IPOs: the real costs and opportunities
The game of the IPO
Since 2020 was a boom year for them and 2021 looks to be about the same, this week, I’ll take a closer look at IPOs.
First, a quick overview. The three most common methods for converting companies from privately owned entities to publicly traded corporations are:
Through investment banks. These are the traditional choice for companies that want to go public. Investment banks have massive infrastructure and a ton of support for companies that are converting from private to public. They provide essential fiduciary responsibility and take on marketing to drum up interest, excitement and investors within their own pools, as well as viable investors outside their firms. The drawbacks? The partnerships can be cost-prohibitive and because of the way IPOs work, many outside investors will never get in on the ground floor of IPO launches, which brings questions of equitable opportunity to the table. Still, investment banks have made it possible for thousands of companies to go public and, at some point, that makes stocks accessible.
Direct public offerings (aka, direct listings), in which companies with significant resources (and brand/industry recognition) go directly to exchanges without the “middleman” role that investment banks and other underwriters play. (Recent examples include Slack and Spotify—and video game company Roblox, which just went public on NYSE on March 10 via direct listing.) Direct listing doesn’t alleviate the legal and fiduciary responsibility or work: companies taking this route face significant financial risk, as well as the legal and accounting work to meet SEC requirements. The upside? They can avoid a lot of typical IPO headaches and go public without issuing new shares at the time of converting from private to public, and without raising new capital, which works out for a lot of tech startups that have a lot of cash in hand.
Special purpose acquisition companies, or SPACs. SPACs are non-operational shell companies that raise to take a company (or group of similar entities) public via an IPO. Although SPACs have been around for several decades, in the last couple of years, they’ve boomed.
The upside to SPACs is that they make it easier for companies to go public because the SPAC does the legwork of raising funds—in fact, at the time a SPAC goes public, it may not even have an associated company/ies. Therein lies the rub: the potential downsides are that SPACs may bring companies public that aren’t ready for the legal, financial and other responsibilities and relatively few have reached “unicorn” status—a benchmark in which the value of the company is $1 billion or more.
Why people love IPOs
As best I can tell, IPOs have created more appreciation of wealth for the founders and initial investors than just about any other existing economic engine. That’s why people love them and the stories that swirl around them.
Investopedia defines IPOs as “...the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors.” In a nutshell, then, if you privately own a company and decide to take it public, the shares sold create equity value in the future corporation.
With a typical IPO, a company will hold about 20-30% of shares and the rest are made available to the investment banks that underwrite the IPO and other investors. In addition to the innovation and growth that can result (ideally but not always) from an enormous infusion of capital, an IPO also means (potentially) significant wealth for owners and investors and, often for employees who may have employee stock options as part of their benefits.
While there are different classes of shares and things can get complex, overall the hope is that when the company goes public, the buzz generated around the IPO and the future corporation sends shares soaring above the initial offering price.
That’s how fortunes are made in a day and the stories have become the stuff of legend. And legends, as we know, are based in fact and embellished along the way.
Not too long ago, a company valuation of $1 billion meant that you were in IPO-issuance territory. Today, that’s been pushed by the crazy exuberance of the markets—Coinbase’s pre-IPO valuation near $100 billion is a good example.
Behind the hype: The costs of IPOs
The preponderance of IPOs in recent years might lead one to believe that not only is there great wealth to be gained, but that IPOs are relatively easy to launch.
The former may be true and the latter never is. (This next statement isn’t for those with delicate sensibilities so if you have them, skip to the next paragraph, please: I’ve been known to describe the IPO preparation process as the reporting equivalent of having an enema and a colonoscopy at the same time.)
I’ll break down the process as simply as I can while also trying to convey its rigors:
In the early stage, a company must have already achieved certain financial or other benchmarks that make it a strong prospect to go public; to get to this point usually takes years and years of hard work. For example, Microsoft was founded in 1975 and went public in 1986. Apple, notably, was founded a year later than Microsoft and went public in 1980—a very quick turnaround that may reflect corporate-culture differences between the two companies.
When a company reaches the point in which it considers going public, typically it will dog-and-pony show its way around to investment banks to garner an interested underwriter. Or, in the best cases, investment banks vie for the opportunity (Microsoft was a winning ticket for Goldman Sachs; Morgan Stanley underwrote Apple’s IPO).
With an underwriter secured, the company and outside firms undertake the arduous task of pulling together all of the information for the SEC S-1 filing, which is a copious report of essentially all financial and operational aspects of a company. (If you missed the example in last week’s post of the Compass S-1 filing, you can get the doc here.)
Along with the information for the SEC filing, the underwriter and associated firms market the potential IPO to various investors to gauge/build interest. In addition, a corporate board is formed for the new entity (the private company becomes a new public entity with the issuance of the IPO).
The underwriting bank typically identifies an exchange for the IPO. Keep in mind that exchanges are businesses and thus, not every company that has an interest in going public can get onto the exchange of choice. While the majority of U.S. companies that go public will aim to be listed on a U.S. exchange, it’s also very desirable for some foreign companies to get listed on U.S. exchanges, because our system’s regulations often mean greater exposure and financial gains.
