Stake Academy - IPOs
One of the most exciting events of any markets calendar is IPO day. Let's look into what goes on before the iconic ringing of the bell.
One of the most exciting events of any markets calendar is IPO day. Years of hard work and growth are rewarded with the ceremonial ringing of the bell and life as a public company begins. Companies we’ve known and loved from their earliest days can now secure a place in your portfolio.
Why IPO in the first place?
Show me the money
IPOs offer companies access to new capital.
In the past, companies IPO’d when they reached profitability. At the time, the market valued stability and the prospect of dividends.
Now, a listing can be a growth engine; a chance to raise money, build a large marketing and product budget and continue the quest to take over the world. In 2009, 81% of companies were profitable following their IPO. In 2020, just 22% of companies were posting green figures. The market is more comfortable owning companies that aren’t guaranteed to deliver a profit or a dividend in the immediate future
Private companies may be valuable, but cashing out is a difficult exercise. Shareholders are unable to easily sell their holdings and realise gains. An IPO gives holders access to the secondary market. Their shares can be exchanged for cash and their success can be realised in a more secure asset.
Be aware that many insiders are subject to mandated holding periods. To avoid executives offloading millions of dollars of shares on the listing day and suppressing the stock price, often insiders are required to hold their stock for months or years before selling.
There are also secondary, derivative benefits to being a listed company. The media coverage and publicity listed companies receive compounds act as a marketing exercise. Tesla is an extreme example but consider the attention Tesla as a brand has received due to the stock’s performance.
Moreover, public companies have an easier time accessing debt at a lower interest rate.
Let’s now get into the specifics. How does a company go from private to public? There are typically 2 paths a company can take: the traditional bank under-written IPO or the more recently popular direct listing. Reverse mergers and SPACs are an alternative method that will be covered in a separate Stake Academy article.
A company looking to go public will approach an investment bank to underwrite the process. What does this mean?
Part of a traditional IPO involves issuing new shares. An investment bank like Goldman Sachs or JP Morgan will work with the listing company to determine a fair value for these shares and the company. The bank then buys some or all of the new shares straight up from the listing company. They then sell those shares on to their network of funds, banks and high net worth individuals all for a cut. The listing company receives the benefit of cash upfront without the resource-intensive process of selling shares to scores of different buyers.
Then the big day comes. Once shares have been allocated, the company begins trading. The bank will offer an allotment of shares to the public market and trading commences. The underlying, predetermined price and valuation tends to bring stability to the stock but we have seen trading prices deviate greatly from initial underwritten valuations often in the past.
For example, Coinbase shares were priced at US$250 each before it listed in April. It began trading at US$328 on IPO day, well above the price institutions had access to.
Individual investors are often priced out of appealing listings which makes alternatives like a direct listing appealing.
A recent trend, some of the biggest names in the market from Spotify to Panatir have opted to go public via direct listing.
The company forgoes the underwriting process and insiders are able to sell shares directly to the public market. The stock price and value of a company are entirely determined by market supply and demand. Existing insider shareholders can sell their shares at a price they calculate as fair while traders and investors determine their bid price. The stock initially trades where the bid and the ask meet. Such a process risks extreme volatility as the market determines a fair price.
Of course, while a less resource-intensive process, direct listings do not allow companies to sell new shares and raise money. The NYSE is working on new hybrid listings which allow companies to raise capital while also listing directly.