13 Reasons Why IPOs Perform Poorly Long Term: An Investing Series

The IPO market is revving up in 2019, after solid IPO activity in 2018. As ride-sharing Lyft shares recently took off in the public market, many companies are ready to take the plunge into the public market.

Should the average investor buy shares of a company at the IPO price? Or, if they weren’t able to buy at the IPO price, should they seek the shares in the secondary market after the stock has made its debut? What are the risks?

As a former Wall Street insider, let me explain:

• the initial IPO process
• the potential risks of buying at the IPO price
• buying shares in the secondary market shortly afterwards.

Let me also throw an alternative: buying after some risks are better known or after the lockup provisions expire for original owners and  employees. See our Part II of this series.

The Initial public offering (IPO) process in 7 steps:

1. When a private company first sells shares of its stock to the public, that is you and I, they are seeking to transition the company’s ownership from private ownership to public ownership. The company and its board of directors make the decision “to go public” for a variety of reasons but largely to raise capital to further expand the company into new and existing markets. The private company may have received venture capital or private equity and expertise at earlier stages of its development.
2. The rule of thumb is that a private company should not tap the market before they are of a minimum market capitalization (or caps) of at least $250 million-$300 million to establish a more liquid trading market.  However, many companies have been going public at far larger market caps like ride-sharing Lyft. They raised $2.34 billion for a market cap of $20.462 billion at the $72 per IPO share price.
3. Some companies remain private without plans to sell shares to the public market (think Koch Industries run by the very private Koch brothers), or ultimately tap the public markets after being a private company (such as Levi Strauss & Co. planning an IPO in 2019), or a certain amount of maturity (like Alphabet, Facebook).
4. Once a company decides to sell shares, it chooses a lead underwriter, such as Morgan Stanley, to help with the very detailed securities registration process required by the SEC (Securities Exchange Commission), company management go on an intense “roadshow” to meet with potential investors, to determine the distribution of the shares and gauge aftermarket support of the public shares. In large IPO deals, the lead underwriter will select a couple of underwriters among a group of investment bankers and broker dealers who will handle the syndicate, or the distribution of the shares to the larger institutional investors and retail investors.
5. Investors will see more IPOs coming to the public in bull markets, that is when there is more enthusiasm for the stock market and better valuation comparisons (often called “the comps”) for the company going through the IPO process compared to valuation of existing peer publicly traded companies. The IPO market dries up in the bearish stock markets, when investors are more worried about the existing shares in their portfolios and have less appetite to look at new issues.
6. Typically, the lion’s share (about 90%) of the IPO shares are allocated to institutional investors, (5%-10%) going to retail investors and direct shares that go to the “friends” of the company, including friends, family and key employees.
7. Institutional investors are entities including banks, pensions, investment advisors,  insurance companies, endowments, and mutual funds. They have pools of money to invest in newly issued IPOs to add to their stock portfolios. When they are allocated shares by the underwriters, they get only a small percentage of their desired ownership, particularly if it is a particularly “hot deal.” The bankers’s expectations are that these large investors will be actively buying more shares in the aftermarket which supports or further boosts the newly traded shares.

IPO performance after initial offering and longer term can be very different

The average IPO on its first day of trading rises about 15%-20% above the IPO price as the excitement of the new issue spreads to all investors along with the institutional investors adding to the shares they received at IPO price. Linkedin shares soared over 100% but others weaken soon after. The IPO market was pretty active in 2018 and assessment of their performances are here and here.

Facebook’s IPO experience provides some lessons for future IPOs

• Take the case of Facebook’s huge IPO which priced at $38 per share on May 18, 2012. Its lead underwriter was Morgan Stanley, along with co-underwriters JP Morgan and Goldman Sachs. The original IPO range was $28-$35 per share, but the price range was raised along with the expanded number of shares offered as order demand was very strong, including from retail investors who were able to get more shares than was customary.
• This was Facebook and hoodie-laden Zuckerberg, among the fast-growing Internet players on earth with close to 1 billion eyeballs on its network. I was among the retail investors clamoring for some shares. The stock rose quickly to $45 per share but it hit a wall and closed that initial day up pennies higher than its IPO $38 price, dropping fairly quickly to the teens by the end of 2012, before recovering in 2013.

Using Facebook IPO as case study, what were some of the problems that their shares faced so soon:

• The expansion of the Facebook share offering simultaneously with the higher price tampered down the typical buying that supporting the shares in the aftermarket. Those who wanted to buy more shares had already gotten bigger portions.
• Rich valuation concerned some investors given that Facebook was focused on growth, not earnings. While it was expected to have 1 billion users and grow significantly from that base, investors started questioning where earnings were going to come from. Facebook’s plan for advertising was well into the future and not well developed as the advertising behemoth is now is.
• Facebook was won over by NASDAQ, rather than listing its shares on  NYSE. A big win for NASDAQ but they had trouble handling all the shares of the offering and there were glitches. Indeed, I recall hearing many retail investors were getting twice the number of shares they bought in the aftermarket in error.
• Given the larger amount of Facebook shares that were allocated to retail investors, you sometimes see investors flipping shares soon after they received the shares. Flipping of shares, that is, not holding them a longer time, usually occurs when there is a big pop in the early days of trading in the secondary market. Flipping is frowned on as bad practice and an institutional investor flipper will likely not get new shares of the next hot deal. However, retail investors that were allocated shares may tempted to sell their shares. Fidelity, among other online brokers, warns retail investors not to sell their shares for a period of time.

