IPOs vs SPACs

Came across two competing ideas this week. First, ...

Posted by Madeeha Ghori on September 2, 2020

Came across two competing ideas this week. First, from Bill Gurley, IPOs are inefficient and leave money on the table. The second, from Alex Rampell and Scott Kupor of Andreessen Horowitz: it’s natural and even healthy for an IPO to pop.

The two can, of course, co-exist. To piece the two together would look something like this… Let’s assume I have a company, Phenomenal Studios, that’s going public.

Step 1: Find an underwriter

Phenomenal Studios teams up with an underwriter. Let’s say the underwriter is called Community Bank. Community Bank is responsible for finding buyers for the stock.

Step 2: Fundraising

This is when Phenomenal Studios says “Hey, Community Bank. I want to sell 9 million shares and get $100-200M for it.” These shares aren’t actually going to be sold to the public. The folks who buy these 9M shares will have the option to sell them to the public.

a22r

According to a22r, in the fundraising step, all stock must be sold to all investors for the same price. It’s never really explained why. So Community Bank needs to find a collection of investors that are willing to buy 9 million shares for roughly $100-$200M.

a22r argues that this is the first factor in a natural IPO pop. You may have a group of investors willing to pay $33/share. But that group may only be willing to buy 1M shares. Meanwhile, a much larger group of investors might be willing to buy all 9M shares at $15/share. Yeah, your share price gets cut in half, but you get $135M instead of just $33M.

Gurley

Gurley argues that there’s incentive for Community Bank to push that $15/share number lower and lower. In today’s era, he says, Community Bank is the agent not just for Phenomenal Studios but also for the investors1. A big IPO pop means Community Bank can say “Hey, rich folks of the world! Put your money in our investment accounts and you’ll get deals on IPOs like Phenomal Studios’. Did you see the last IPO we fundraised popped 2x on its first day of trading?”2

Step 3: Put the shares on the public market

a22r

At this point, there are two different things at play:

Decreased Supply: The percentage of shares on the market is completely different from the percentage of shares sold. Those investors who bought at cheap prices yesterday? They’re mostly long-term thinkers. They’re not gonna flip and pay income taxes on their gains. Community Bank will even have to let folks into the round purely as “yes, we promise to sell” plays. So while 9M shares were sold yesterday, maybe only 1M are sold on the public market today.

Increased Demand: The investor mix is completely different. We said the folks yesterday were mostly long-term institutional folks. Well, now that it’s on the public market, a higher percentage of day traders, speculators, etc are in the mix. Not to mention that it’s the public market! The upper limit of demand is exponentially higher than before. So of course the price per share will rise. And further more, it needs to rise in order to tempt yesterday’s investor group to let go of shares.

a22r goes one step further here as well. They argue that if there isn’t an IPO pop, that’s a bad sign for the company overall. We opened up the stock to the entire world and demand wasn’t higher than it was yesterday? Not even risk-taking investors think the price big investing orgs paid was worth it? Yike, my friend. Yike.

Gurley

At this point, the round is already designed to pop maybe 100x. If you work at Community Bank getting investors to subscribe to Phenomenal Studios’ IPO round, Gurley says:

You are told the “optimal” target is to be 30X over-subscribed. This is not a joke. You are told that you actually need 30X more orders than you actually plan to sell. This is an explicit admission that they plan to ignore 97% of the actual orders and fill only 3%. (One huge side note here — most investors are blocked from even putting in an order, including the majority of all retail investors. So the “real” oversupply is likely much, much higher than 30X … [it] might be over 100X.)

Putting it all together

So how do these two come together? a22r explains why it’s natural for some pop to occur in an IPO. But Gurley points out inefficiencies (why can’t you legally raise funds via direct listing instead?) and conflicts of interest that lead to a much bigger pop than necessary.

  1. Yes, that’s as bad an idea as it sounds. Imagine the buyer and seller of a house sharing the same real estate agent. ↩

  2. check out Gurley’s blog post for details and potential sources (an academic paper and a screenshot). ↩

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