011: IPOs: Let’s Break It Down

IPOs: Let’s Break It Down

Color Commentary

Table of Contents

1. What is an IPO?
(a) “Offering”
(b) “Public”
(c) “Initial”

2. How does an IPO work?
(a) The Startup
(b) Why Go Public At All?
(c) Going Public

3. Let’s Get Practical

A few issues ago, in Issue #008, I delved into how the Lyft IPO, as a risky new offering, really highlighted its Mission and became a resource for my practice. As I was writing that issue, I realized – wait a second, what IS an IPO? What are the mechanics? They’re so fabulously wrapped up in startup company details that it makes my cold startup lawyer heart sing.

I wrote a 30 second overview in that issue, but I think going deeper into an understanding of an IPO – an “Initial Public Offering” – can really help us understand overall how a stock market works. It can also help us understand what’s happening in the investing news we read everyday because right now, it’s dominated with news of the Uber IPO and its disappointing debut – and I for one find the whole thing fascinating. As I’ve said before, IPOs aren’t Buffett or Rule One style investing, but they are sure a great to learn about and practice understanding the emotions of the stock market. Links are in the “Let’s Get Practical” section at the end of this issue.

1. What is an IPO?

An IPO is how a private company offers shares of ownership to members of the public on a stock exchange. Once a company sells its shares publicly, people the company has never heard of, like you and me, can buy shares (portions of ownership) of the company.

Every single public company has gone through an IPO, and, the longer a company is publicly listed, it’s easy to forget that fact. Sometimes it feels like AT&T or Boeing or General Electric have been there forever and will be there forever. Remembering how they all got here is also a good reminder that they will probably not always be around.

As I said last issue, IPO stands for “Initial Public Offering.” Its name matters. Each component has a specific legal meaning.

There are three parts to the name: (1) Initial, (2) Public, and (3) Offering. I’ll go through them backwards because it’s really lovely to understand each component of the process. That way, when you encounter an “Initial Offering”, for example, you’ll notice how and why it’s distinct from an “Initial Public Offering”.

Important caveats and disclaimers about the following: This is NOT legal advice! This is an extremely bare-bones explanation that is frankly, nowhere near complex enough to truly explain the issues. It’s simply a very high-level understanding of an IPO. I’m going to use as few American-centric terms in this explanation as possible, but please remember that I am an American lawyer, and I was trained with US terms and structures. It’s the concepts that matter, not the terminology.

a) “Offering”

An “offering” means a company is literally offering people something to be purchased.

As a lawyer, if someone comes to me and says “I want to create an offering for my company,” one of my first questions is, “what do you want to offer?” The company could offer debt, equity, or a combo of the two. I’m going to skip explaining debt and the combination option, and go straight to equity, because equity is what is offered to the public on the stock market. An equity offering means the company is selling ownership in the company (which could be, in the US, units in a limited liability company or shares in a corporation; either way, it’s ownership). No matter what instrument is being offered, don’t lose sight of the fact that the concept is, at its core, super simple: the company is making an offer to someone else to buy ownership.

b) “Public”

The word “public” here is in contrast to “private.” You cannot understand how a company IS public or GOES public until you understand the limitations on a private offering. A company is, by default, private, and its offerings are private. So, to understand what a public offering is, you have to know what a private offering consists of.

If it’s a private company making the offer, then there are LOTS of laws and regulations that govern private offerings and who can participate in them. To participate, the potential purchasers must meet certain qualifications of wealth or otherwise be qualified as a savvy investor who can determine if this private offering is a total sham or legit. Most countries figure that if you’re a “wealthy” person, you can make that decision. If you’re NOT, then you CAN’T. Let me say that again: any of us who don’t meet the requirements of our country to participate in these private offerings are barred from many kinds of private investments for our own protection.

Those laws and regulations were put into place to protect us, because we, us non-wealthy potential investors, kept on being taken by total shams in private offerings. Easy to make the wrong choice, right? Someone shows you some books that look good, you figure it’s probably ok to invest your your friend’s brother-in-law, and presto change, five years later your money and the brother-in-law are gone. It sounds jokey, but it happens all the time, even to people who are supposed to know what they’re doing.

But all is not lost for us! We have access to the public markets.

If a company is offering its equity up to the public for purchase, then it’s a “public” offering. “Public” is actually a legal term of art here, with a specific meaning: that any member of the public can purchase what is being offered – and here’s the important contrast to private offerings – without qualification. Doesn’t matter if I am a stay-at-home mom making zero dollars per year or a doctor making 900,000 Swiss Francs per year, both of us can buy shares on the public market and no one will bat an eye. Why? Because public offerings are usually overseen by a regulatory body that requires companies to provide truthful information to the public (obviously, with varying degrees of success as to the effectiveness of that oversight, which is why we also have to do the work of determining who has integrity ourselves). Cases in point: The Biggest Stock Scams of All Time and more in graphic form.

