Take the Money and Run




Such delicious, outrage-inducing, front-page-of-the-NY Post-worthy words. Unexpected that they’d be used in defense of a company—LinkedIn, in this case, following its much anticipated, eye-popping public market debut on the New York Stock Exchange last week. And rather than emanating from the NY Post, the headlines came from former Wall Street analyst, Business Insider CEO Henry Blodget and New York Times Op-Ed columnist Joe Nocera.

The source of their ire: accepted wisdom holds that a properly priced IPO trades up 10%-15% on its first day in the market. The expectation of that increase lures investors into the new, untested stock, while proper pricing ensures that the company is able to pocket the majority of the proceeds from the transaction. LinkedIn’s shares, priced at $45 each, ended their first day in the market up 109%. A 109% increase sounds fabulous. Yet when an IPO trades like that, investors have benefited from the deal as much as--or in this case, more than--the company has. The company has, in Blodget’s parlance, been screwed by a mis-priced transaction (and whether or not that mis-pricing is driven by underwriter incompetence or willful fleecing is yet another layer to the conversation).

It is of course true that LinkedIn--and its selling shareholders--would have ended up with more money in its coffers had its IPO been priced at $85, $75 or even $55 a share. However to conclude that the company was ripped off because the deal was priced at $45 a share is problematic from a number of points of view: it is a very short-term and entirely non-strategic view of the situation, it presumes that company management and major shareholders had no say in or perspective on the pricing—which is highly unlikely in any IPO and especially in this one, and most problematic of all it continues to apply the long-outdated metric of a 10%-15% first day increase as an appropriate one-size-fits all measure of a successful, well-structured deal--which it is not.

First the short-term perspective: as investors in January’s Demand Media IPO can attest, strong first day returns are no guarantee of future performance. When the company originally announced the terms of its deal, it was expected to raise $112.5 million, issuing 7.5 million shares at $15 a share. In the end, underwriters determined that investor interest in the transaction was strong enough to justify issuing 8.9 million shares at $17 a share, a 35% increase in deal size (and a commensurate 35% increase in banker fees). The stock traded up 33% its first day to market, closing at $22.65 a share. Yesterday, four months following the IPO, the stock closed at $13.74 a share, 20% below the IPO price. If anyone feels screwed by the deal, it’s investors.

On the other hand, if you invested in eBay’s IPO in 1998 you paid $18 a share. The stock closed at $47.38 on its first trading day, up 163% with a market capitalization of $1.5 billion. Today, thirteen years later, the company’s market capitalization is $40 billion. The chances that the company feels any remorse at all about the $80-$100 million left on the table at the time of its IPO? Remote.

It’s necessary to a take longer-term than one day view when assessing IPO performance. With perfect hindsight, Demand Media’s underwriters might have been more conservative structuring its deal. This would likely have led to an even greater first day pop in price—and would have left more money left on the table--but it also might have created more resilience in the stock.

It takes a certain amount of fortitude to resist the temptation to be greedy and a certain amount of wisdom to think strategically, recognizing that in forgoing a take-the-money-and-run mentality a company begins to establish relationships and a reputation with investors, creating good will, opening the path to return to market again—repeatedly, if necessary—in the future. And—as the Demand IPO illustrates, deals can go south. Investment bankers are acutely aware of this. Their interests are, in fact, aligned precisely with those of their clients’.

Because this is true—and as very effectively explained by the often cranky and generally spot-on finance blogger, Epicurean Dealmaker—underwriters not only actively engage clients in the process of selling an IPO but also update them regularly throughout the marketing period on levels and sources of demand for the company's shares. This transparency does not guarantee total understanding of the complex process of structuring IPOs by all companies—especially those brand new to the IPO arena. However, in the case of LinkedIn the company's Co-founder, Chairman and largest shareholder, Reid Hoffman, is no rube.

A twenty year veteran of Silicon Valley startups, Hoffman was Executive Vice President of PayPal when it went public in 2002. That experience? The company was the first internet company to issue stock in almost a year when it came to market. Its shares rose 55% on their first day trading, a week later they were below their IPO price, two weeks after that they were again flirting with their original opening price, six months later the company was sold to eBay. Like LinkedIn, PayPal had no need for cash when it issued—it was profitable and creating a public market for its stock.

Given Hoffman’s ownership position in LinkedIn, his PayPal experience, his success as an entrepreneur, his broad and deep network of entrepreneurs and venture investors who have successfully taken companies public and his undoubted grasp of the need to think both long-term and strategically about an IPO, chances are good that he had a strong perspective on and input into the pricing of LinkedIn's transaction. At the very least, the chances of him being bilked by a bunch of Morgan Stanley and Merrill Lynch investment bankers? Slim to none. More likely: a roll of the eyes, if he saw Blodget or Nocera’s articles.

Which brings us to the last problem with Blodget and Nocera’s arguments: the idea that a 10%-15% increase in first day price is a reasonable target or metric by which to measure all IPOs. As illustrated, first day performance is a poor stand-alone barometer of transaction success. But if--if!--one insists on looking to that performance to begin to take stock, then each deal needs to be assessed in the context of its own unique characteristics, including, among other things, issuer size, growth rate, industry, industry growth rate, number of comparable companies already trading publicly, number of shares offered, number of shares offered relative to total shares in the company, use of proceeds and likely timing of any potential future offerings.

