Max Mednik

My last entrepreneurial finance class was filled with so much cool stuff that I'm splitting up the main points into three separate posts. This post covers the IPO process, the last "technical" part of the class where we reviewed the prospectus and 10K for Oakley's IPO from cover to cover. Though I previously knew some elements of what we discussed, it was interesting hearing about the process in more detail from the guest investment banker who actually led the Oakley IPO and could offer us some of his inside perspective.

1. IPOs provide liquidity by selling new shares as well as liquidating existing  shareholders. I was always under the impression that IPOs mostly served to raise new money for the company (new, primary share sales), and that existing shareholders could sell their stock down the line, after various lockout periods had elapsed. I didn't know the extent to which IPOs could actually transfer money straight from the public into existing shareholders' pockets.
   
   For example, in the Oakley IPO, almost two-thirds of the IPO proceeds were going to the two founders. This was a big shock to me, but I guess it makes sense because otherwise it's just a delay in the liquidity event. However, this just seemed to me to be something that would be impossible to sell to the public. In fact, the banker guest speaker told us that they advise at most 20% of an IPO to be secondary sales (liquidating existing shareholders) and that one could never get away with a 100% founder harvest straight up in the IPO.
   
   
2. The underwriting spread compensates several parties and forms of risk. The spread is the difference between the public sales price per share and what the bank actually gives to the company or liquidated shareholders. It's typically about 7% of the IPO proceeds, which is extremely large compared to other forms of investment fees, like on mutual funds. There is obviously a lot of work that goes behind this, and it's a different type of risk as well.
   
   Our professor explained that the underwriting spread compensates various risks as follows:
   
   Underwriting (market risk of the offering) 20%
   Arranging (the managers arranging the deal) 20%
   Selling (the process and time to sell the offering) 60%
   
   I learned that to spread this risk, it's customary for practically all of the banks to participate in some degree in all of each others' offerings as a sign of good faith and camaraderie. This seemed a bit strange to me, but I'm sure it's in their self-interest in the end.
   
   
3. The "Green Shoe" option helps to stabilize price by allowing overselling by 15%. I learned that the underwriters almost always exercise an option allowed by the SEC to sell 15% more stock than initially planned for; if the offering goes well and there is demand, the extra supply helps to stabilize the price. If the offering doesn't go well, this option can be left on the table and no harm is done.
   
   This option highlighted how much people care about price stability and having the IPO be a “good deal” and leave a "good taste in the mouth" (price stable or up). The banker commented that this is a core determinant of investment banking firm reputation, and many banks regularly take personal losses so that their IPOs' prices are buttressed. This seems like blatant price manipulation to me, but I guess it's common practice.
   
   
4. Going public gives credibility to a company as it tries to grow to the next level. This always seemed like a poor reason to me to go public (caring about your perceptions rather than actually needing the money), but apparently in the marketplace being public gives a lot more reassurance to many people of long-term stability. I think there is a good deal of manipulation here as well, and it should be clear from recent experience that public companies can often be more risky than private ones when they grow unwieldy.
   
   
5. IPOs (and public company regular statements) provide good data on a company's operations. The obvious disclaimer here is that financial statements and audits are directly manipulable and can be faked to show almost any message, but if you believe in a specific company's honesty, its public data can give good insight into its performance and how the market is perceiving it.
   
   I learned from the guest that a P/E multiple at the same numerical level as the company's growth rate (i.e. P/E of 20 when the company's profits are growing at 20% per year) is good. I also learned that for many companies with negative or low earnings, the PEG (price to earnings growth) ratio is often a more popular metric.
   
   Public company 10Ks not only provide good data on a target company (that you're considering investing in, doing business with, or having as a customer) but also on its competitors. I liked learning about the trick of reading the 10Ks of all of one's competitors to learn some in-depth information about what threatens their operations and their major business practices and plans going forward, since quite a lot of this needs to be disclosed in the SEC filings.
   
   Another part of the research that's useful for students and anyone seeking jobs is compensation. The 10Ks list a company's salaries and option plans (usually aggregated/averaged somehow), but they can still give a good sense as to how the compensation compares to others' compensation.
   
   
6. Auction-style IPOs can be subject to gaming and fraud. The banker (for obvious reasons) was pretty pessimistic about auction-style IPOs (like Google's) and even said that Google after the fact had qualms about the process. He stated that because the auction mechanics are sub-optimal, there are incentives to lie and manipulate one's bids in order to affect one's IPO purchase amounts and prices. This seems little different to me than similar issues affecting the stock market and the traditional IPO process, and I have to believe that there must be theoretically optimal auction models (at least towards some important objectives) that can be feasibly implemented in real life at some point in the near future.

Though I'm nowhere close to seeing a company go public firsthand, it's a topic that interests me and that I hopefully will get to learn about eventually more in depth.