The Idiocy Of The IPO Price Pop

Posted by Michael Kitces on Wednesday, November 13th, 6:07 am, 2013 in Investments

With the rise of social media companies in recent years, there's been a rise of social media company IPOs, creating a frenzy almost on par with some tech company IPOs of the late 1990s, especially for big, high-profile companies like Facebook and more recently, Twitter.

Yet along the way, it seems that we've lost perspective of what constitutes a "successful" IPO in the first place; while Twitter has been hailed as a success, with its whopping 73% pop in its IPO, while Facebook was viewed rather negatively, as the company struggled to even hold its IPO price in the open markets, the reality is that from the perspective of the companies themselves, arguably Facebook was the success and Twitter marks Wall Street at its worst. After all, think about it from the perspective of the company - if you were selling a portion of your business to raise capital, you want to see your portion of the sale occur at the best price possible, not at an lower price that limits the benefit for the company and maximizes the short-term profit for those lucky enough to get their hands on an "underpriced" IPO!

While the reality is that some price "pop" on the day of an IPO is healthy, inasmuch as it alleviates fears of IPO buyers and makes them more comfortable to take on the risky unknown that is IPO pre-commitment of share purchases. Nonetheless, the fact remains that expecting a pop as big as the one Twitter saw may be more notable for the amount of money Twitter left on the table - money that the company won't be able to use towards justifying the market capitalization that has now been established. And from the individual investor's perspective, arguably buying IPO shares on the open market when they start trading - the practical reality for most retail investors who don't have access to direct IPO shares - represents the worst of both worlds, simultaneously paying the maximum price for the shares, and investing in a company that doesn't even get the full benefit of its own IPO value. So perhaps its time to stop celebrating the idiocy of the big IPO price pop, something that benefits neither the retail investor, nor the company they're buying!

The inspiration for today's blog post was the recent Twitter IPO, which has generally been hailed a "success" because the price popped a whopping 73% from its offer price at $26 to its open on November 7th at $45.10 (before rising as high as $50.09 and closing at $44.90). By contrast, Facebook was generally viewed as a dismal IPO, with an initial offering priced at $38, which opened at $42.05 on the morning of May 18th, 2012, and closed at $38.23 at the end of the day, but only after what was rumored to be a significant amount of buying by the underwriters to defend the $38 price (and in the months that followed, Facebook declined as low as $17/share before rebounding all the way back above the original IPO price a few months ago).

Yet while the stunning price pop of Twitter was almost reminiscent of the big price jumps witnessed in the era of the tech-booming 1990s, it's rather astonishing to recognize that from the perspective of the company itself, the reality is that the Facebook IPO was actually a success, while Twitter's IPO should arguably be viewed a dismal failure that cost the company dearly.

Understanding The Mechanics Of An IPO

To see why the Facebook IPO was a success for the company, and the Twitter IPO was a failure, it may be helpful to view the IPO in an analogous context more familiar to most: a piece of real estate.

So let's imagine that you own a nice piece of undeveloped land, free and clear. This piece of real estate is located near a key part of town that will soon go through massive development, which is anticipated to make it significantly more valuable; while today the undeveloped land might only sell for $100,000, you figure that properly developed it could be worth $4,000,000 in a few years and $10,000,000 by the end of the decade! Unfortunately, though, properly developing the land with new zoning permits, committing to nearby infrastructure, and more, could cost $1,000,000, which you don't have, and the bank isn't exactly about to lend $1,000,000 against a piece of real estate that so far, is only a $100,000 piece of undeveloped land.

Accordingly, you realize that if you really wants to make some money building up and developing the property, you needs a partner - someone who can bring cash capital to the table to fund the necessary improvements, in exchange for which you will give up a portion of the equity in the property. While the bank wasn't willing to lend as much as desired, you figure that by putting some equity value on the table, a more aggressive investor who sees the opportunity and potential would be willing to part with some hard-earned cash in exchange for an equity stake.

Stage 1. Pricing the Offering.

You guesstimate that if you offer a 50% interest in the real estate in exchange for $1,000,000 of cash, you can get the money needed to develop, and the investor will still have plenty of upside with a 50% interest that could be worth 50% of $4,000,000 in a few years and 50% of $10,000,000 by the end of the decade. There's still a lot of risk to the deal - more than the bank loan officer is willing to take - but the promising potential is good enough to attract a wealthy speculator or few who's willing to bet on the future growth potential.

Unfortunately, you don't know any such millionaires, so you engage a (real estate) broker to help facilitate the transaction. The broker goes out and after gauging interest, tells you that yes, indeed, there are several investors who would be interested in having a piece of this deal, and that he thinks he can get 10 investors to buy a $100,000 share each in exchange for 5% interests. In fact, rumors are that the city may make an announcement of the new development plans soon, so the broker indicates that the shares could probably be sold for $110,000 each! Absolutely thrilled, you tell the broker to go ahead and pull the trigger on the deal. The broker makes it happen.

Stage 2. Selling the Offering.

