KU Business faculty experts discuss: Initial public offerings (IPOs)
What does it mean when a company “goes public” or is traded? An initial public offering (IPO) allows for privately held companies to become public and sell shares to investors in exchange for a stake in the company. While there are many benefits to going public, companies must consider the different pros and cons of hitting the stock exchange.
Kevin Pisciotta, an assistant professor in KU School of Business Finance academic area, shares his insights on why companies choose to be publicly traded. Pisciotta received his doctorate in business administration from Penn State University and his bachelor’s and master’s degrees in finance from the University of Delaware. His research interests include empirical corporate finance, IPOs and information intermediates.
Why would a company choose to go public?
There are a few edge cases where firms have little option but to go public. These cases are extremely rare. There are some regulatory requirements on private firms that if they grow too large in some very specific ways, they basically have to go public if they want to continue growing. Private firms are required to start reporting information to the SEC like public firms once they reach 500 distinct shareholders. This limit is the primary reason Facebook went public when it did in 2012: It had hit 500 shareholders and was unable to continue raising money privately, even though there was plenty of demand.
The SEC recently proposed new rules that would dramatically increase the rate at which private firms hit the 2,000 limit. In some rare cases, firms do not so much choose to go public, but are more so pushed.
The motives for going public are very often a combination of information-related reasons: accessing a deep pool of money at a better price point than what’s available in private markets, increasing access to future capital, expanding the investor base, expanding investor and customer awareness, paying down debt, etc.) and liquidity-related reasons (pre-IPO investors wanting to monetize their shares).
How do we gauge the success/failure of an IPO?
I think the most common way to evaluate an IPO is by looking at the return of the stock on the first day trading, which often called the first day “pop,” or the amount of “underpricing.” This metric is useful because it is often correlated with the amount of investor “interest” in the deal (more interest, higher return; less interest; lower return). But basing everything on the first day return I think is incomplete.
That return is largely dependent on several factors like the offer price that underwriters and the issuer set the day prior to trading and how well the underwriter disseminates information about the issuer. Another reason basing everything on the first day return might be incomplete is because it ignores everything that happens after that first day. I think an evaluation the stock’s return over the first month or the liquidity of the stock over some more extended period like a year, could all help provide a more complete picture.
Well-known companies like Reddit and Birkenstocks recently went public. What does an IPO do for companies that have been in their respective markets for while?
IPOs can still offer a host of benefits to firms that have been around a while. Some of the reasons firms go public is to expand their brand and visibility among investors and consumers. But some of the reasons have less to do with that. Going public not only expands access to current financing, but it also expands access to future — going public often reduces the rate that banks charge the firm for new loans and allows the firm to raise additional public equity in the future on very short notice.
Lastly, for Reddit and Birkenstock, going public also creates a way for the firm to allow their customers to become investors, which is nearly impossible when the firms are privately traded.
Birkenstock’s IPO was considered a failure. How can companies work to overcome those disappointments?
Birkenstock had an abnormally low return on the first day of trading. Not only was it not close to a rough historical average of around a +20% return, it was negative. It would be impossible to pinpoint a single reason for why its first day return was so low.
But things have not going that poorly for Birkenstock. Within about a month and a half of its IPO, its stock had recovered above its issuance price ($46). And, at one point a little over a month ago, the stock was up 13% from that issuance price.
The market sees the first day decline for Birkenstock’s stock and thinks, “wow, it must have done something terribly wrong.” But, in some sense, Birkenstock made a good trade. It sold shares at a price higher than what the market supported once the stock started publicly trading. Pricing IPO shares is just as much art as it is science. But to the extent there is a material science component, companies can work to avoid these type of outcomes by being more conservative in pricing IPO than Birkenstock was. Birkenstock seemed to aim for the top end of that range, instead of being more cautious and increasing the chance of a strong first day return.
What should people know about IPOs that they may not realize?
Each deal is unique. Firms come to the table with their own reasons for considering an IPO and their own benchmarks for success. There are some periods where there could be several IPOs a week for months on end. And then there are some periods where there are literally no IPOs for months. It’s weird to think of the bankers that work those deals during the active times, and then they just have absolutely no deals to work on for months. Roughly 25 percent of deals are pulled at some point during the process, and almost every time, the firm quotes “market conditions” as a reason.
Is there anything else you’d like to add?
I think many people in my field think studying IPOs is a tired area of research; most of the important questions are answered. I disagree. There are several things to study over the next few years, like how the model for going public continues to evolve. As private firms continue to get more mature, as private-funding markets continue to develop, as index funds continue to growth their share of the market, and as technology continues to make the world smaller, I think it will become more common for firms to either use more stripped-down versions of IPOs or abandon the traditional IPO model altogether (e.g., by conducting a direct listing).
