How investments in private companies at IPO stage work
United Traders product manager
IPO investments represent one of the most popular types of investment ideas on the United Traders platform. You will find this article helpful if you want to understand why they have the potential of delivering such attractive returns and to be ready for changes in the work of these ideas.
The chart shows the results of the investments in every IPO we offer. The results shown include commissions.
What IPO meansPrivate and public companies
But first, let us give you a traditional definition of an IPO.
IPO (Initial Public Offering) describes the process by which a company initially offers its shares to the public. Usually, such offerings are accomplished through stock exchanges, and that’s where “initial public offering” derives its name from.
A company (stock seller) goes public to raise funds for growth initiatives, while investors in the company at this stage expect income in the form of dividends or profit from stock growth.
Before a company goes public, it is seen as private and its shares belong to its owners, employees and early investors. The shares of such companies don’t trade on exchanges, but they can be bought in the over-the-counter market. After a company becomes public, its shares are listed on an exchange.
Apple, Facebook, Coca-Cola are some of the well-known publicly listed companies
SpaceX, DigitalOcean and Coursera are some of the well-known privately held companies
Why IPO investments are profitable
There are two reasons why IPO investments are profitable:
- The participants involved in the IPO procedure and their motivation.
- The right understanding and use of the knowledge you get from the first item.
The participants involved in IPO procedure and their motivation
Founders and investment funds
decide to do an IPO
improve business indicators and prepare the report
help attract investors
approves the filing based on the report
arrange a roadshow for major investors
Investors at the IPO stage
buy stocks on a subscription basis
forbids early investors from selling to prevent price fall
Investors at exchange
buy shares since they couldn’t do it earlier → price grows
IPO is done by a company. At first glance, it is supposed to be the main participant of the IPO process. This company has been growing for many years and now has reached one of the key milestones in its development.
But we won’t consider it a participant!
The way we see it, a company doesn’t have any motivation per se since it basically hides its management and stakeholders’ interests.
They became owners on the day they set up a company. They, as a rule, are its largest stakeholders.
Founders are guided by the only motivation — to raise money to fund their company’s growth initiatives. To raise money in a way as to keep investors interested enough to attract their funding in the future. This can be accomplished if the shares of this company will be growing steadily.
However, founders may have another motivation — to sell a portion of shares, rewarding themselves for having been in business for decades.
As a rule, founders don’t only own shares, they also actively participate in its management, so naturally, they decide whether this company is going public or not.
raise funds for growth opportunities
Investment funds joined over the years the company has been in business: they backed its growth initiatives in exchange for a portion of its shares.
An investment basically represents the fund’s investors and its management. And all of them got together as part of a fund with the only purpose — to make money from money. But this requires them to look for buyers.
A fund doesn’t always plan to sell shares at IPO or immediately after it, funds need to sell shares at any moment. It’s much easier to find buyers on exchanges than in over-the-counter markets. As a result, such funds are interested in companies going public, but they have an even bigger interest in the share price remaining high after IPO.
When it comes to deciding on an IPO and choosing an IPO date, funds may exercise enormous influence on founders. Of all stakeholders, they have the most experience of raising funding.
look for stock buyers
We could mention minor investors here who invested money in the over-the-counter market (see our article) since their motivation is very similar to that of the funds, but their share is negligibly small, and so is their influence on the processes, and this is the reason we won’t be considering them further.
Founders aside, the key people in the IPO process are CEO and CFO. Their task is to prepare all the financials and reports in compliance with a regulator’s demands.
In the end, a company must submit the so-called S-1 form, disclosing all the financials of its dealings over the past years prior to its initial public offering. The purpose of this form is to provide investors with the key information to help them make informed decisions about whether to buy the company’s shares on an exchange or not.
Executives and managers
improve business indicators and prepare the report
Once a company files an S-1 form, it’s usually 20 to 30 days until it goes public.
However, reports alone can get you only so far. In reality, a company needs to demonstrate great results and business opportunities.
And this is where the company’s top management steps in. Once a decision is made to go public, IPO takes place within 1 to 3 years. During this time, the company’s managers try to show maximum results in their key business areas and to take the minimum risk, shaping a positive picture of their company’s future.
When it comes to managers, the key thing is stock options. All the key personnel at a company have stock options and can exercise them on stocks, netting some good money. As a rule, this money is many times more than their salaries, and therefore IPO represent a powerful incentive for them. Few of them want to sell everything at once, so managers are also interested in stocks growing post-IPO.
Describing business opportunities is quite a formalized procedure. Exchange-traded companies do not only issue quarterly reports but also follow them with an informal report to investors called “company guidance”, detailing its projections of revenue in the near future.
IPO underwriters are typically major investment banks who help companies in their IPO process. They consult managers and stakeholders through all stages: starting from financials and ending with major sales ahead of IPO.
These banks’ customers are some of the wealthiest people in the world. And the company’s management team makes stock sales pitches to them — roadshow. They travel to different locations and make presentations promoting their business and stock growth prospects.
Often a considerable part of the underwriter’s services is paid in the form of stocks, and therefore underwriter has the biggest interest in a successful IPO for the company.
Everything that will happen to stocks post-IPO is of huge importance to the underwriter. Stock growth post-IPO will demonstrate the success of IPO, leading to new companies as clients.
help attract investors
Regulatory agencies across countries and spheres serve the only purpose: to maintain order and a sense of justice and, as a result, political stability.
SEC (the Securities and Exchange Commission) is no exception. That is why SEC seeks to ensure that only vetted companies become listed on an exchange. They standardize and review the documentation that companies are required to submit in anticipation of an IPO. This documentation is issued to make sure that the company is honest with its investors and has provided the necessary information for informed decision-making.