An explanation here about how the pricing of IPOs are generally decided

•  Underwriters and the companies typically debate the final IPO price in the last day or so, weighing the strong demand for shares and the expectations for share price appreciation in the aftermarket. The company whose shares are going into the public market are hoping to raise the highest amount of capital as that was their goal. The underwriters also enjoy a big payday that revenues generated from the deal based a percentage of the amount of the capital raised.
• On the other hand, there is a strong argument for underpricing the deal too for the new investors to the company. These are the largely institutional  investors who will benefit from the potential appreciation from the shares in their portfolios. Remember, the bankers need these same investors for their next deals!
• Underwriters do support the newly public shares immediately after the pricing. Analysts associated with the underwriters of the investment banking firms are expected to cover the new companies with research and recommendations through ratings such as Strong Buy, Buy, Hold or Sell after the “quiet period.”. These quiet period restrictions are placed on analysts affiliated with the investment banks involved in taking the company public.
• Although this period has been relaxed to 10 days in 2015 by the SEC, those analysts will likely to wait the traditional 25 day period. As an analyst about to initiate research coverage of a newly minted public company,  I often found the longer time was a comfort for management about to face a larger more public world while letting the stock settle down.

Longer term, 6-12 months later, the average price is generally poor, well below the IPO price. There have a number of companies whose shares performed poorly. Among companies that have faced challenges were Groupon, Zynga, Snap,Twitter, Pets.com, Blue Apron, and some of the companies have since been able to right themselves.

 

 

13 reasons why there is poor performance after 6-12 months:

1. Young management, often founders, are inexperienced with dealing with public investors with short term goals. The transition for many such company management, going from a private company to the public arena is tough. They are now responsible to many more owners who have their own responsibilities to generate good returns in their portfolios and shorter term horizons from their investors. Institutional investors may not be as patient with fractional price declines.
2. Communicating with “the street,” that is analysts and investors, can be difficult. I often found that there was a learning curve for the management of new public companies. They were clearly uncomfortable, becoming defensive at the questions thrust at them by the analysts, they themselves having their own learning curves with the new company.
3. Some management may get very hostile. Remember the Elon Musk’s scolding of analysts on Tesla’s earning call? This is not good for the stock price performance. I was often the only analyst covering a small company, and I felt responsible to the institutional investors when the company missed earnings, and the company was either hostile on the call, or worse, no where to be found to answer the question.
4. Lockup provisions that expire soon after the company go public. The original owners of the company, which include the founders, management, employees, and venture capital/private equity funds (VCs and PEs) among other possible owners can be potential substantial owners of shares that are “locked up” for a waiting period of a time, usually from 3 months to 24+ months.  In other words, they are prevented from selling their shares in the public market for a specific period. New shareowners do not want these shares to be sold enmasse, because these sales will depress their share price. Investors typically prefer senior management to remain owners of their stock to reflect their confidence in the company, “their skin in the game.”
5. There is often an overhang or dampening effect on the shares until certain investors, especially the VCs or PEs, who want to get their capital investment plus appreciation for their years of managing and grooming the company for public ownership. Investors grow concerned about the timing of potentially millions of shares being sold into the market at the same time.
6. Some companies, shortly after their public offering disappoint their new investors with a myriad of issues and challenges in communicating  and explaining the reasons for the “bad news”  to their shareholders and to new analyst coverage on conference calls. Some young companies with spectacular growth look like nothing could harm their skyrocketing path, until of course it does.
7. Missed revenues or earning results compared to expectations. If this occurs in the earnings report shortly after the company became public, it will cast doubt in investors about managements’s grasp of its company. And if this recurs in a subsequent earnings report, management credibility could be lost.
8. Revised forecasts that are adjusted downward for missed orders, lost customers, or  declining growth.
9. Delays in new products or services or misjudging demand.
10. New or emerging competition that is occurring at a faster rate than previously realized.
11. Increased capital spending, increased losses, increased borrowing. This doesn’t have to be necessarily bad news for investors if the management is adept at explaining this as an opportunity for  the company.
12. A key management departure that was not expected.
13. Insensitive Twitter comments made by management.

With all the upcoming IPOs expected in 2019 from the likes of Levi Strauss, UBER, Palantir, Airbnb, Pinterest, and Postmates, what could investors do to be better prepared whether they have an opportunity to buy at the IPO price, or will consider buying shares in the secondary market.