At this point, all seems good. You have put forth a "public offering" of 50% of your real estate development opportunity, and received $1.1M in cash for a 50% interest in your land that was previously worth very little. You now have the cash available to grow and develop your real estate project (in fact, $100,000 more than you had originally wanted!), which you can reinvest to make both yourself and the investors much richer in the long run (at least so you hopes if the development goes well!).

And in the meantime, you realizes that since you still have your own 50% stake, that presumably means your share is now worth about $1.1M now, too (valuing the total project at about $2.2M)!

Stage 3. Post-Offering Buying & Selling.

A few days later, though, the broker gives you some additional "interesting" news. It turns out that a few of the investors have already sold their shares to subsequent investors, and that the going rate is now about $200,000 for each 5% stake. "Great news!" says the broker, "now your net worth isn't just $1.1M for your 50% stake, it's $2M! What a success!"

While it's true that the post-offering trading at a higher price means your remaining shares will make you even wealthier than you had anticipated, the astute reader will realize that there's a problem here. Remember that your original goal was to raise $1,000,000 of cash to develop the property. If the reality is that those 5% shares could have been sold for $200,000 each instead of only $110,000 each, then you actually only needed to sell 25% of your ownership to raise the capital you needed, not 50%! In other words, you might be happy you're worth $2M, but if you really knew that the sales would go so well, you could have kept more. You should be worth $3M!

Or alternatively, given that you had already committed to sell 50% of the real estate, if the broker had let you know that the shares were going to be selling for $200,000, you should have received $2,000,000 of cash back for the initial offering, not a "mere" $1.1M! This could have meant far more cash to do some additional development on the real estate, that might have even led to more growth potential. Or alternatively, maybe you could have just taken a little of the extra cash and paid off some of your other bills, or even allocated a bit of it to his other financial planning goals. If only you had "known" that the shares were going to sell for $200,000 each in the first place!

The Psychology And Shenanigans of Pricing An IPO

A bit frustrated, then, you go back to the broker and ask "why is it that my investors are flipping their shares for 81% more than the price I sold them? If you're such a great broker, why didn't you price my shares at $190,000 in the first place?"

"Ahh, I see your confusion," the broker responds. "I had to price the shares a little conservatively. After all, it's hard to know who's really going to come to the table to buy when the moment comes. As you may recall, you originally had said you wanted to sell the shares for $100,000, but I had an inkling that people might be willing to pay a little more, so that's why I priced them at $110,000 for you! Remember, that means I brought you an extra $100,000 of cash when I sold all of your offering for $1.1M instead of the original $1M you asked!"

"Yeah, but couldn't you have priced the shares a little higher?" you say. "I appreciate you sold the shares for $110,000 instead of $100,000, but now they're trading at $200,000! Did the pricing really have to be that low?"

"Well," the broker responds again, "I have to confess, some of the people who were interested in buying your shares aren't exactly long-term investors. You know, some people have money to invest, but they just have a shorter time horizon! But since you had a very specific time horizon to raise capital, I wanted to be certain your IPO went off without a hitch! So I wanted to price low enough to make sure that we'd have enough investors in total to clear out all of your shares, even if a few of them were just looking for a quick return."

"Wait a sec," you retort now, "So you're saying you basically knew and all-but-promised some of these investors that they would make money immediately off my shares, just to get them to participate? Who exactly were these 'lucky' individuals who got the sure-thing bet on the shares I was selling?"

"I'd prefer not to give you the details on that," replied the broker somewhat more defensively. "Let's just say that they are some investors with whom I do a lot of deals, and their consistency helps to ensure everything goes smoothly. Yes, perhaps there were a few of my key clients in there who give me a lot of business in return. But you know, the unfortunate reality is that there's a lot of give-and-take in the investment business. Sometimes they give me a nice opportunity on something, and sometimes I have to give them a good deal to maintain the relationship."

"But that makes no sense!" you say, increasingly frustrated. "If you knew they could flip my shares to someone else who would pay more, why didn't you just sell my IPO shares at a higher price in the first place to whoever was willing to pay more? If you knew they could get a higher price - to induce them to participate - why didn't you just give me the higher price!? Aren't I your client, too?"

"Well," said the broker, "the truth is that a lot of the subsequent buyers are pretty short-term investors as well. We've found over time that if they don't think the shares are really 'hot', they don't necessarily buy them from my investors, and if my investors don't think they can re-sell the shares, they won't buy them either, and then you'll have no one to sell to! Solely relying on long-term investors is a risky business in today's market!"

"I guess, but now this almost seems overhyped," responded the client. "I was only projecting this deal to be worth $4,000,000 in a couple of years after all the development. It seems like all those secondary buyers at $200,000 have no real chance to make any money for years now! Maybe I could have justified this price if I had all $2,000,000 of cash to work with to develop the real estate, but I'm just not certain it's feasible when I only got $1.1M. With this outcome, I feel like I got screwed, the investors who own the shares now are going to get screwed, and the only people who made money are you and your 'friends' who got to flip my IPO shares for an easy $900,000 profit!"