In the end, SEC is just as interested in share price stability after IPO as the rest of the participants of the process.
approves the filing based on the report
A stock exchange is a marketplace where stocks are traded. More precisely, this is an organization that creates and maintains all the terms for selling and buying stocks. An exchange used to require a physical location and strict rules of interaction among the participants. Nowadays exchanges are more about powerful server capacities and user-friendly interfaces.
Stock exchanges make money through commissions on trades for stocks made by a huge number of investors. An exchange charges an investor for every transaction of this type. If an investor is content, he will make more and more transactions and bring more and more money for the exchange. And the investor is happy only on one condition — if the share price is growing!
Customers of stock exchanges can be divided into two types: private and institutional.
forbids early investors from selling to prevent the stock price from dropping
These are individuals who possess varying degrees of investment experience and understanding of how exchanges work. They have access to stock exchanges through chains of intermediaries. They are also called retail investors.
To a large degree, they are the reason why IPO happens. Practically everywhere in the entire world massive investments in stocks are possible only at exchanges. This means that millions and millions of people can’t invest in stocks of companies that haven’t yet gone public.
Investors at an exchange
buy shares because they couldn’t do it earlier → the share price grows
Institutional investors represent organizations that make their money from stock price growth. Of them, we are interested in those who can’t invest anywhere except on exchanges for one of the reasons:
- Their investment strategy implies the possibility of selling at any time, and this can be done only at an exchange.
- Regulators’ restrictions on a stock purchase. As a rule, such restrictions apply to funds that collect money for investments from retail investors. Pension funds would be the most typical example here.
Now that we know all the participants of the roadshow, let’s look at how they do an IPO and make it succeed.
- Executives, founders and funds that have invested in a company at the early stage, are getting it prepared for IPO.
- An underwriter joins at the last stage of preparations.
- This company files with the SEC and can now be tracked in the IPO calendar. SEC gives the green light to the company as a government regulatory agency responsible for protecting investors.
- The underwriter helps with a promotion campaign (roadshow).
- The underwriter gathers orders for buying the company’s stocks from those who have seen presentations in the roadshow.
- It is up to the underwriter to decide to whom and how many stocks will be sold and at what price.
- A stock exchange supports it, forbidding from selling securities in the first trading months, and especially from opening short positions (short-selling).
- Institutional and retail investors buy stocks at an exchange.
- Nobody makes disruptive, sudden moves, and shares steadily grow.
An underwriter’s key role in this process is to generate as much interest with investors as possible, yet to leave unsatisfied demand! Therefore only a part of demand becomes satisfied.
The first trading day’s price is often higher than the price at which the investors bought the shares at the IPO. This occurs if everyone keeps to the long-term perspective.
The above-described process triggers the “built-in protection” of IPO investments from a crisis. A crisis means is a lack of desire to buy stocks at an exchange on the part of private and institutional investors. When there’s no desire to buy, IPO can’t happen. This was the case during the COVID-19 pandemic throughout 2020.
Share allotment refers to the percentage of allocation of shares granted by an underwriting firm during an IPO. The increasing popularity of IPO investments causes allotment to decrease every year. This tendency will continue in 2021.
An example of a negative scenario
To better understand the advantages of the approach above, let’s look at an alternative where none of the participants is interested in share price growth:
- An underwriter is motivated to gather the maximum volume of investments in the company possible and is not worried about the stock price’s future.
- He or she collects orders for IPO.
- He gives as many shares to anyone as he wishes to buy them and at the maximum possible price, without leaving unsatisfied demand.
- Now stocks start trading on an exchange, but there’s no one to buy them — their price after IPO tumbles.
This happens when the participants are focused on the outcome for a certain IPO, and not on the long-term perspective for all participants in the process. All this makes an underwriter the orchestrator of an IPO process and stock price movements in the first months following it.
How to use information about IPO participants and their motivations
Such complex, overlapping motivations are present among participants in the U.S. and Silicon Valley, which is why we predominantly invest in companies from this region.
The effect from participants’ activity is most powerful in the first months following the IPO. This is the reason we invest up to 3 months, no longer. A longer investment period would indicate a stock market investment, not an IPO investment.
Investment is sort of a medium-term trading strategy based on a specific balance of power at a certain point in the lifecycle of a company and the attendant sustained upward tendency toward share growth post-IPO.
From IPO investments to pre-IPO
The long-term success of IPO investments lies not only in grasping the current situation but also in being aware that one day the market will change and such investments will no longer be so profitable. We see these changes already today.
In the first place, they have to do with the fact that large investment funds invest in stocks in the early stages of companies’ development and are unwilling to share profits with those who earn their money from IPOs. Hence the tendency: companies postpone IPOs for longer periods and remain private. Meaning that their price is raised as much as possible before an IPO, and at the IPO they are sold at maximum prices to private investors: directly or through institutional investors who represent their interests at a stock exchange.
The next step is a direct listing process that doesn’t involve an underwriter who organizes the IPO. Recently the IPO calendar has seen a growing number of companies that organize listings on their own. More often than not, these are well-known companies that can attract investors because of their household name. Spotify went public in 2018 through a direct listing, Slack did in 2019, Palantir and Asana — in 2020. Analysts expect more direct listings in 2021.
In the end, IPO investments will no longer bring big profits since immediately after IPO the stock price will fall.
This conundrum can be resolved by investing in companies in the early stages of their development, such as pre-IPO, or even earlier, those that trade over-the-counter.