I’ve decided to write about something I don’t really understand, but I’m interested in (especially because I work at a startup!): namely, how IPO’s work and why there seem to be consistent pops. Pops are jumps in share price from the offering to the opening, and then sometimes the continued pop (or would that be fizz?) for the rest of the trading day. Here’s an article about the pop associated to LinkedIn a few weeks ago. The idea behind the article is that IPO pops are really bad for the companies in question.
The way a standard IPO works is that, when a company decides to go public, they hire an investment company to help them assess their value, i.e. form a sense of how many shares can be sold, and at what price.
A certain number of people (insiders and investors at the investment bank in particular) are then given the chance to buy some shares of the new company at the offering price. This is an obvious way in which the investment bank has an incentive to create a pop- their friends will directly benefit from pops. In fact the existence of pops and their accompanying incentives have inspired some people (like Google) to use Dutch auction methods instead of the standard.
And the myth is that there are consistent pops (here are some examples of truly outrageous pops during the dotcom bubble!). Is this really true? Or is it a case of survivorship bias? Or is there on average a pop the first day which fizzles out over the next week? I actually haven’t crunched the data, but if you know please do comment.
One question I want to know is, assuming that the pop myth is true, why does it keep happening? If it’s good for the investment bank but bad for the business, you’d think that businesses would, over time, train investment banks to stop doing this quite so much- they’d get bad reputations for big pops, or even possibly would get some of their fees removed, by contract, if the pop was too big (which would mean the investment bank hadn’t done its job well). But I haven’t heard of that kind of thing.
So who else is benefitting from pops? Is it possible that the investors themselves have an incentive to see a pop? While it’s true that the investors sell a bunch of their shares into the IPO to provide sufficient “float,” which they’d obviously like to see sold at a high price, they also have the opportunity to buy a restricted number of “directed shares“, which are shares they can buy at the offering price and then immediately sell; these they’d clearly like to buy at a low price and then see a pop. So I guess it depends on the situation for a given insider whether they are selling or buying more – I don’t know what the actual mix typically is, but I imagine it really depends on the situation; for example, there are always shared created out of thin air on an IPO day, so it will depend on how much of the float is coming from the investors and how much is coming from thin air.
The most standard thing though is for someone like an employee is to have common shares (or options to buy common shares) which they can only sell 6 months (or potentially more if the options are vested) after the IPO, which I guess means they are probably somewhat neutral to the pop, depending on its long term effect.
Speaking of long term effects, I think the biggest and most persuasive argument investment banks make to investors about stock evaluation, is that it’s better to underestimate the share price than to overestimate it. The argument is that a pop may hurt the business but it’s great for investors and thus the reputation value is overall good (this argument can obviously go too far if the pop is 50% and sustained), but that an overevaluation could result in not being able to sell the shares and having a sunken ship that never gets enough wind to sail. In other words, the risks are asymmetrical. I’m not sure this is actually true but it’s probably a good scare tactic for the investment banks to use to line their friends’ pockets.