This company had an IPO! They’re Going Public! If you’ve ever heard that statement and wondered what it means, you’re not alone.  IPO stands for Initial Public Offering, which is when a company goes public. Oh, you don’t know what that means either?

This article is long and has a lot of background around initial investors. If you want to skip to the part explaining what IPOs actually are and how they work, click IPOs. 

Background

     Before we get too far into IPOs, it will help if you’ve read my earlier articles “What is a Stock” and “What is the stock market” or have a working knowledge on these topics. Are you caught up now? Good. So in theory, anyone can start a business. If you decide you want to open a restaurant, you might only put in your own money or you could go to a bank and get a loan. This is traditionally referred to as the bootstrapping method, where you only rely on yourself to build up the value of the company. This is fine if you’re doing something small. If you have grander plans though and say need very expensive manufacturing equipment, or an expensive highly skilled workforce, you might go the investor route. Letting people invest in your company is saying give me money now, and you can have a percentage of the business. The single greatest learning tool I can offer you on how this works is to go watch the show Shark Tank. The “sharks” are high net worth individuals. Regular people come onto the show to pitch their ideas for investments. For the best ideas, the sharks fight over who gets to invest in the companies. For the regular joe’s who get investments, they not only get money but also valuable other resources, such as mentorship. 

Shark Tank is an example of what’s called Angel Investing. The idea behind that name is that you find an individual, an “Angel” who can give you all the money you need to get your business going. While going on Shark Tank sounds like a wonderful life experience, there’s only so many angels in the world. People who are looking to start bigger companies, or whose needs have grown beyond what their angel can invest, often go to Venture Capital firms, or VC firms. Venture Capital firms have already done the work of getting high net worth individuals or other companies to give them money, and those people trust the VC to invest their money for them. VC’s can have a focus, whether in an industry or in a size of business they invest in. As a new business owner, you can go to a VC firm and ask for an investment, and they may choose to give you money on behalf of the people who invested in the VC. The important thing to remember is that Investors now own a share of, or stock in your business.

The trick is that eventually, no matter who your investors are, everyone wants their money back, and they expect to get back more than they gave you. Unlike a loan, investments don’t require monthly payments or accrue interest the longer it takes you to pay them back. Sometimes investors are paid back a “dividend”, which can be a percentage of annual profit, a set amount, or literally any other amount negotiated into the deal. 

At year one you have a small company, and get investments to help you grow. Five years later you have a much bigger company, which is hopefully much more valuable. You could, at this point in time, sell your company to an even bigger company or firm. However, there are some downsides to this, primarily being your potentially megalomaniac CEO who prides themselves on being a self-employed entrepreneur would … have a boss. Your company would lose the autonomy to make decisions for itself.

For more information, do yourself a favor and watch the entirety of the TV show Silicon Valley.

IPOs

So, in order to stay firmly in control of the business they’ve created, CEO’s can make the decision to go from a private company to a public one. A public company is one that is traded on the stock market for anyone, say any member of the public, to purchase shares. All public companies on the United States stock market are subject to regulations from the Securities and Exchange Commission, or SEC. 

The actual process to go public is quite complicated and technical. We’re not scared of that here though, so let’s dive in. 

When a company decides they want to go public, the first step is to file an S-1 with the SEC. 

The SEC defines an S-1 as follows:

SEC Form S-1 is a registration filing form for companies to complete registration of securities offering under the Securities Act of 1933 [pdf] (see also, 15 USC Ch. 2A, Part 77. This act, also known as the Truth in Securites Act was inacted to bring greater transparency to securities. Through form S-1, companies offering securites are required to disclose a description of the company’s properties and business; a description of the security being offered; information about management running the company and financial statements that have been certified by independent accountants.

S-1 registration filings typically include information about the total number of shares offered and the price per share as well as Investment Prospectus information offered to investors.

