IPOs Revisited

I’ve commented earlier on this blog about investment bankers shafting companies that want to raise money from the market, by pricing the IPO too low. While a large share price appreciation on the day of listing might be “successful” from the point of view of the IPO investors, it’s anything but that from the point of view of the issuing companies.

The IPO pricing issue is in the news again now, with LinkedIn listing at close to 100% appreciation of its IPO price. The IPO was sold to investors at $45 a share, and within minutes of listing it was trading at close to $90. I haven’t really followed the trajectory of the stock after that, but assume it’s still closer to $90 than to $45.

Unlike in the Makemytrip case (maybe that got ignored since it’s an Indian company and not many commentators know about it), the LinkedIn IPO has got a lot of footage among both the mainstream media and the blogosphere. There have been views on both sides – that the i-banks shafted LinkedIn, and that this appreciation is only part of the price discovery mechanism, so it’s fair.

One of my favourite financial commentators Felix Salmon has written a rather large piece on this, in which he quotes some of the other prominent commentators also. After giving a summary of all the views, Salmon says that LinkedIn investors haven’t really lost out too much due to the way the IPO has been priced (I’ve reproduced a quote here but I’d encourage you to go read Salmon’s article in full):

But the fact is that if I own 1% of LinkedIn, and I just saw the company getting valued on the stock market at a valuation of $9 billion or so, then I’m just ecstatic that my stake is worth $90 million, and that I haven’t sold any shares below that level. The main interest that I have in an IPO like this is as a price-discovery mechanism, rather than as a cash-raising mechanism. As TED says, LinkedIn has no particular need for any cash at all, let alone $300 million; if it had an extra $200 million in the bank, earning some fraction of 1% per annum, that wouldn’t increase the value of my stake by any measurable amount, because it wouldn’t affect the share price at all.

Now, let us look at this in another way. Currently Salmon seems to be looking at it from the point of view of the client going up to the bank and saying “I want to sell 100,000 shares in my company. Sell it at the best price you can”. Intuitively, this is not how things are supposed to work. At least, if the client is sensible, he would rather go the bank and say “I want to raise 5 million dollars. Raise it by diluting my current shareholders by as little as possible”.

Now you can see why the existing shareholders can be shafted. Suppose I owned one share of LinkedIn, out of a total 100 shares outstanding. Suppose I wanted to raise 9000 rupees. The banker valued the current value at $4500, and thus priced the IPO at $45 a share, thus making me end up with 1/300 of the company.

However, in hindsight, we know that the broad market values the company at $90 a share, implying that before the IPO the company was worth $9000. If the banker had realized this, he would have sold only 100 fresh shares of the company, rather than 200. The balance sheet would have looked exactly the same as it does now, with the difference that I would have owned 1/200 of the company then, rather than 1/300 now!

1/200 and 1/300 seem like small numbers without much difference, but if you understand that the total value of LinkedIn is $9 billion (approx) and if you think about pre-IPO shareholders who held much larger stakes, you know who has been shafted.

I’m not passing a comment here on whether the bankers were devious or incompetent, but I guess in terms of clients wanting to give them future business, both are enough grounds for disqualification.

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