So the public – that’s ME, sitting on my couch, a total stranger to the company – can make a purchase in this public offering. What can I buy? Ownership. Shares of stock.

c) “Initial”

“Initial” means this is the first time shares of stock have ever been offered to the public. The company most likely has done other private offerings to investors – to angel investors, to friends and family, to employees, to venture capitalists – but this is the first one that’s available to the public.

2. How does an IPO work?

This initial public offering is colloquially called “going public”. Going public is a big deal, takes a bunch of time to meet all the requirements and set everything up to be listed on a public stock exchange, and is generally a big pain in the booty that hopefully gives the original owners and investors a huge payoff.

The company makes its Initial Public Offering on a stock exchange, which is a marketplace that is set up to enable members of the public to buy shares of stock. I’m not going to get into the nitty gritty of what a stock exchange is because my dad and I already detailed it in Chapter 2 of Invested. But basically, imagine a bunch of Dutch people sitting around in a bar in the 1600s haggling over how much the Dutch East India Company ships would be worth if they made it back to the Netherlands. But now with computers and Jim Cramer yelling about it on TV.

To “go public,” a company decides on a certain number of shares to sell publicly. The people who are owners of the company still privately own their shares, and the company issues additional shares for the public market.

Here’s an extremely simplified example of how this works in real life.

a) The Startup

Let’s say I start a company that is the first to invent a reliable and safe self-driving electric car called the Amazing Car Company. I’m the only founder, and own 100% of the company at the beginning.

When I needed to raise money to build more cars and expand the company, I created a private offering of equity for 20% of the company and sold it equally to two investors. So now, the ownership of the Amazing Car Company looks like this:

Me: 80%
Investor A: 10%
Investor B: 10%

That’s the ownership percentages, but what about the actual shares of stock? Each company decides, on its own, how many shares of stock it creates. Yup, it’s completely up to the company. A company can create 3 shares of stock or 3 million shares of stock, it does not matter – because it all comes down to the ownership percentages, not the actual number of shares. For perspective, a typical startup company will initially issue a few million shares of stock. That many shares gives the owners flexibility to hand out small percentages. They might want to bring other investors on at some point and sell them even smaller percentages of the company, and probably will want to give some shares to their wonderful early employees. Having a bunch of shares available makes these divisions logistically easier. (I’m not going to get into the differences between authorized, issued, and outstanding stock here, but budding startup lawyers, you can read all about it here and here.)

In the Amazing Car Company, if, as the founder, I decided to create 10 shares of stock, I would own 8 shares, and my investors would own 2 shares. With 10 shares of stock, the ownership looks like this:

Me: 80% – 8 shares
Investor A: 10% – 1 share
Investor B: 10% – 1 share
= TOTAL 100% – 10 shares

If I decided to create one million shares of stock, I would own 800,000 shares, and my investors would own 200,000 shares. So now, the ownership looks like this:

Me: 80% – 800,000 shares
Investor A: 10% – 100,000 shares
Investor B: 10% – 100,000 shares
= TOTAL 100% – 1,000,000 shares

Notice: It’s still the same ownership of the Amazing Car Company in the same percentages. The actual number of shares does not matter at all.

So, there I am with my 80% ownership of my company, feeling great about how many self-driving electric cars people are buying from me and how safe my cars are making our roads, and we start to talk about going public.

b) Why go public at all?

There are several reasons a company would go public. The primary reason for most companies, particularly those that have raised a LOT of money from investors, is to give investors a way to sell their shares and realize their return. Those investors need to get their money back (and hopefully make a lot more than their initial investment), and right now, in a private company, their money is kind of locked up. Yes, they could possibly find someone to buy shares from them, but that’s a lot of work and probably won’t make them as much money as if the shares are publicly sold. My investors want to make money on their investment, and selling their shares on the public market is the most straightforward way to do that. In startup terms, it’s called an “exit” and it’s a founder’s job to create a great exit for her investors. Most high-growth tech startups want to go public as soon as they think the company will do well on the public market, which usually means having strong revenue, competitive advantage, and sustainable business model – but doesn’t always mean that it’s profitable, as we’ve seen with Uber and Lyft.

Another big reason to go public is to raise money for the company to use to continue to grow. More on that below.

And I, of course, as the founder, would ALSO like to make money by selling some of my shares.

