Companies use IPOs to raise money by selling shares to the public at a certain price.
But one of the things about IPOs is that companies don’t (can’t?) sell all of the shares they want to sell to the public directly on Day 1, when the company “goes public”.
Instead, the underwriters, the ones that help said companies go public, take a chunk of shares being offered and divvy them up amongst their prized clients at the offering or list price.
But as soon as the shares go on the market, on Day 1, investor demand can drive up the share price (or down too, as we will discuss later). The general public believes that if a company’s stock “pops” on opening day and closes at 200% or 300% of the list price, it indicates a “hot” stock.
Perhaps…but from the perspective of the company that is going public (not its officers though), the higher the pop, the worse the offering price. Let us use a quick example to illustrate this:
1. Company offers to sell 1000 shares.
2. The underwriters advise the company, after a investor roadshow designed to gauge interest, to set the list price at $10.
3. The company will therefore raise $10,000.
4. But on Day 1 of the IPO, if the shares close at $30, the company would have still only raised $10,000. The difference, “$30 – $10″ times 1000 = $20,000 went to someone else.
5. Had the shares been priced at $30 to begin with, the company would have raised $20,000 more.
Therefore, it is very important that the list price be set correctly.
And that’s where the underwriters come in…presumably, they have the expertise and the experience to advise the company going public on an appropriate list price.
And since the underwriters’ compensation is a % of the gross proceeds (excerpt from a PWC report on the costs of IPOs below), you would think that the list price is set as high as can be supported by the market. In other words, the incentive alignment is such that the underwriters profit from high prices.
In the case of Goldman Sachs, at least in the case of the 1999 IPO for eToys, strangely, that does not appear to be the case.
Documents unearthed by Joe Nocera at the NYT suggest this (pay attention to the 2nd paragraph):
What they clearly show is that Goldman knew exactly what it was doing when it underpriced the eToys I.P.O. — and many others as well. (According to the lawsuit, Fitt led around a dozen underwritings in 1999, several of which were also woefully underpriced.) Taken in their entirety, the e-mails and internal reports show Goldman took advantage of naïve Internet start-ups to fatten its own bottom line.
Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions, according to depositions given in the case.
And this matters because Goldman Sachs presumably set the list or offering price at $20 but on Day 1, the shares closed at $77. So priced right, instead of the $164 million the company raised, it could have raised ~ $631 million. so where did some of that “missing” $450+ million go? Into Goldman Sachs’ clients pockets – which the bank graciously requested a cut of…
The full article makes for an interesting read.
But that was 1999 and this is 2013, so is this still relevant? I think so, because
a. Underwriters still seem to wield an outsize influence on the list price.
A recent IPO that was famously mis-priced is Facebook, last year. In that case though, it appears that the stock was overpriced…Initially the underwriters seemed to be doing Facebook a favor and themselves a disservice by agreeing to only a 1.1% slice of the proceeds, in exchange for the opportunity to be associated with a red hot company, but the subsequent slide (to, what, $17, from $38?) seems to suggest that maximizing the slice of the proceeds may have played a large role in the mis-pricing.
b. Sweetheart pre-IPO share allocation still seems de rigeur.
Its not just Goldman Sachs seemingly egregious behavior above, but the process of allocating shares by the investment banks to their favored clients doesn’t really sound right. Does it? Admittedly, as part of the IPO underwriting process, the still-private company can do what it wants with its shares, but this seems like a distortion and an anachronism of sorts. If the underwriters are already getting their fees, what explains this practice?
c. Companies are being screwed.
Especially when the IPOs are underpriced, the company that wanted to do an IPO to raise capital in the first place is not capturing a portion of the value that its IPO is creating.
Perhaps the solution to all three problems is to set the underwriting fees as a % of the stock’s closing price 3 months after the IPO, barring any events outside of anyone’s control. But if the underwriting business functions as an oligopoly, who will break ranks first?