When each of these factors is taken into account and held up against long-term objectives--the pricing and first day trading of an IPO like Glencore’s—a Swiss commodities firm whose $11 billion deal was also underwritten by Morgan Stanley and which traded down 1% on its opening, also last Thursday--was no more a failure for the company than was LinkedIn’s. The likely truth is that Morgan Stanley and Merrill Lynch—and, importantly, Hoffman and LinkedIn’s blue chip venture investors–knew, with near certainty, that LinkedIn’s stock would close on its first day somewhere well north of $51.75–a 15% increase over the IPO price and a valuation of 20x 2010 sales. And taking everything into account, they determined that an IPO price of $45.00 a share was one that made strategic sense for the company. Then they put it out to market and let investors decide the rest.

It’s great–and easy–sport to be outraged at investment bankers these days, and there are, in many instances, good reason to be. But LinkedIn was neither screwed nor scammed, so needlessly adding fuel to the banker outrage fire seems so, well, needless. Nocera may not like it, but bankers do play a critical role in capital formation, helping companies raise the money they need to grow and prosper. Senseless and yet highly visible rants like his and Blodget's do absolutely nothing to add to constructive discourse on how financial markets might be improved to even better serve the needs of entrepreneurs, companies, investors and our economy.

The Epicurean Dealmaker's first post responding to Nocera's article is here. He was nearly derailed by Blodget's off-target housing analogy, and he perpetuates the 10%-15% rule-of-thumb, but otherwise? On point as usual.

And Felix Salmon of Reuters' response is here. In it he touches in passing on the issue of appropriateness of underwriting fee levels. I don't think that bankers' fees are too high, given the risks and effort involved in executing IPOs. However, I do think they should be based not only on deal size but also on after-market performance, with a portion paid at IPO pricing and the balance at some fixed date following the deal's close, measured against the stock's trading during that period. And his comments on executing IPOs in stages via SecondMarket mirror the ones I made about OTC Markets' OTCQX platform in my article on IPO Innovation several weeks back. I agree with his thinking--and OTCQX is open to individual investors and already equipped for what he's suggesting.


(June 2, 2011) Today Financial Times OpEd columnist John Gapper published a piece entitled A Better Way to Price Internet IPOs basically reiterating Blodget and Nocera’s arguments—and recycling Blodget’s house sale analogy. In it Gapper quotes former PayPal CEO Peter Thiel as saying that the LinkedIn deal was mispriced. If Thiel thinks it, then perhaps Hoffman, LinkedIn’s management and shareholders do too. I still don’t, based on all of the points above—and a few more offered here.

First to Blodget’s house sale analogy, which posits that if I sell my house one day via an agent who turns around and flips it the next, I have been screwed by my agent. The problem with this analogy is that it absolves me, as the seller, of any responsibility for hiring the agent I did, for performing due diligence in order to understand the market into which I am selling my piece of property or for accepting the agent's price. And it assumes that there’s no reputational impact at all on the agent for the flip. In my mind, these issues seriously limit the usefulness of the analogy.

Second, the issue of prices on IPOs jumping more than 10%-15% is not an internet-related phenomenon, although our recent experience would have us think that. The first so-called moonshot IPO—one whose stock doubles on its first day of trading--was Genentech’s back in 1980. It was the first biotech company to come to market at the time and opened the way for others over the next few years.

Pixar went public in 1995. Its stock too jumped over 100% on its first day of trading, and the company, which had $5 million in revenues, ended the day with a market cap of over $1.5 billion. Similar to my comments about eBay above, my guess is that Steve Jobs and other Pixar shareholders felt very little regret about the money left on the table at the time of the IPO when they sold to Disney for $7 billion 10 years later.

I’m not cavalier about first day price differentials, I just think for most ambitious, small, high-growth companies—internet-focused or otherwise--there are much larger and longer-term considerations in play—as outlined above--than how much money is left on the table at the time of their IPO--especially when they are strongly cash flow positive. Also, being first to market in a new sector does impact demand for a stock. And to dismiss the meaningful though intangible positive benefits that accrue to a company from the buzz associated with a strong first day performance is disingenuous.

Finally, to Gapper’s thoughts on auctions—it’s something of a mystery to me as to why auctions don’t work better in the IPO market. But they don’t seem to very well. Yes, Google priced at the top of its range--but it had to downsize its auction-structured IPO to get it done, so it ended up raising significantly less money ($1 billion!) than anticipated when it originally filed. So did Rackspace, another company that used the auction structure more recently—in August 2008 (its deal might also have been affected by market conditions at the time—which were terrible). If LinkedIn had run an auction process, do we really think that its IPO would have been priced significantly differently than it was? That would have meant investors stepping up for shares at a valuation of 25x-30x 2010 sales—and a sense of a limited upside. That seems fairly unlikely.

I hate to be such an apologist for investment bankers—especially during the internet era there were examples of egregious mispricing, and I am certain that LinkedIn could have gone out at $50, $55 or $60 a share and still had a successful IPO in the context of the longer-term, broader considerations in play. But painting the company as a victim and bankers as the bad guys really seems—as I said before—to limit the path to constructive, creative conversation on the topic of optimizing financial market performance—for all involved.

Henry Blodget published an article discussing the issues with auctions in 2004 at the time of the Google IPO. It is here.