Initial Public Offerings
A company that is in the process of selling shares to the public for the first time must navigate a minefield of competing interests.
Introduction
A company that is in the process of selling shares to the public for the first time must navigate a minefield of competing interests.
The purpose of going public is to raise equity capital and this involves diluting current shareholders in exchange for an inflow of cash. Naturally, shareholders do not want to give up part of their ownership interest at a bargain price. At first glance, this would argue for trying to maximize the valuation of shares in public offerings but doing so carries significant risks in the long run.
It is considered embarrassing for shares to open for trading on public markets below the offering price. It can also be demoralizing for employees, especially those who have received substantial stock-based compensation, because the media often equates a falling stock price with a business that is failing. No company wants to repeat the outcome of Birkenstock’s recent initial public offering.
The best way to navigate these treacherous waters is for current owners to take great pains to disclose as much as possible about the business without compromising its competitive position. Although Warren Buffett took control of Berkshire Hathaway as a public company, his approach to issuing Class B shares in 1996 serves as an example for companies in the process of going public.
It is helpful to consider the players involved in the initial public offering process to better understand their point of view which will always be driven by incentives.
Current Owners
Owners of the business prior to a public offering will view the event based on whether they have a short or long term mindset. Owners who are participating in the offering will naturally want to get top dollar for selling their shares, especially if they are exiting entirely. Owners who are not participating but are looking toward the exit in the near-term will also prefer a high valuation. On the other hand, owners who plan to hold their interest indefinitely should prefer a price that adequately compensates for the dilution of their interest while attracting other long-term oriented owners.
The composition of a company’s board of directors will determine which owner constituency dominates the process. If short-term oriented owners are dominant, they will seek to “dress up” the company as much as possible. Tactics might include using aggressive accounting methods and inventing non-GAAP metrics that present the business in the best possible light, even if the metrics are not particularly relevant to the long-term prospects of the business. It is important to note that this need not involve outright fraud. Presenting a rosy portrait within the confines of securities regulation is par for the course on roadshows.
If the board is dominated by long-term oriented owners, it is more likely that the roadshow and securities filings will be candid. Owners who view the IPO process as an opportunity to raise capital to expand the business should not want to attract new shareholders who will quickly become unhappy. There is no point in painting a rosy portrait if the reality is more challenging. In extreme cases, existing owners could even lose control of the company if the offering is large enough and new owners decide that they were seriously misled.
The bottom line is that long-term owners are concerned about how the company will use the equity capital that is being raised and the types of owners who they will partner with. This is a rare mindset because there are few truly long-term oriented owners and boards do not always represent owner interests very well.
Executive Management
If a company is managed by its founders, there is little difference between the outlook of current owners and executive management. However, when founders and other large owners have delegated management to executives, it is important to examine their compensation structure to understand incentives and agency problems.
Top management should hold significant amounts of stock outright with stock-based compensation structured with a multi-year vesting period. There should be large ownership requirements relative to the executive’s cash compensation.
The analysis is similar to how investors should look at annual proxy statements except in the case of an IPO, there should be a special focus on the risk of top executives having incentives to leave the company shortly after going public. A long-term investor would have no interest in participating in an IPO unless a company is well run with top management already in place and likely to remain in place.
One can attempt to judge the motivation of executives in subjective terms but the reality is that sudden wealth can change anyone’s outlook on life. This is especially true if an executive is not already wealthy and suddenly finds himself worth eight or nine figures. Family pressure and changing priorities can cause executives to retire. The point is not to demand onerous or punitive golden handcuffs, only to prefer situations where there are still meaningful incentives to stay for several years.
Employees
It is common for private companies to provide stock-based compensation to their employees. The motives for doing so depend on the circumstances of the business as well as the industry in which it operates. Many early-stage companies, especially those without commercially viable products, suffer from a shortage of cash and limited opportunities to obtain credit. Employees can often be attracted with below-market cash compensation if they are provided with stock options or restricted shares.
