Why the Day One IPO ‘Pop’ Is Overhyped

The current class of 2020 IPOs make a strong case for more direct listings

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After a delayed start, the IPO market is heating up again as companies look to resume going public. This recent spate of IPOs — Agora, Vroom, ZoomInfo, and Lemonade — has resurfaced the familiar occurrence of the “IPO pop,” where companies’ initial share prices see large increases relative to their original IPO price on the first day of trading. The recent class of 2020 IPOs has seen its stock price go up, sometimes by multiples, in the first few days of trading.

This pop is often billed as a positive trend and a marker of a successful public debut because of the jump in shares, which increases the company’s overall market cap value. But these IPO pops can actually shortchange companies of capital and result in dilution, reducing each share’s intrinsic value. Here’s what the IPO process looks like and what the 2020 data of the current round of IPOs tells us about whether these pops are in fact a net positive for the company or more of an overhyped trend.

The IPO process at a glance

Companies choose to go public for a multitude of reasons, including:

  • raising capital (though this is arguably a less important factor for companies that can access the capital available in private markets)
  • offering liquidity for earlier-stage investors and early employees and/or founders
  • gaining more credibility with potential future employees and/or customers
  • instituting discipline throughout the organization, since going public creates more transparency and accountability with quarterly earnings

When a company plans to go public, it hires bankers who serve as intermediaries. The bankers help craft the S-1 prospectus for the company, which narrates the company’s story and informs the public about the future prospects of the company from its current business model, competitive landscape, and pricing methodology. The S-1 form, which is filed with the SEC, includes an initial pricing range for the stock and an initial volume of stock the company intends to sell, or capital it plans to raise in the offering.

The bankers then run a marketing process known as the roadshow, where they pitch institutional investors (for example, hedge funds, pensions, and endowments) on the company, its prospects, and other selling points for why they should invest in the company as it goes public. During this process, they’re typically gauging investor demand as well as gaining additional business intelligence on the IPO price that other prospective investors would be willing to pay.

Of the 61 IPOs to debut in the U.S. stock exchange in 2020, the median company that went public saw a “pop” of 20% on the first day.

After the roadshow wraps, bankers typically work with the company to update the number of shares offered and the listing price. With IPOs, companies are selling new shares to these institutional investors — shares which they ideally want the investors to continue to hold onto over time. Additionally, IPOs typically have a 90- or 180-day lockup period, where insiders cannot sell shares, and so the number of shares available for trading is typically a small fraction of the overall outstanding shares.

The IPO pop

Historically, IPOs tend to pop on the first day of trading, meaning that they are underpriced relative to what the market is willing to pay. The data for 2020 helps support this trend: Of the 61 IPOs to debut in the U.S. stock exchange in 2020, the median company that went public saw a pop of 20% on the first day. Only 25% of companies ended the day trading lower than their IPO price. Meanwhile, 28% of companies ended the day trading more than 50% higher than their IPO price. Put another way, if you had bought $1,000 worth of each of the 61 companies at their IPO price, your $61,000 investment would be up 29% after just one day of trading in each of the IPOs.

Note that the number of shares being traded at any point on day one of the IPO is often only a small fraction of the outstanding shares because of the lockup period, so a small pop might be considered normal given the (limited) supply and demand. However, some IPOs register a much larger pop in share price, both before and after the lockup expires relative to the original IPO price, indicating a general trend in underpricing.

If a company that went public was priced “perfectly” from the start (a somewhat unrealistic expectation), it would end the day within a few percentage points of the original IPO price. If the closing price was a lot higher, then the company was diluted (sold more shares than it needed to), more than it should have been or raised less money than it could have otherwise since it issues shares to investors in the IPO at less than what the market valued the company’s shares.

An IPO in 2020 shortchanged the median company of $44 million, or $110 million, on average.

For example, say a company sold 5 million shares to institutional investors at $20 per share, raising $100 million in its IPO and then ended the day trading at $30 per share (seeing a 50% pop). This means the company effectively lost out on $50 million, which is the additional money it would have received had the IPO been priced at $30 per share from the beginning.

In aggregate, the 61 companies that went public in 2020 so far raised $6.7 billion less than they would have been able to if their IPOs were priced at what the market valued the company. Put another way, an IPO in 2020 shortchanged a company of $44 million (the median value) or $110 million on average, with some companies like Royalty Pharma, ZoomInfo, Vroom, and Agora especially losing out.

Recent IPOs in depth

To bring this to light, we can look at a few recent examples of high-growth tech companies, which have all popped over a whopping 100%.