Viewing IPOs In The Real World

Of course, in the real world IPOs are for companies in a wide range of businesses, not just real estate and undeveloped land, and I have glossed over some of the technical details and mechanics of how an IPO pricing really works (for a more detailed explanation of the Twitter IPO pricing, check out this article). But the underlying principles remain the same; an IPO represents a situation where a company chooses to sell a portion of itself (its equity) to outside investors to raise capital for various business purposes. While the ultimate price of the shares determines the overall value of the company, and sets a price point for the remaining shares still held by the original owners, it doesn't change the fact that the difference between the IPO share price and the subsequent price of the shares in the secondary market represents economic value lost to the company, and economic value the 'final' investor does not enjoy either - it's value harvested by those investors and institutions who receive the opportunity to grab a share at IPO price and flip it immediately thereafter, at a price that makes them an immediate profit and poses far less chance of a return for the subsequent buyer anytime soon.

Ironically then, while the Facebook IPO was highly criticized because its value declined after its IPO, and many subsequent buyers lost money, from the company's perspective the Facebook IPO was a fantastic success. They raised capital for their company by selling it for a fantastic price, putting a large amount of cash on their balance sheet to use to advance the goals of the company. Arguably - if its subsequent share price performance in the months that followed is any judge - Facebook actually got more than they should have for their IPO shares at the time, and the company has only just recently managed to regain its prior IPO value with subsequent growth. While that's produced colorful headlines regarding the net worth of Mark Zuckerberg and the remaining shares he owns, it doesn't change the fact that Facebook raised a whopping $18.4 billion of cash with its IPO, while doing the IPO at its nadir of about $17/share would have netted it only about $8.2 billion. Score one for Facebook.

In the case of the Twitter IPO, the numbers were smaller. The Twitter only raised about $1.8 billion in the first place, barely a tenth of the size of the Facebook IPO. Nonetheless, at a $45/share market price, the IPO "should have" raised about $3.1 billion of cash for the company. In other words, Twitter never saw that last $1.3 billion of value (or as much as $1.6B at Twitter's $50/share peak); sure, the shares the founders still own have enjoyed that appreciation (if they can even sell them righ tnow), but the company itself didn't get any benefit for it... they just left over $1 billion on the table. Nor do the investors who now own those Twitter IPO shares enjoy the benefit; those who bought on the public markets at the publicly traded price have to see the company appreciate from here to benefit, and without Twitter being able to use the extra $1.3B of cash to help itself and its current shareholders! Instead, the only people who benefit for the "missing" $1.3B are those who were lucky enough to get their hands on the IPO shares themselves directly in the offering - a benefit that, sadly, the investment banks tend to steer disproportionately to institutional (and perhaps some other "key" clients), far more than the typical retail investor (which is justified as promoting market stability and to protect retail investors, though it's hard to see how if it just means retail investors buy the same shares anyway, but at a higher price, on the open market).

To be fair, it's worth noting that some price pop is healthy for the IPO marketplace. The investors who take on those initial IPO shares can't always count on seeing the 70%+ pop they did from the Twitter IPO; in the case of Facebook, the initial price on the open market was barely more than 10% over the IPO, and barely held the IPO price point on the first day of trade below (and fell by about 20% within a week). If every IPO came out the way that Facebook's did, investors would be more fearful and less willing to take on those shares in the first place; if you expect the price to fall by 20% in a week, you don't pay $38/share in the first place, and companies like Facebook don't raise as much money as they did. In other words, the Facebook IPO may have fared so well for Facebook because the initial investors thought it would fare more like Twitter did, than how it actually performed.

Nonetheless, the point remains that there's little to celebrate for Twitter in the fact that apparently they left as much as $1.3 billion on the table, from an IPO that only raised $1.8 billion in the first place (or alternatively, if they wanted to raise $1.8B, they needed to sell less than 2/3rds of the actual number of shares they did). While it's doubtful that Twitter could have captured that entire spread for themselves with a higher starting price, it's hard to see why they should be happy leaving that much behind, either. Sure, ultimately it's Twitter that decides what price to set for its IPO, but they nonetheless are acting on the advice and guidance of their investment bankers, whose clients seem to have enjoyed a $1.3 billion rainfall by buying the IPO at $26/share, a value that Twitter itself will never see, nor will the retail investors who bought it on the open market at a price point close to $45. And frankly, if investors wanted to buy Twitter at $45/share, they should have been even happier to buy the company at $45 if it had another $1.3B of cash on its balance sheet!

So the next time your client is interested in buying into an IPO, remind them that at best there should only ever be a slight price "pop" from the IPO shares to the market price, and that a big jump may be more of a sign that the company lost out than that investors had a big win (except, perhaps, the investors lucky enough to get their hands on some underpriced IPO shares). Of course, whether Facebook, Twitter, or the next IPO succeed in the long run, and whether their share prices are worthwhile for their value and growth potential, is a fair question for any investor to ask and consider. But just bear in mind that when you're trying to buy an IPO at the opening market price on the first trading day, you're the very, very last person in line to get a crack at tapping into that value, and the bigger the price jump, the less capital the company will be getting from its IPO to actually justify that value.

 


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