This week was supposed to be a coming out party for a new IPO pricing process dubbed the "hybrid auction.” Newly public companies have long complained that large first day gains for their stocks enriched institutional investors with immediate profits, with no corresponding benefit to the listing firms. Given that an IPO is often desired to raise additional growth capital, being forced to “leave money on the table” is a big disservice to these young firms.
Inefficient IPO pricing is not surprising given the actors involved. Companies are advised by investment banking firms, whose job it is to allocate stock to their large institutional clients. The incentive, then, is to keep your clients happy and instantaneous profits on day one certainly accomplishes that. While a higher IPO price would give the banks a bigger take on the total deal value, a company can only go public once. The ongoing long-term relationships the banks have with their buy side clients are far more profitable and important. As a result, the banks have little reason to price IPOs as close to market demand as possible. It is a simple conflict of interest situation.
This new “hybrid auction” idea was supposed to help with this problem. Rather than picking a price and then taking orders from investors, the new model does set an initial price indication, but it asks would-be buyers to not only submit how many shares they want to buy, but also allows them to offer the price they are willing to pay. The idea is to get a better gauge of demand by seeing just how high buyers will offer if they think a higher bid will increase their odds of getting stock.
Perhaps you can see the problem already. A buyer of an IPO wants to get the lowest price possible to maximize their potential profit. By giving buyers input into the price they end up paying, they have an incentive to keep the price low, without being insulting or risking missing out to other buyers. So, the most likely outcome is that buyers submit strong bids, maybe even a bit higher than the indicated price range, but without getting too aggressive. Therefore, the real demand is never determined, because you would be crazy to bid anywhere near the highest possible price you are willing to pay.
The results this week were therefore quite predictable (huge first day price spikes) but I think the end result was even worse than most would have guessed. DoorDash (DASH) priced at $102 and opened at $182 (+78%). The Airbnb (ABNB) deal was even worse, with an opening trade of $146, a stunning 115% above the $68 IPO price.
So what is the solution? Well, Google (GOOG) had the right idea back in 2004 when it opted for a dutch auction for its IPO. The company saw a first day price increase of just 18% because it decided to actually sell its stock to the highest bidder (what a novel concept!). A dutch auction simply sells the available stock at the highest price possible. Potential buyers submit a max buy price and a desired quantity and the IPO price is set to be the highest price such that there is a bid for every share being sold. For some odd reason, companies have not copied the Google approach. Until they do, they stand to keep leaving a ton of money on the table with nobody else to blame but themselves.
One innovation is worth mentioning as having been successful and that is the “direct listing.” Many private companies are profitable and don’t necessarily need to raise additional growth capital via an IPO. However, they still might want to be a public company in order to provide their shareholders and employees liquidity and also have a currency with which to make acquisitions. In a direct listing, the existing shares outstanding simply begin trading on the stock exchange, which opens them up to everyone. The market price is immediately known and there is no “first day pop” because no actual IPO price needs to be settled on (no new stock is being sold, so no price for a sale is needed).
The only possible downside for a direct listing is that all of the shares are dumped on the market at the same time and so it could be met with a large wave of selling early on. While not indicative of any problem at the firm, optics are important and a falling stock price will always raise questions. The solution, however, is quite simple. A rolling lock-up expiration - say, 10% of the stock each month for 10 months - would require holders to sell slowly over time to cash out, and therefore would have a minimal impact on the stock price.
So here we sit and Airbnb and DoorDash have two problems; 1) they left billions on the table, and 2) their stock prices are so high that it will be harder for them to attain the financial expectations that are embedded in the current price. Both of those are detriments to the very people they were trying to help with the IPO (their shareholders).