Vroom, the used car marketplace, priced its IPO at $22 a share offering a block of 21.3 million shares. It closed at $47.90 a share on the first day of trading, a one-day return of 118%. The company raised $468 million through its offering. Had it sold its shares at $40, it would have been able to raise an additional $380 million, and still provided a “pop” to IPO investors.

Agora, an API-powered company for voice and real-time video communication, priced its IPO at $20 a share offering a block of 17.5 million shares. It closed on its first day at $50.50, seeing a pop of 153%. The company raised $350 million through its offering but could have raised double that amount by pricing its share at $40. IPO investors are still up over 100% a few weeks into trading.

Lemonade, a full-stack digital insurance startup, priced its IPO at $29 per share offering a block of 11 million shares. It closed at the end of day one at $69.41, a pop of 139%. The company raised $319 million through its offering, but had it priced at say $58 a share, it could have raised another $319 million (and investors could have still gotten a 20% pop). Currently, the stock trades at ~$78, meaning that IPO investors have made a return of almost 175% in a few weeks.

Why do banks underprice IPOs?

Banks tend to underprice IPOs for strategic interests and incentives. Note that the three key stakeholders involved in going public are the companies, bankers, and institutional investors. The institutional investors want to make a return on their investment, so their goal is to get the stock as cheaply as possible. Bankers have to please both the company and the institutional investors and as a result have a delicate balancing act to juggle if the two stakeholders’ interests differ. Companies also have competing interests: On one hand, they want to raise as much money as possible while minimizing dilution. But on the other hand, they care about the long-term success of the company (including factors like the long-term stock price and its market cap).

Given these sets of interests, there are three main reasons why IPOs tend to pop. Banks take many companies public and often return to the same institutional investors again and again (the typical institutional to retail split of an IPO is 90/10). Meanwhile, a company usually only goes public once. Therefore, while banks and institutional investors play this game repeatedly, most companies only play it once. With banks having to appease both sides, it’s not crazy to think they choose to satisfy the party with whom they have a long-term ongoing relationship.

In addition, as mentioned above, companies themselves have interests that are at odds with one another. Underpricing an IPO may indeed be the better move for them in the long term if it leads to satisfied investors who continue to hold onto the stock and buy into the company story. In return, the company gets some of the momentum benefits of a strong IPO. Or at least that is what banks will try to convince companies. Also, it’s important to note that while a company issues 15% to 20% new shares in the IPO, the rest is owned by founders, employees, and existing company investors. So all things equal, a company would rather start trading at a lower price and rise higher (with the remaining 80% of shares appreciating) than start very high and drop to below what they might have been with a lower opening price.

Lastly, I think the media plays a role in perpetuating the hype. An IPO with a big pop is portrayed as a marker of success, whereas one without a pronounced pop is seen as an anticlimactic public entry (although in reality, the company got a better deal in the latter case). This increases some of the momentum and reputational benefits that a company might get from underpricing an IPO and provides further ammunition to banks to sell companies on underpricing (for example, “Hey, you saw what happened to Facebook right? Let’s not be greedy with the IPO price…”).

The case for more direct listings

The rest of 2020 promises to be a busy period for more IPO hopefuls with companies like Airbnb, Doordash, Asana, Robinhood, and Palantir all expected to go public over the next 12 months. But considering their strong performance as high-growth tech companies, coupled with the fact that these companies will likely face underpricing similar to the current class of IPOs, one wonders whether they will choose to go the traditional route.

Slack and Spotify both famously went public in April 2019 and April 2018, respectively, with a direct listing — an alternative to the traditional IPO, where no new shares are issued but instead existing shares are sold to the public. Direct listings typically have lower fees, no lockup periods, and are priced algorithmically on the stock exchange (similar to how every stock trades day in and day out).

Two big drawbacks have been noted about direct listings: First, that you can’t raise new capital while going through one, and second, without the traditional roadshows and price stabilization functions of banks, it may only be an option for household name companies with strong brand equity.

But given the more than adequate supply of capital available in private markets and an ongoing proposal by the NYSE to allow companies to raise additional capital in direct listings, the first drawback may not pose too much of a concern for most companies moving forward into the future. The second issue of general lack of brand awareness, however, may prove to be more difficult to overcome. But for a portion of companies that enjoy high growth and some level of recognition with loyal or niche customers, the direct listing may offer a preferred alternative to going public (and provide liquidity for investors) without unnecessarily diluting the company or selling equity at a price lower than the market will bear.

A version of this piece was originally published on Tanay.substack.com.

Curious about technology, economics, and business. You can find me on twitter (@tanayj) or substack: https://tanay.substack.com/

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