Spotify was in the news lately for its unique structure for going public, direct listing. I can barely find a decent article that explains it (this FT one ain’t bad), but what you need to know is that instead of the company selling a bunch of new shares to the public, existing shareholders are now able to sell their shares to the public. That’s it. Spotify itself isn’t raising any cash.
But I’m not here to write about this particular little maneuver. Instead, let us debunk the most common pseudo-intellectual argument about IPOs, one I see from journos just a little too often.
Spot the Issue:
See if you can spot the issue with this fortune article.
…But if the creators of Snapchat are so smart, why did they allow their Wall Street underwriters to price the shares at far less than they’re really worth, depriving the money-losing startup of a mountain of cash?
…A syndicate led by Morgan Stanley, Goldman Sachs and J.P. Morgan pre-sold 145 million shares in Snap at $17 a share, raising $2.45 billion in cash needed to bolster its treasury….
…Had it sold those 145 million shares for what investors were really willing to pay––$25 a share––it would have raised not $2.45 billion, but $3.55 billion. In a single day, Snap left $1.1 billion on the table, money that was pocketed by mutual funds, ETFs, and hedge funds that could have greatly strengthened its balance sheet….
…Viewed another way, Snap could have sold 31% fewer shares and still raised $2.45 billion.
The article goes on to suggest that Wall Street is playing a con game where it has convinced everybody that this is how to keep the wheels spinning and that by making some profits for their best clients, everybody wins. They’ve pulled the wool over everybody’s eyes, or something.
But Wall Street is Bad, Where’s the Problem?
This is all wrong. The error stems from the oversimplification of thinking that the market cap (shares times price) is actually the value of the company if one were to buy all of the shares (or sell) at any given moment. But that’s wrong.
The stock market just tells you what price the last two people that traded shares for cash were willing to do their deal at. It certainly does not tell us what all of the shares could be bought or sold for. To know that, we’d have to be familiar with calculus, and understand that what we need to know is the area under the curve, because while some people might sell at the current price, there are others who obviously would not, as evidenced by the fact that they haven’t sold yet. And they would require a higher price. How high? There is no way of telling. The average premium is around 37%, so we aren’t just talking pennies.
Give Me an Example:
So how does this apply to IPOs? It means we have no idea how much money is left on the table if the stock ends the first day up. The company has to guess at what price they will sell as many shares as they need to raise the capital they are looking for. There may be 5 million people willing to buy one share for $20, but if they need to raise more than $100 million, then they are going to need to lower the price. Perhaps if they sell at $19, they can sell one share to 6 million people, and raise $114 million. If the price subsequently rises to $20 does that mean $6 million was left on the table? Certainly not. Was any money left on the table? For an IPO that sells all of the shares being offered, certainly some was.
However, if those 5 million people get their shares for $20 each, presumably they all value the shares at or above that $20, and therefore we would expect to see the price go up. One of those holders may only value the share at $21, and if someone else values it at $22, the $22 guy will buy it from the $21 guy at $21.50 (or something like that).
There are clever ways for companies to maximize what they get out of the process, dutch auctions for example. But even with a dutch auction, we’re in a situation where the investors have bought something for a price they feel is fair or better than fair, and unless the rest of the market disagrees greatly with the investors who buy at the IPO, there is going to be a ‘pop’ on day one.
All of this isn’t to say that there is no value in having access to IPOs or that the companies don’t end up leaving money on the table. What I am saying is that the amount left on the table is very unlikely to be anywhere close to the closing price minus the IPO price times the shares issued.
What Does It All Mean?
The next time you hear somebody talking about the dumb company that left $X billion on the table during their IPO, remember that the person who said it probably has no clue about how markets actually function, and that while more than $0 is left on the table during an IPO, the actual amount is completely unknowable and very probably not anywhere near the usual naive calculation.