The drawbacks to going public are how much energy, work, and money it takes to prepare the company to meet the regulatory requirements, and that from then on, the company has to publicly file a huge amount of information about it, which its competitors can read and learn from. Compliance with public company regulations is no joke. It takes time, effort, and manpower, and the consequences to getting things wrong are loss of reputation, loss of company value, or even jail time.

c) Going Public

I have decided those drawbacks are worthwhile because my investor are clamoring for an exit, and I wouldn’t mind selling a few shares for a profit either. Now, what happens when I take the Amazing Car Company public? First, I would win all sorts of accolades for having such a rare startup that only went through one round of fundraising and has only two lovely investors, and also a lot of people would be asking why I never gave any stock to my hardworking employees, but whatever, I am an autocratic ruler who doesn’t appreciate her people at all. Let’s go public!

But wait – what shares will we sell to the public in our Initial Public Offering? All the shares are owned by myself and my two investors.

Simple. I just create additional stock to sell, by amending my corporate documents. (Or, if my lawyers did a good job, we already had the stock authorized.) An IPO typically sells about 20% of the company publicly. That portion of ownership has to come from somewhere, so creating the public offering dilutes our ownership. (In the Amazing Car Company, I did a good job choosing investors who were fine with us all having our ownership diluted equally, but that is not always the case. It might be only the founder(s) lose part of their ownership, or it’s only certain investors and not others – it entirely depends on the agreements between the parties.)

So the Amazing Car Company creates 20% more shares, sets up the IPO, and upon the IPO, the Amazing Car Company’s ownership now looks like this:

Publicly Listed Shares: 20% – 250,000
Me: 64% – 800,000 shares
Investor A: 8% – 100,000 shares
Investor B: 8% – 100,000 shares
= TOTAL 100% – 1,250,000 shares

Again, that’s a super overly-simplified example, not least in how I ended up with 64% of the company at an IPO, which is ludicrously unrealistic. Many founders end up with 5-10% of the company by the time they have an IPO because of how many fundraising rounds they must do to stay in business, with each round diluting their ownership further. Pinterest went public recently, and several co-founders have wildly differing ownership stakes, due to when each joined the company – to the tune of about an $800 million dollar difference (based on original pricing). Zoom’s founder, Eric Yuan, impressively managed to keep 22% of his company, an ownership stake worth somewhere around $3.5 billion upon its IPO.

Not that those are real take-home dollars – that is net worth on paper, but those guys have to actually sell some shares to get the cash. They probably won’t be able to for a few months. Most investors and founders have contractual restrictions to not sell their shares for a certain period of time after the IPO. It’s called a lock-up period, and it’s meant to protect a company’s stock price from cratering right after the IPO because everyone is trying to cash out right away. The Financial Times reported that there might have been some hanky-panky with Lyft’s lockup, which accounts for its quick dip after going public. Astute IPO speculators will find out when the lock-up periods end and look for a possible price dip around then, as founders, early employees, and VC funds sell some shares and move the money out of the stock market and into their bank accounts – though it doesn’t always happen if company’s stock is selling like hotcakes.

According to NASDAQ, Pinterest and Zoom both have a six month lockup period ending on October 15, 2019, but my guess is that there may be private contracts for investors and employees that differ from that date. There is no way for us outsiders to know when those privately-contracted lockup periods end, but they’re not going to go on forever. My guess (purely a guess) is that it’s a year, max. Longer than that would be strange. (Also, Pinterest is listed on the New York Stock Exchange, not the NASDAQ, but I think that NASDAQ page just copies from the company’s SEC filings.) For us long-term investors, any small dip from the lockup period ending probably won’t matter much to getting a good price on the company, but I do think it’s important to understand what’s happening within a company as much as possible, and the end of the lockup period is certainly something all the people running the company will know is coming.

Once those 250,000 shares of the Amazing Car Company are offered on the stock exchange, the Amazing Car Company no longer owns them at all. AT ALL. If the price for a share goes up, the company doesn’t see any of that profit; only the seller gets the profit.

If you’re thinking “then why do companies care if their stock price goes up? Because they sure do seem to care a lot,” then yeah, you’re exactly right. Public companies DO seem to care a lot about their stock price going up. This is a weird fact that makes it seem like public companies get paid directly from their public stock, but they don’t.

They care about their stock price because: a) it makes management look good, b) high-up management often are paid through stock, so they have a personal reason for wanting the stock price to go up, c) having a higher stock price makes the company overall more valuable, so they can borrow money more easily or can issue more stock publicly if they need to raise some money for the company, and d) they could sell the entire company for higher and higher prices. A company that has already gone public can still make offerings. It can issue additional shares to be sold on the public stock exchange. Any public offering following the initial one is much easier because the initial regulatory requirements have already been met. It can also still make private offerings. All of that is made easier and raises more money when the company’s public stock price is high.

So that is an Initial Public Offering. Isn’t it the coolest how much of understanding an IPO stems from understanding a startup company? The way startups allocate ownership, set up corporate structures, and make offerings to investors all set up the company for that holy grail of startup land, the IPO.


To jump-start your wandering Investing Practice this week:

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