SOURCE: Fortune, 1986, archived
Not including the years of work leading up to this, IPO exploration and preparation typically takes about 18 months and thousands of hours of work. There are also substantial related costs, although some of the parties involved bank on the hope that their payoff will come when shares are issued and the money rolls in.
When SEC approval is granted and the other pieces are in place, the company owners and underwriters propose an issuance date and price, although neither is set in stone and both typically change up to the time of the IPO’s launch.
And when the day finally comes, the rewards can be enormous: in cases like Apple, Microsoft, Tesla, Amazon and Google, the founders and early investors became multi-multi-millionaires in a day.
Are there any downsides to IPOs?
In addition to the obvious financial risks, there are many reasons why otherwise-qualified companies never go public and most boil down to control.
While investors may have bought into the founders’ vision, once a business goes public, that vision is often secondary to shareholder dividends. This may seem like a small price to pay when you could potentially gain a fortune, but for many founders and owners who have put a lifetime of work and passion and sacrifice into a business, it can be a tough pill to swallow. Nor can they just walk away—there are contracts and commitments that need to be fulfilled and losing founders can be devastating to corporations when they’ve recently gone public. And despite a lot of enormous egos at this level of success, in this day of celebritization, many founders and CEOs simply aren’t prepared for overwhelming public recognition and accountability.
IPOs and brand stories
Here’s another point that I find fascinating: today, nearly 20% of cars and trucks owned in the U.S. are made by GM—that’s almost one out of every five cars and trucks—while only 1.4% are by Tesla.
SOURCE: Barron’s, This was the Busiest Year for IPOs Since the Dot.com Bubble
Still, I’m willing to bet that you’d be hard-pressed to find a living, breathing American who doesn’t know that Elon Musk is the founder of Tesla, while relatively few GM owners could tell you GM’s founders or the current CEO’s name.
In this blog, I’ve talked a lot about the importance of branding—I often say that brand is everything—and this is a good example of how that plays into a company’s IPO success. It took 18 years for Tesla to show a profit, but Musk is one of the wealthiest entrepreneurs in the world and I have to believe that no small amount of it is due to his eccentric-genius self-branding that everyone’s bought into by now, including me.
If a company has a great product and is well-managed but runs a bit under the radar, it’s imperative that an expert is called in to elevate and promote the brand prior to shopping it out for an IPO. Otherwise, it’s too hard to drum up enough public excitement when the number of launches is surging.
In sum, the world loves IPOs and I do, too: I love a system that rewards innovation, risk and creativity and that also makes room for the general public to buy in and benefit, too.
In my opinion, though, the frenzy we see now with IPOs (and SPACs) is a bit of a turnoff: I prefer to go in when companies have a lot of room to grow and when the market isn’t so overwrought.
I won’t ever give you investment advice, but I hope to offer insight that helps you make better decisions for yourself and here’s how I see it with IPOs:
When a company goes public, it’s a massive financial, legal and regulatory undertaking and risk. So, if you’re thinking about investing in an IPO, do your homework. Try to understand the “why” behind it: Why is the company doing it? What does the company’s SEC S-1 filing tell? What kind of growth potential exists? And what are the potential pitfalls for the company and the industry?
Answering these questions can tell you a lot about where a company is headed post-IPO, when most people can get in the game. And in 2021 or thereabouts, a lot of hot companies are planning to issue IPOs. As reported in Kiplinger’s, these include familiar companies like Instacart and South Korean giant Coupang. The better you understand the motivation behind an IPO, the better you’ll understand the risks and opportunities.
Now, on to residential real estate update
I believe that housing prices will stay high because inventory will remain too low for a healthy balance between buyers and sellers for some time, although we’ll likely see a slowdown in the rapid rise that we saw in 2020.
In fact, to truly impact the inventory part of the equation could take years: construction takes time and many building materials like lumber are scarce now which hinders inventory and drives prices. Even with interest rates rising for 30-year mortgages, I think we would have to experience a very significant increase to truly impact buyers right now—the 2% or so increase that we’ll likely see this year or next still means low rates overall, given recent record lows.
In my opinion, we’re at a point where affordability is in the hands of the government. Local zoning codes need to allow for and even require density in some areas and affordable housing needs to be a requirement for many areas.
Markets, bonds, cryptocurrency and taxes
In regard to stocks and bonds, pretty much everything I predicted has held true. Watch the markets for a day or a week and you’ll see that there’s still significant volatility and wild swings (although not just up, as they largely had been).
In my opinion, I think we can anticipate some easing in tech-stock velocity while also seeing optimism in industries related to post-pandemic life (fingers crossed that we all get there soon and safely), including travel and hospitality, energy and even brick-and-mortar retail. These industries were hardest hit and the survivors are poised to rebound with help from the $1.9 trillion stimulus plan.
On a cryptocurrency note, the IRS is launching “Operation Hidden Treasure” to crack down on taxpayers who “omit” crypto info from their tax returns, according to this fascinating Forbes article by Guinevere Moore. Read the article if you have (or had) crypto, then contact a professional if you need legal or accounting help -- or both.
Clearly, despite my misgivings about what I see as a nebulousness about them, our federal government is paying attention.
