Inefficient Public Offerings: Could they be Improved?

Initial Public Offerings (IPOs) are expensive, risky transactions that on one end of the pendulum can leave massive amounts of funding on the table to be snapped up by short-term investors and on the other side can leave the issuer (the company that sells its shares) with undermined confidence and without funding. Even in the most efficient outcome where shares are correctly valued, the company must still undergo the tremendous “price-finding” costs associated with an IPO. In this post, I discuss the inefficiencies of an IPO and how the process could be better structured to align incentives and minimize dead weight loss.

The issuer’s goal in the IPO is to sell all shares for the highest possible price, raising funds that can be used for purchasing capital, funding research and development and paying off debt. The underwriting investment bank’s goal is to value the company so that it can build a reputation to help it land future deals and maximize long-run earnings. The most efficient outcome is where the shares are sold for the highest amount that investors are willing to pay and the stock price does not move after the offering. Even in the best case, the firm paid a tremendous “price-finding” cost. Not only are there tremendous pecuniary costs to pay fleets of attorneys and accountants to meet regulatory hurdles and provide necessary information for the bank to correctly value the company, but there are also non-pecuniary costs of the extended amount of time where key management is focused on the IPO instead of the long-term success of the company.

In the event of an undervaluation where the issuer “pops” or rises in value post-IPO, significant funds are left on the table to be snatched up by short-term investors when the funds could be better used by the company itself to maximize long term profit. Notable “pops” where the issuer lost out on significant potential funding include eBay whose stock jumped 163% on the first day of public trading, Yahoo! (154%) LinkedIn (109.4%) and Twitter (72.7%). In an overvaluation employees and management can be left in disarray, both lacking necessary operating capital and uncertain about future growth. Additionally, IPOs underperform the market by a significant margin in the years following the sale. CB Insights looked at all US Venture-Capital backed tech IPOs since Facebook’s May 2012 public offering through October 2015 and found that the return was a lowly 7.05% over that time period. This assumes you invested the same amount in each company on the first day of trading’s closing price. During the same period, the S&P 500 return was 60.5% and the Dow Jones Industrial Average returned 42.8%.

Wouldn’t it be nice if there were an alternative to the IPO that minimizes the cost of an initial public offering, better incentivizes correct valuation and allows for much greater returns? Next I propose an “Efficient Public Offering” (EPO) with four distinct phases. In the first phase, an independent auditor gathers financial and nonfinancial information necessary for valuation and releases it to the public. In the second phase, the public takes in the information and works to correctly value the company. In phase three, investors enter a blind market and bid their purchase price along with a set fee that is paid to the independent auditor that released the information. Lastly, the issuing company views the bids and chooses a selling price. After a price is chosen, bids below the price are not rewarded with a share and bids at or above the purchase price are given a share at their bid price.

There several key advantages to the EPO. The first is that the independent auditor is only rewarded by the fee paid by investors and is not incentivized to maximize purchase price. Additionally, the auditor’s profit is dependent on minimizing costs. Secondly, the costs of the IPO are born by the investors and the company itself does not have to pay exorbitant costs of an IPO that could stunt future growth. Next, uninformed investors are discouraged from bidding because of greater likelihood to either pay the fee and not be rewarded with a share or overpaying for the stocks they do purchase. Last, companies are not overvalued by IPO hype and subsequently are able to fetch market returns following their public offering. With a draw of a relatively inexpensive public and reduced risk of a “pop”, there are gains to be found by companies willing to venture away from the traditional IPO to an “Efficient Public Offering”.