5 tips for investors on whether buying at IPO price or in the aftermarket:

Read and analyze the company’s S-1 registration once it is filed. Be aware that this document may be amended several times before the final IPO pricing with potentially material information.

What’s in this preliminary prospectus:

1. Get an understanding of the company, its markets, its near-to-intermediate term plans for market and product expansion.
2. What is company management experience, their compensation,  their share ownership of the company before and after the expected IPO. How deep is their bench as they grow more significantly. Some of the management have been very young (Alphabet’s founders skateboarded to work, Zuckerberg’s hoodie on the Facebook roadshow) and investors needed to get a comfortable and trust in their short years as head of the company.
3. Lockup provisions of existing shareowners and timing of their expiration must be disclosed to potential investors.
4.  The current plans for the capital raising associated with the IPO but what about future expansion plans and follow-on offerings which may dilute these shareowners.
5. Does the share structure reflect a dual ownership where the company’s founder/management retain super voting power of the company at the expense of the new shareowners? This has become more common but there are some institutional investors that have policies against this structure.

The risk factors are increasingly comprehensive as the SEC is requiring more disclosure of any potential issues that may arise. It will provide you with possible flags you should be concerned about regarding  the company. You should raise your concerns from your previous experience or what you know about the management from their public comments.

7 Risk Factors in the  S-1 to be aware about:

1. Industry issues vary and should be disclosed and understood. Some industries are more capital-intensive, more competitive, subject to more regulation, more people-intensive, exposed to commodity pricing or shortages.
2. Regarding economic issues, some companies may be more exposed to global economic pressures while a few may be more defensive and able to weather recessions better.
3. Substantial risks to the company’s business model due to changes in technology that may make a certain company’s technology obsolete.
4. Low barriers to entry from potential competitors plague some companies.
5. Revenue concentration by a small number of customers could make it difficult if a company any one of those customers.
6. The company’s need for high capital investment over the next few year will potentially impact the company’s balance sheet, borrowing needs, earning potential and potentially dilute shareholders.
7. Management may disclose that their primary focus is on growth and leveraging the market while the “window of opportunity” remains open to the company. Emerging growth companies are letting you realize that losses should be expected or worsen with less emphasis on earnings.

This is not an exhaustive list for what you read and understand about a company and its fundamentals in the S-1 or hear from companies on their roadshows as they meet with potential investors. It is also a working list of questions or issues you need to understand about any company you are considering when making any stock investment for your own stock portfolio.

Buy at the IPO price if after you read the final version of S-1 and have done your homework:

• The company has outstanding management and you have comfort that they have a talented team and a good plan you think they can execute.
• The company’s risk factors are surmountable and the capital raising will enable to company provide investors measurable indicators of the success.
• The company is well positioned and differentiated in an attractive market and has a solid game plan.
• The company’s valuation is rich but is comparable to peer companies in the universe. The company may be priced at a rich valuation, usually a multiple of revenue, or EBITDA which stands for earnings before interest, taxes, depreciation and amortization or a very high price-earnings ratio but is expected to normalize over the next couple of years.

The big question is whether you should buy the stock soon after the company goes public because you are enthused about the company but were not able to buy at the IPO price but you watched as the stock went straight up on the first day. It is also tempting to chase a company you see performing well after IPO but sometimes that is the worst time to buy it.

Generally, I would say exercise an abundance of caution. I don’t want to be cute but what goes up often goes down. There are particular times when you may be able to buy that particular stock in the near-to-intermediate future.

Four possibilities of when you may have an opportunity to buy the targeted shares:

1. When the company reports its first quarterly results after the IPO, the company may report in line or slightly better than what was forecasted. Investors may have hoped or expected  “a big beat” in results and instead the report is largely in line or may even be a little light because of management distraction by the IPO process.
2. The lockup waiting period is usually well known and about to expire and it may put some short term pressure on the shares you want to buy. Sometimes the underwriters and the insiders who own the shares have arranged for an organized sale of those shares and the disruption of the shares may be very temporary but provide you with a chance to buy those shares.
3. More IPOs will flood the market and some institutional investors may need to shift their stock portfolio around putting pressure on some of the stocks that came to market.
4. The market declines on worries over a bunch of factors (eg. trade talks fail, economic woesthat have little to do with the company whose shares you wish to buy but it takes all of stocks down with one brush. Sometimes it provides an investor with a chance to buy a stock they were looking at and it has declined with.

 

This is part 1 of a two part series on investing in IPOs.

Please read part 2 of our Investing Series on 7 Tips and 7 Risks For IPOs

 

To some extent, the active IPO market in 2019 is very reminiscent of the 1990s “dot.com” era when the IPO market was filled with many great companies and not-so-great companies, many vying for public capital raising just by literally adding “com” to their names. While it gave us companies like Amazon, names of many of those companies are no longer remembered.

Do you typically participate in the IPO market, or wait for the dust settle on the newly minted stock? What is your experience in the stock market with new companies? Can you share your experience with us? We would like to hear from you!