10/19)
The point is the initial public offering is exactly that, an initial public offering. Correctly pricing the IPO is about raising cash for the business, and has no bearing on the long-term success of the company (except to the extent that gross mis-pricing provides insight on the likelihood of future poor decision-making by the company’s leadership). On this metric Uber performed very well, maximizing the cash it received, regardless of the press coverage. In any event, neither Uber’s nor Zoom’s IPO have any bearing on their future success or long-term forward returns.
In Summary
The CEO’s goal is to maximize returns for shareholders. The vast majority of time this is consistent with pursuing an increasing stock price. The IPO creates a different dynamic, because the company itself receives the proceeds from a higher sale price. During an IPO, the CEO and company’s goal is to maximize cash receipts for the company. The best indication of the company’s success in that effort is a stable to decreasing stock price following the IPO. Under-pricing the IPO shifts value away from the business to unaffiliated third parties. Finally, there are alternative mechanisms for setting the IPO price that private companies should leverage to mitigate the experience and leverage asymmetry between their CEOs and Wall Street’s market makers.
Richard Keiser is the founder and CEO of Common Energy, a software platform that connects the public and businesses to lower cost clean energy. Prior to founding Common Energy, Mr. Keiser led the Technology Strategy Group for Sanford C. Bernstein in New York. Mr. Keiser’s research has been featured in the Wall Street Journal, The Financial Times, Forbes, and energy publications around the world. He is a graduate of MIT.
