LinkedIn did it. Groupon's doing it. Suddenly everyone is talking IPOs. But if you aren't market savvy, you may be more familiar with C-3PO than this hot acronym du jour. Or more likely, you may think you know IPOs, but do you really? Since I have previously worked on IPOs ranging from Aavid Thermal Technologies to the largest franchisee of Papa John's pizza, I thought I would share some basics.
Here are few things to know about IPOs.
What is an IPO? An IPO is an acronym for Initial Public Offering. This is when a company lists its shares for sale on a stock market for the first time, so that they are freely tradable. When companies are private (i.e. their stock is not listed on a stock market), investors can't freely buy and sell (aka "trade") shares in the company. When the company "goes public", however, now investors can buy and sell their stock more easily. Having this ability to freely trade the stock is considered having liquidity. Note: stock and shares in a company mean the same thing -- an ownership interest in the company.
Why would anyone do this? Liquidity is something of value. If you were being paid for your services, would you want something that you could easily convert into cash, like gold (which is considered "liquid") or something more challenging to convert into cash, like kangaroos (which is considered "illiquid"). Having a publicly tradable stock makes the stock a currency that has liquid value. This means it is easier for the company to raise capital in the future to fund their growth, gives them a currency (other than cash) to make acquisitions and gives their investors the ability to exit the company. This also means that public companies typically carry a higher valuation than their private counterparts. However, there are downsides, like onerous and costly disclosure requirements for public companies.
What are primary and secondary shares? When a company files to go public, it may have more than one objective and it may issue primary and secondary shares. Primary shares are stock that the company is issuing for the first time to new investors in order to raise money for the company. This increases the total number of shares outstanding in the company. However, some of the existing investors in the company (particularly venture capital and private equity firms that have been invested for several years) may use the IPO to sell all or a part of their stake in the company. When these existing investors sell their stock, no new shares are being issued -- the ownership is just being transferred. These are called secondary shares, since the transaction doesn't increase the total number of shares outstanding in the company.
How is the share price or value determined? You may have heard folks lamenting that LinkedIn got screwed because their IPO was priced at $45 and almost doubled in the first day of trading (which means that the company raised money at the $45 price, but the demand indicates they could have received more money if the price was set higher by the investment banks). But truly, the IPO valuation process is an art, not a science. It typically starts with the company going on a "roadshow" with their investment bankers to meet with institutional investors. These are professional investors like mutual funds and pension funds, which account for the majority of investments in the stock market. Institutional investors differ from retail investors, which are folks like you and me that may buy stock directly for our own investment accounts.
Thoughts about the value of the company are based on other companies that are of similar size, with similar growth prospects in similar industries that trade in the stock market. These are considered comparable companies and provide a benchmark to help figure out the value of the company. Other financial valuation techniques (like the "DCF" or Discounted Cash Flow analysis) may also be used as part of the valuation process. Investors scrutinize the metrics and details of the offering, such as future growth prospects, sustainability of the profit margins, how many shareholders are selling their stock and the amount of debt the company has as part of their analysis.
After the roadshow presentations, the institutional investors run their valuation models and place orders for the stock, giving the amount they would be willing to buy at different price levels. Based on the demand from these investors, that's how the IPO stock price is determined. Because it's impossible to visit every investor in the world and investors may low-ball the price that they are willing to pay, if there is even more demand once the stock starts trading, you may see the stock price rise on the official day of the IPO (the first day of trading). This is known as the IPO pop.
And then what? After the IPO, the company is officially considered a publicly traded company. The stock price of the company over time will be determined by how well the company performs (i.e. grows its revenue and profits, manages its debt load, etc.), and the demand that performance generates from investors for the stock.
So, hopefully you can feel a bit more informed now when others start talking about IPOs. With the current over-inflated valuations of Web2.0 companies, you are sure to hear a lot more about them -- good or bad -- in the future.