In certain industries, companies must provide stock-based compensation even if they are not short on cash. In the technology field, employees have come to expect equity, often in addition to generous cash compensation, but sometimes in exchange for less cash. Technology companies typically grant stock-based compensation to a wide range of employees, most of whom have no direct influence over the company’s value.
If employees have given up cash compensation, either in reality or in their minds, they will view the process of going public as both an opportunity to gain financial rewards and as validation of their work. In other words, there is usually a great deal of emotion involved. I saw these emotions firsthand on September 24, 1998 when I witnessed the reaction of eBay’s employees to the company’s IPO. Sadly, I was only a witness and not a participant in the festivities, but the emotional high was contagious nonetheless.
A sinking stock price on the first day of trading would naturally produce the opposite reaction among employees. Even if the lower stock price leaves employees wealthy due to much lower strike prices on their options, it is natural for humans to build castles in the air. If a company prices its IPO at $100, that is the “value” of the stock implanted in the minds of employees. When the stock trades down to $80 on the first day, employees will feel that they have “lost” $20 even if their option strike price is $5 or $10. They have already mentally accounted for their net worth at a $100 valuation.
It would be crazy for management and current owners of a company that has granted stock-based compensation to ignore the psychology of their employees. Just as long-term oriented owners should want to attract new owners with the same mindset, it is important to ensure that employees understand the value of the business and do not build castles in the air which can often breed disappointment in the long run.
Investment Bankers
I am not among those who view the role of investment banking as parasitic but my eyes are wide open when it comes to the incentives of bankers in the IPO process. Bankers are usually a necessary intermediary between the providers of capital and the company raising funds. Even Berkshire Hathaway had to pay bankers for its offering of Class B shares in 1996 and, on a routine basis, when issuing debt.
Bankers will generally have no interest in the intrinsic value of the business and are focused on current market sentiment and assessing what potential buyers of the stock might be willing to pay. In other words, they are pricing the offering based on supply and demand, considering the availability of other IPOs and general market conditions.
The offering process involves allocating shares to institutions and sophisticated individual investors with whom they have longstanding relationships. Many of these investors are better described as traders — their goal is to participate in the IPO and then “flip” the stock they are allocated to the public on the first day of trading.
From the perspective of a banker advising a company on the offering price, it makes sense to seek a high price, but one that still leaves “room” for a moderate rally on the first day of trading. A moderate rally, perhaps between 5-10%, will reward traders who are allocated shares of the offering without unduly irritating existing owners who could feel that the price was set far too low. The last thing a banker wants is for the shares to fall on the first day of trading, leaving traders who were allocated with shares holding the bag. This could very well include the bank itself.
The role of the investment banker is to provide advice to the board regarding the process and pricing. As experts in gauging market sentiment, bankers can inform the board regarding how market participants are likely to react to various prices. Of course, the roadshow will also reveal whether investors are excited about the offering. The ultimate decision on pricing, however, rests with the board of directors.
Conclusion
Many investors prefer to value a company based on its fundamentals before looking at the stock price. This prevents anchoring and encourages independent thinking. Of course, it is very rare to come across a company that is interesting enough to research without being aware of its current market capitalization.
In the case of initial public offerings, investors will know the target range that has been set for the offering but there is no indication of where the shares will actually trade in the public market. Individual investors may participate in IPOs but the process is fraught with peril and there are restrictions intended to protect the public.
The IPO process also leads to psychological risks especially when recent offerings led to large pops in the stock price on the first day of trading. This breeds a fear of missing out, also known as “FOMO”, and can be hazardous to your wealth. Rather than thinking like potential long-term owners, it is very easy to fall into a trading mindset. From there, it is a short step to participate in the offering with the intention of flipping the shares to the public after a pop on the first day of trading.
There is a fundamental asymmetry when it comes to IPOs. The current owners and management know far more about a private company than potential buyers. They also get to choose when to go public. While some private companies may place a high priority on attracting long term oriented owners, most will seek to maximize the valuation of the business despite the risks outlined in this article.
The well-worn advice in financial markets is caveat emptor and this is even more true for public offerings. In my opinion, they are best avoided for most investors.
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