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What, exactly, is an IPO?
My RSS feeds, tweet stream and favourite websites are all awash with news of Facebook’s IPO. But I also picked up questions at a much more basic level like “What is an IPO?”
So why did Facebook float, and what does that mean?
What is an IPO?
An IPO is an Initial Public Offering. It means that a company chooses to register (or “list”, hence “listed company”) on a regulated stock exchange to enable members of the public (hence “public company”) or institutional investors (such as the people who manage your pension fund or life insurance) to buy or sell shares in the company.
In the UK, it is also known as a flotation, and we would say that a company “floated on the stock market”.
Why would you IPO? – answer 1
The text book answer is “to raise money”. If you want to have more cash available for expansion – to buy a new factory, to build a new product, to open international offices or whatever – you can sell shares in your company.
You could sell them to friends and family, to a venture capitalist, to a growth or private equity investor or to investors in the public markets.
Investors in the public markets are very late stage. They are more focused on stability than growth. They worry about the downside as much as they get excited about the upside. Hence companies that go public have often passed the peak period of growth and expansion, and are settling down to the long-time grind of running a successful, profitable (but no longer hyper-growth) company. (See my former colleague Bill Gurley’s excellent post on Facebook’s S-1 and analysis of whether Facebook is past its peak).
As a result, institutional investors expect companies which float to be lower risk than the types of businesses that VCs and private equity invest in. They therefore expect lower reward, and are happy to take a smaller slice of the company, at a higher valuation, than an investor who is investing when the company is still private.
So you would float to raise money for your company at a better valuation than you could in the private markets (see “Why wouldn’t you IPO? – answer 2” for why this may no longer be true.)
Why would you IPO? – answer 2
The problem with answer 1 is that Facebook doesn’t need the money. It is raising $5 billion when it is already sitting on $3.9 billion in cash. So why is it listing now?
The answer is liquidity.
Let me give you an example. A long time ago, I was CFO of a dotcom startup, a comparison shopping website called Shopsmart. We’d raised some money from a bunch of high net worth individuals, and on the basis of our page views alone, the FT said we could be worth as much as £400 million.
Some of the development team had joined the company in the early days and had options over 0.25% of the company. They were millionaires! Some of them even started spending as if they were millionaires.
Only they weren’t. It was an estimated value in an illiquid stock, meaning that there was no way for them to sell shares to someone else. Until the company was acquired, or floated on stock exchange, their stake in Shopsmart was simultaneously hugely valuable (if you believed the dotcom hype) and totally worthless (because they couldn’t sell their shares to anyone).
A stock exchange is an exchange. It is a place where buyers and sellers come to sell things (in this case financial assets like shares, bonds and derivatives). Its primary function in society is a sophisticated pricing mechanism for risk.
But it is also like ebay. A place for matching buyers and sellers. A place where you discover what something is actually worth by offering it for sale and seeing what someone will pay for it.
So for Facebook, an IPO is a liquidity event. By being public, employees with options and investors who invested in the early days of Facebook can convert theoretically valuable things (options or shares in Facebook) into cash.
This can be done outside of a regulated exchange, but it is much easier when a company is public. I don’t think that Facebook is listing to raise money. It is listing to provide liquidity for employees and investors.
Why would you IPO? – answer 3
The third answer is ego, both of the executives and the investors. Taking a company public makes the early investors look good. It is good for the Silicon Valley ecosystem. It can make the CEO feel more important (although Mark Zuckerberg was pretty damned important anyway). It can make employees feel that they are working for a bigger, better, more “real” company.
In the case of Facebook, this is the main reason I think it is listing.
* * *
Why wouldn’t you IPO? – answer 1
Going public is very expensive. As soonas you decide that you are going to be a public company, your administration costs start to spiral. In the US, you have to get ready to file your financial statements every three months. You have to reveal your company’s inner financial workings in great detail in a registration statement (also known as an S-1). This is a much bigger for wrench for American companies (which have never had to reveal any financial details before) than for British ones (which are used to having to file their annual accounts at Companies House anyway)
How much will they go up? Well after the spectacular crash of companies like Enron a decade ago, a couple of US Senators pushed through the Sarbanes-Oxley Act which required much more stringent financial reporting. That adds direct compliance costs of $2.3 million to your company, as well as creating an environment where experimentation, risk-taking and new projects can be much less attractive because of the costs of monitoring and reporting on them.
Whenever a private equity firm takes a company private, their logic is often that they have “to restructure the company and help it adapt to changing market conditions away from the glare of public scrutiny and a fixation on quarterly performance.”
Add together the regulatory cost and the short-term perspectives of public investors and you can see why many companies prefer to remain private.
Why wouldn’t you IPO? – answer 2
Because you might be able to get a better valuation in the private markets. Economic theory suggests that the lower the risk an investor is taking, the lower return he will expect, because he does not need to be compensated for the risk that he loses his money.
The corollary of this is that a lower risk investment is worth more, and when you are selling shares in your company, it is good to sell them at the highest price that you can.
Theoretically, publicly listed companies are lower risks than private ones. They are regulated by the rules of the exchange. They have to be audited and be transparent about their financial affairs. If you want to sell your shares, you can do so at the touch of a button, rather than via tortuous negotiation involving lawyers and contracts.
However, this may not hold true at the moment. The emergence of sovereign wealth funds and enormous late stage investors like DST have meant that companies like Zynga and Facebook have been able to raise vast amounts of money in the private markets.
So much so that the investors in Zynga’s final round as a private company may be sitting on a paper loss after the IPO. With private investors prepared to value a company more highly (possibly because they didn’t have access to the same level of information as public company would have to provide), why would you take your company public?
Why wouldn’t you IPO? – answer 3
Being the director of a public company is heading towards having more downsides than upsides. As an executive, your salary and earnings become public knowledge and you become fair game for tabloid rabble-rousers due to your “public status”. As a non-executive, you have responsibility – true, legal responsibility – with little authority for relatively low pay. The reputational risk can be pretty high. I’d much rather be a non-executive of dynamic private company than a regulated public, particularly with the current anti-business sentiment running through the press and the nation. Never say never, though.
An IPO is an important newsworthy event because, particularly in the US, it means that a company is revealing information about itself that has only been known to insiders before. It is a transformation of a company from a secretive outside to part of the public establishment. It is a key moment in a company’s life.
I wish more people knew what it was all about.