7 minute read

The Economics of IPOs

Getting Public Investment    7 minute read

The Economics of IPOs

Last year was the worst one for IPOs since 2009. It was heavily marked by political uncertainty, which made private companies wary of going public. Analysts predict bigger and more robust IPOs this year. The truth is that 2017 started out strong with Snap Inc’s going public last month (in spite of its rollercoaster share price). While none of the other remaining private tech giants has officially announced plans to file for an IPO, analysts are confident that some of them are already planning the move in order to get public capital.

The downside, as always, is opening up their accounting to investors. A bad financial situation or slow growth in clients or users are usually the two main reasons that drive the valuation of companies down when they first go public. If companies are looking for public capital, they need to get their finances in order. And that might prove to be a problem for publicly celebrated “unicorns” like Uber which, in spite of its massive user base and popularity, is reportedly still struggling with heavy quarterly losses.

Accessing Public Capital

When a private company wants its stock to be publicly traded, they need to file for the initial public offering (IPO). In the filing, the company is usually helped by investment banks which underwrite the securities, suggests the offering price and, most importantly, the right amount of shares to put up for public sale.

A team of lawyers, accountants and other experts gather all the company’s financial information in what will become the company’s prospectus (the “red herring”). The document is filed with the right authorities – in the case of the US, the Securities and Exchange Commission (SEC) – setting up a date for the offering and the company is the officially audited.

Valuing the company at a specific share price can be tricky, so entities have to be extremely careful with the timing they choose to file for their IPO. Their valuation is also dependent on the valuation of other similar companies who are publicly traded.

How much the company is expected to grow in the near future is one of the determining factors when deciding the valuation. When a company goes public, investors can buy and sell shares whenever they want, so if the growth potential is not very high, the company will not likely attract many investors or reach their initial goal. Plus, the entire purpose of going public is to reach these goals in order to afford an expansion of some kind, depending on the business model.

Share this chart

A Risky Move

IPOs are usually a tricky investment for individuals. The available historical data on the company is extremely scarce and it is difficult to predict what is going to happen to the stock.

For example, when Facebook filed for its IPO in 2012, the set share price value was set between $28 and $35. However, the financial institutions who underwrote the filing raised the value, arguing that the demand was high. Even though the company is the most successful social network in the world, the stock price did not shoot up as expected in its market debut and for the next few months, it fell more than 50%. Only one year later were the company’s shares being traded at more than $38.

50% is how much Facebook’s share price fell a few months after its IPO

After being publicly traded, the share price set up for the IPO is usually used as the benchmark.

Rough Start

Line, the Japanese messaging app, was the biggest IPO of 2016. The company debuted strongly in the public markets and raised $1.3bn, but things started to take a turn for the worse in the last quarter of the year. The company’s earnings report revealed that it had only seen profits of $66.5m for the year, while famous social networks like Twitter continued to report heavy losses every quarter.

$66.5m were Line’s 2016 profits

However, low profits were not the determining factor for investors. In the last quarter of 2016 alone, Line lost 3 million users worldwide, and the total yearly revenue was lower than in 2015. This information went completely against the high expectations the investors had set up for the company, and they did what public investors often do when they are disappointed: they started selling their shares.

As mentioned, last year was a tough one for IPOs. The number of public offerings was the lowest since 2009, according to Renaissance Capital. The fund manager also reported that one-third of the IPOs filed in 2016 were trading at a lower price than their target by the end of the year. Also, all the IPOs combined only managed to raise a total of less than $19bn.

Share this chart

Changing the Game

As poor as the situation might have been last year, the outlook for 2017 seems to be a lot more positive.

Snap’s IPO is the biggest for tech companies since Facebook and Alibaba. According to a report by PrivCo, there are 130 companies who hold the biggest potential of opting for an IPO this year.

$3.68bn How much Snap wants to raise in its IPO

However, now that the US election has passed, there is more clarity in the markets, and some of those estimated $1bn companies might actually file for IPO. As start-ups, they are not necessarily turning a profit yet, and they have raised billions from hedge funds, mutual funds and venture capitalist firms, which means that they will soon be pressured to return those investments.

Still, the valuation based on private investment does not always mean that the public investors are willing to pay the same. If they are not, there is a chance that the IPOs will not be successful.

Share this chart

Growing Speculation

Spotify has, for years, seen rumours of an IPO. However, Spotify operates a service in a field where it is extremely difficult to be profitable. According to the Wall Street Journal, the music streaming platform has recently gone under another fundraising round and raised $1bn in convertible debt from investors, which pressures the company to go public.

Airbnb managed to raise $850m in September, which, together will all the previous rounds of investment, positions the company at a $30b valuation.

$850m is how much Airbnb raised in September

WeWork manages real estate and provides offices for companies in offices in different cities across the world. With an already very high valuation provided by the high private investments it has received, the company might need to go to the public markets in order to get more funding, if it wants to expand into more cities.

Vice media has also been reported as a real contender for an IPO. The media company already absorbed 11 brands and has no plans to stop expanding. CEO Shane Smith met with bankers to discuss an expansionist strategy, and the company will probably need public investment in order to afford it. If it eventually goes public, it will be one of the biggest media IPO in the last decades.

Conclusion

Going public often brings out the real value of the company and has a tendency to expose overvalued companies. An IPO might provide a company with more capital if it all goes according to plan. If it doesn’t, it can have a very negative effect on the goals laid out for the future or even the sustainability of an entity and, as has been obvious in the past, not all companies are built to survive such a shock.

Get articles like this straight to your inbox each morning with our Breakfast Briefing. Sign up by clicking here!

Log in with your details

or    

Forgot your details?

Create Account

Send this to a friend