South Florida Arbitration & Litigation Lawyer Blog
Initial Public Offering (IPO):
Additional due diligence factors to consider before investing in an Initial Public Offering (IPO):
In addition to the due diligence factors that we discussed in an earlier post, which can be found here, an investor may want to take into consideration the following items when making an investment involving shares of a new public company.
Please keep in mind that this post is being provided for educational purposes only. It is not designed to be complete in all material respects. Thus, it should not be relied upon for legal or investment advice. If you have any questions concerning the contents of this post, please contact a qualified professional.
Offering price:
The company and the underwriters make the decision on where to set the offering price. The factors they will consider in setting the price, as well as the terms of the underwriting agreement between the company and the underwriters, are discussed in the prospectus, usually under the caption Underwriting or Plan of Distribution. It is important to understand that the offering price is determined by a mix of market conditions, analysis and negotiation. Competing interests affect the determination of the offering price.
From the perspective of the company offering its shares in the IPO, the higher the offering price, the more capital the company can raise. The underwriters also have an interest in a high price not only to meet the company’s objectives, but also because their compensation is typically a percentage of the offering price.
At the same time, the underwriters are responsible for selling the IPO and will want a price that is attractive to the client-investors to whom they will be selling. Underpricing an IPO creates a discount for the initial investors, increases the demand for the IPO and helps the underwriters sell all of the available shares. Underpricing may also affect how much, if at all, the stock’s price rises on its first trading day. If there is a large increase, or “bump,” from the offering price during the initial trading, the underwriter’s client-investors may be satisfied because the value of their investment will have increased. However, the company may be unsatisfied in that case, as it might have been able to sell its shares at a higher initial offering price and thereby raise more capital.
Informing these competing interests are valuation analysis of the company’s business and the “order book.” Valuation analysis, which can be conducted by underwriters or potential investors, attempt to value a company based on its revenues, customers, financial results and other metrics. The “order book” is the compilation of indications of interest that the underwriters have obtained from the client-investors they solicited regarding the IPO. The order book lists how many shares each client-investor would like to purchase and at what price.
All of the foregoing factor into the determination of the offering price. Whether you have an opportunity to participate directly in an IPO or are buying shares in the open market, it is important to realize that the offering price reflects a negotiated estimate as to the value of the company. The offering price may bear little relationship to the trading price of the securities, and it is not uncommon for the closing price of the shares shortly after the IPO to be well above or below the offering price.
In addition, purchasing shares in the market immediately following an IPO can be risky. Underwriters can support the trading price of the new issue in its first few days of trading with certain trading activities, including purchasing shares of the company. This is often done to keep the trading price from falling too far below the offering price. Once this support ends, the stock price may decline significantly below the offering price.
Selling shareholders:
Existing shareholders can sell their shares in the IPO if their shares are included in and registered as part of the offering. Most large IPOs include only new shares that the company sells in order to raise capital. However, in some cases, shares held by existing shareholders are included in the IPO and the shareholders are called “selling shareholders.” The proceeds from the sales by selling shareholders do not go to the company and instead go to the selling shareholders.
The cover page of the prospectus details how many shares are being sold by selling shareholders, if any. The company will also disclose the number of shares each selling shareholder currently owns, plans to sell in the offering, and will retain following the offering under Principal and Selling Shareholders or a similarly captioned section. Selling shareholders may include, in addition to early investors seeking liquidity on their investment, the company’s founders and management. Companies must disclose any position, office or other material relationship each selling shareholder has had with the company within the past three years. It may be worthwhile to discern the relationships the selling shareholders have had with the company and what proportion of their respective holdings is being sold.
Limited trading volume:
The trading price of a new issue may be affected by a limited supply of shares in the market immediately following an IPO. The shares being traded on the first day are generally only shares that were sold in the IPO. All other outstanding shares, such as those held by founders, early investors and employees that have not been included in the IPO, may often not be sold in the public market so soon after the IPO, either because they are “restricted securities” under the federal securities laws that can only be resold without registration under certain circumstances, or because the existing shareholders have entered into a “lock-up agreement” in which they agree not to sell their shares for a certain period of time, typically 180 days.
Moreover, underwriter policies that discourage “flipping” also limit the number of shares sold in the IPO that may trade on the public market in the first few days or weeks of trading. “Flipping” is the term used to describe the act of immediately reselling the shares acquired in an IPO through the open market. Underwriters may discourage flipping by refusing to allocate IPO shares to customers who have flipped shares in the past, but the practice of flipping, alone, is not prohibited under the federal securities laws.
These restrictions, lock-up arrangements and underwriter flipping policies all serve to limit the number of shares that trade in the public market immediately following an IPO. The resulting limited trading volume, particularly in the case of a highly sought-after IPO, can operate to drive the trading price of an issue steeply up because of the limited supply to meet the high demand.
Market overhang:
The number of shares that are outstanding but cannot be traded at the time of the IPO is sometimes referred to as the “market overhang.” The share price after an IPO may decline over time as shares that were previously restricted become available for sale. In addition, when lock-up agreements expire, the share price may decline significantly if a large number of shares become available for sale all at once. Early investors and shareholders in a company often view an IPO as an exit strategy-a way to realize a profit on their investment by being able to sell shares to the public. The lock-up expirations give these early investors the opportunity to sell their shares to the extent they weren’t able to do so as selling shareholders in the IPO.
An investor can discover the extent of a company’s market overhang in the IPO prospectus. A company must discuss the shares that it has agreed to register for sale or that will be available for sale without registration following the IPO. This disclosure can typically be found under Shares Eligible for Future Sale or a similar caption.
Dual-class common stock:
An increasing number of companies engaging in IPOs have created separate classes of common stock with one class having greater voting power than the class being sold in the IPO. This dual-class common stock structure is often used by companies that are family-controlled or will continue to be led by their founders, with the “super-voting” common stock held by the founders or controlling family. With this structure, the holder of the super-voting common stock has a much greater percentage of the voting rights in the company than his or her equity stake would otherwise provide and can control the company without owning a majority of its shares. Generally, the super-voting common stock converts to the lesser-voting class of common stock when sold by its initial holder. While many successful companies maintain a dual-class common stock structure, investors should be aware that such a structure may make it more difficult, if not impossible, for public shareholders to exert any influence or control over corporate matters.
Investors in new public companies can determine whether a company maintains a dual-class common stock structure and the rights they will have as shareholders by reviewing the first page of the prospectus as well as the section entitled Description of Capital Stock.
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