Basically, an S-1 contains much of the same information that public companies are required to file on a quarterly and annual basis, such as their financial statements, a description of the business and risk factors, and some background on who’s in charge. Most importantly, it is required to have been independently audited. Some private companies choose to be audited, often at the bequest of their investors. Public companies are required to be audited, and are more in depth than a private company audit. Public company audits are very expensive, which is one of the costs of going public. 

Now that the S-1 is filed, the company – usually the CEO and CFO – go on a roadshow. No I’m not kidding, that’s what it’s called. They go on the road, rent a van private jet, and visit potential investors. 

Wait, I thought we already had investors? Hold up.

When a company goes public, everyone who already owns stock in the private company gets to keep their shares. The company might even give out another round of stock to the employees *cough and management team cough* to encourage them to stay. However, anything that hasn’t already been given away will be sold on the stock market. Now, when a company goes public they TYPICALLY don’t just go straight to the market and start selling shares. They have what’s called underwriters of the IPO. Underwriters, usually a few large banks, buy the majority of the stock at a set price, called the IPO price. All of the underwriters will have to agree to the same price. Then on the day the company goes public, the banks buy the shares from the company at the set IPO price, give the money to the company, then immediately turn around and sell those shares to the public. A bank isn’t going to sell it’s entire position, but they’ll start making money. At the end of the day, everyone left holding stock are the new investors. As a note, on IPO day – the day the company goes public, employees typically can’t sell. Insiders – anyone with non-public information about the company or it’s performance – are blocked by the company in a blackout period to avoid the potential for insider trading.

The most fascinating part of an IPO to me is the IPO Price. Let’s say a company sets an IPO price of $10, and sells 100,000 shares to their underwriters. That’s $1,000,000 in cash the company gets on day 1! This cash influx is one of the primary incentives for going public. But what if the stock price at the end of the day is $15? This is called an IPO Pop. That’s good right, that means the company gets more money?! Well.. that extra $5, or $500,000 didn’t go to the company. It went to the banks, the underwriters who bought the stock at $10 and sold it for $15. 

Let’s look at a recent real-world example, the Airbnb (ABNB)* IPO. They filed their S-1 on November 16th, 2020, (see, it’s a public document! You can go look at it whenever you want), and an amended S-1/A with underwriting information on December 4th, 2020.  They had a very fast roadshow, going public on December 10th, 2020. However, they wanted to IPO a few times and kept delaying it because 2020 was such a shitshow, so I’m sure they’d already had those conversations with investors. 

Their IPO price was $68 a share, and per the S-1/A sold a total of 51,914,894 shares. On day one, the first sale was at $146 per share. It went up as high as $150, as low as $144, and closed the day at $148.94. The total trading volume – number of shares bought and sold on day one was 11.26 Million shares. There are many sources for this information but I’m pulling it from Yahoo Finance – surprisingly, stock information is one area Yahoo excels at. So $146 – $68 = $78 per share. The banks got more than double what they paid per share on day 1. Is this fair? Is this efficient? Financial literature says this points to inefficiency – the IPO price was wrong, and undervalued the company. But banks aren’t going to want to underwrite the IPO if they can’t make money on it. 

Shouldn’t the money be going to the company who worked so hard to be successful, not the banks? More and more, people are saying yes, the money should go to the companies instead. Companies are waiting longer to go public, so they’re well known and highly successful by time they go public. In a defiance of big banks, companies are looking at more direct-to-consumer IPO options. One option is a direct listing, and it’s the approach Spotify (SPOT)* took when they went public in 2018. They sold stock directly on the market instead of going through a bank. It worked and most of all – there was no day 1 IPO Pop. The stock was priced correctly for the value of the firm. However, Spotify was a very large and well known firm when it went public, and I have to wonder whether or not a direct listing would be as effective for a lesser known firm. 

Well, I wanted to write a piece to give a little bit of background on the IPO process. Instead, this wound up being more than you ever wanted to know about IPOs.

*PS: When you see letters after a company name, ie Spotify (SPOT), that’s called the stock ticker. It’s how you search for a company’s stock, and what you would reference if you were every trying to buy or sell the stock. 

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