The staying power of this bull market is quite remarkable. U.S. equity markets have staged an epic comeback, tripling off their financial crisis lows. The large cap tech index, NASDAQ 100, has actually quintupled. Oddly, the initial public offering, IPO, market hasn’t received similar vigor.
Back in the late 1990s, the IPO market was red hot, accompanying the stock market meteoric rise. Today it’s quite the opposite. Despite red hot equity markets, there were just 13 venture capital-backed U.S. technology IPOs in all of 2016.1
Before we speculate on what 2017 will bring, here are some IPO basics.
The IPO Process
In an initial public offering, a private company sells equity (ownership stakes) in itself to the public in the form of stock. Then, the shares can then freely trade hands on whatever exchange the company decided to list on. Today, the shares can trade on a number of electronic computer networks or ECNs.
But first, the company must select a broker-dealer to be in charge of selling the stock to the public. These ‘underwriters’ (investment banks) compete to win the business of taking the company public.
Often, the IPO process is shared by a number of different banks, known as the syndicate, to reduce the risk of one firm not being able to sell all the shares themselves.
These firms handle all aspects of the capital raising process including scheduling and handling invitations for the marketing roadshow, legal due diligence and lining up buyers for the shares. Through their network of financial advisors, the firms sell the shares of stock to their own customers, often institutions such as insurance companies, hedge funds, large pension funds (such as CalPERS and TIAA-CREF) and high net worth individuals.
Sometimes, there are more indicated buy orders for the deal than the number of shares being offered by the company. In this case, the deal is termed “oversubscribed”, which is what the company and underwriters want. The company can either increase or decrease the number of shares depending on the demand.
But it’s not easy for individual investors to be involved in the process. For the privilege of investing in these deals, individual investors must first have an account with one of the underwriting firms. If they can buy stock, they are often required to hold the position in cash accounts for a pre-determined period of time, known as the holding period.
This is typically not an official policy from the underwriters. Instead, the pressure comes from the financial advisor themselves. If a customer does sell the shares early, it harms the stock broker’s ability to be allocated future shares. The capital markets group may even take away the commissions earned by the broker on the deal.
The underwriters typically take a cut of around 5% of the total capital raised for the issuing company. This is down from 7% in the late 1990s and early 2000’s. Follow-on offerings command roughly 3% of the total.2
These can be quite lucrative so brokers are incentivized to push the deals. For example, commissions are typically not paid by the customer for purchasing these deals.
The Case for Going Public
There are a number of reasons why a company decides to issue its shares to the public. Typically, there is a need for more capital to expand operations or simply pay down debt. Sometimes, an early investor or founder might want to ‘cash out’ by liquidating their stake.
There is also the instant publicity generated from an IPO for those who may have never heard of the company or its services.
Many public companies plan to use their newly issued stock as currency, often they believe is stretched in value, to make purchases of other companies.
In a sector where ‘cash burn rates’ are an important metric, high growth tech companies typically prefer to use their own stock instead of valuable cash for M&A deals.
But target companies often want the security of cold hard cash, whose value won’t fluctuate that much like stock can.
An example of this from the dotcom days was when Marc Cuban’s company, Broadcast.com, was purchased by Yahoo using their stock. Cuban’s newly acquired Yahoo stock soon dropped like a stone.
Smartly for Cuban, he was able to protect his gains through the use of an advanced options strategy (known as a ‘collar’) that sold calls and bought puts on Yahoo stock.3 Typically, a combination of cash and stock is the end result, a compromise for both sides.
The Case for Staying Private
The major reason many founders don’t want to sell their company to the public is they want to retain control. When you go public, the individual shareholders are the new company owners. They can appoint board members, and even fire managers and founders (Steve Jobs was famously fired by Apple back in 1985).4
Regulatory scrutiny and costs is also an issue. It is almost prohibitive for many small companies to IPO for this fact alone. For example, there needs to be compliance personnel in place to navigate the various legislation of Sarbanes-Oxley and Dodd-Frank.
Many companies simply don’t need to go public anymore. There is ample access to capital with the booming and mature venture capital landscape. Sovereign wealth funds and asset management giants like Fidelity Investments now invest in private companies.
Secondary markets including SharesPost and SecondMarket have surfaced, allowing insiders to liquidate their holdings without going public by matching buyers and sellers.5
Finally, emerging growth companies today can file confidential prospectuses with the SEC to gauge demand.6 So, they know if they’re IPO is likely to be a dud. Nobody wants to be known as the next Pets.com, the poster child for the dotcom bust.
The IPO Calendar
If Trump’s deregulation materializes, there should be plenty of new deals for investment bankers and 2017 could be a big year for new issues. The upcoming IPO calendar for 2017 includes names like Bitcoin Investment Trust, Zika vaccine-producer Visterra and Latin American for-profit education company, Laureate Education (formerly Sylvan Learning).7
Smaller underwriters including Leerink Partners, Raymond James and Stifel are bringing these deals.8
It’s safe to say that the larger underwriters, JP Morgan, Goldman Sachs and Banc America, are waiting for the bigger companies like Uber and Airbnb. They know if they can land the lead underwriter role, and do a good job for the company, there could be a coming boom in fees for the bank through future secondary offerings, and advisory roles on M&A transactions. There has also been a boom in debt offerings as companies scrambling to borrow at historically low interest rates.
The Rise of the Unicorns
Enter the unicorn. No, not the mythical creature, but private companies with a valuation of at least one billion dollars. Amazingly, there are over 200 such companies. Valuations have deflated a bit, but are still robust. These private companies may finally take the leap to go public, riding the tailwind of deregulation that some hoped President Trump will bring to financial markets.
Maybe the most anticipated IPO of the New Year is Los Angeles-based Snapchat, the application that allows users to send text and pictures that will later ‘disappear’.
This service is extremely popular among millennials, but the company has plans to grow their brand well beyond that service and into a full-fledged media company. Snapchat is also developing their ‘Spectacles’ project- a set of wearable sunglasses that records short videos. It’s hoping to succeed in this area where ‘Google Glass’ could not. Their business model will derive revenue from advertising dollars through sponsored content.
Early Snapchat investors include such venture capital firms Lightspeed and IVP, but also Chinese e-commerce giant Alibaba.9 But the earliest investor was Benchmark Venture Partners who invested $13.5 million back in 2013 in a Series ‘A’ funding round which valued SnapChat at about $70 million according to data from Pitchbook.10 A CNBC article posits that Benchmark’s investment could go down as one of the greatest VC investments of all time, growing their original investment over 300 fold in roughly four years.11
At current levels, Snapchat is valued at around $25 billion, putting Benchmark’s stake somewhere in the $3 billion range.12
Morgan Stanley is rumored to be in the running for the lead underwriter position of the potential deal, considering they have already assisted Snapchat with a private debt deal last September. SnapChat’s IPO date hasn’t been announced yet, but could come as early as March.
You can certainly expect investment banks to be salivating over the opportunity to get involved in even bigger unicorn deals such as Uber and Airbnb deals. Uber could bring a $60 billion IPO which could generate roughly $3 billion in underwriting fees to help fatten up banker’s year-end bonuses. Of course, the fee percentages should get negotiated down in order to win the deal. We look forward to watching the 2017 IPO calendar unfold and will update readers on the higher profile transactions.