Wednesday, 1 July 2009

How IPOs worked in the dot-com bubble

Another snippet from Manias, Panics and Crashes. Quite interesting to read that in some IPOs there wasn't a lot of interest in actually... err... raising capital for the company:

[I]nvestment bankers appeared to set the price for IPOs so as to maximise the price pop on the first day of trading - and not maximise the cash received by shareholders who were selling. From this point of view a lower price for the IPO might be preferable to a higher price, for the demand for the stock would increase - at least for a while - as the pop increased. The entrepreneurs sold only a small part of their total shares at the IPO; they calculated that the larger the pop the greater their wealth. They were more interested in the apparent value of the shares they owned at the end of the first day's trading than they were the amount of cash they may obtain from the IPO.

On some IPO days the number of shares traded was three or four times the number of shares that had been sold at the IPO. Since many of the buyers at the IPO had been told to hold their shares, the float was much smaller than the number of shares sold, and so those shares in float might have been traded five or six times in the course of the day.

The efficient allocation of capital eh?

7 comments:

Nick Drew said...

well, personal experience here

(a) the avowed purpose of an IPO is two-fold: to raise £££ AND to establish liquidity in the shares for all concerned

(b) The entrepreneurs sold only a small part of their total shares at the IPO: they are only permitted to sell a small part - usually 10% - of their shares at IPO, for the obvious reason that new buyers don't want to see them dump and run. Likewise, thereafter they will typically be tied up for at least 6 months, and only ever be allowed to sell on restricted terms

(c) the purpose of a company is to make money for its shareholders ... (I'm sure you knew this, Tom!)

Tom P said...

I'm not sure we're disagreeing here are we? What I thought was interesting that (in this analysis) dotcom IPOs were structured in a way that seemed to have little to do with what I assumed the main function of the IPO is - ie capital raising.

I might be being dumb here Nick, but why is liquidity in the shares an objective for the company? I'm not saying it might not have benefits (though you know I like the Keynes line about liquidity fetishism!) but what would their interest be in this?

Nick Drew said...

by the time a company is considered to be IPO-worthy, the entrepreneurs will have achieved some significant achievements:

- successfully overcoming start-up risk, which finishes off most companies and which, prior to IPO, will have been borne by themselves (and their VC / angel financiers) alone

- growing the company to a fair size;

traditionally this will have earned them a very high return on their capital: really successfull new companies are uncommon

some of them will dream of being Bill Gates, and intend to hang on to all their shares for decades

others (most, let's be realistic) will seek to bank at least some of the gain they've made; or at a minimum, have the option of doing so

for this, they need a liquid market in the previously quite illiquid shares

who would want their £££ tied up come what may ? they might need it for who-knows-what, who-knows-when. (Do you own a house ? how would it be if you couldn't sell it whenever you wanted ?)

seriously, liquidity is a Good. Come on, Tom: empathise with us capitalists !

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Tom P said...

hhmm I see what you mean. But is an IPO the only way you can realise any financial benefit for the blood sweat and tears you've put in?

Nick Drew said...

no: you can of course sell shares privately

- to new individual investors;
- to new institutional investors;
- a trade sale to another company operating in the same space, who would either be seeking to grow by acquisition, or to take out a competitor before it grows any bigger

(the 1st 2 of these can be viewed as 'second-round financing' and indeed they may be specifically set up as such)

but this tends to be episodic and binary; i.e. a snapshot valuation is put on the company, and there may be limited or no opportunities to do anything other than accept (or reject) the price on offer at that time - and potentially a change of control (very likely in the 3rd case) - perhaps to the exclusion of later opportunities. It may even be equivalent to fully cashing-up and quitting, there and then

whereas with an IPO

(a) you won't be selling all your shares at that time (indeed, only 10% or so, as I said before) & you can ride with the company as a (diluted) shareholder for as long as you like in the future;
(b) ... but at the same time you get the option to sell in future, at a known price, with minimal hassle, some or all;
(c) control in the company is most unlikely to be changing - at least, not until the float gets very much bigger and a predator comes along;
(d) with an explicit market valuation now avaialble, and liquidity, you are much more easily able (as an individual shareholder) to borrow against your shares

all this can be much more attractive for entrepreneurs who wish to stay involved, as investors or directors or both, rather than cash up & quit

finally, there's always dividend. But companies at IPO are typically still growing strongly, and will probably wish to retain earnings within the business at that stage, and for some while yet to come

keep asking the questions, Tom !

Tom P said...

Very interesting stuff Nick - thanks a lot!