First-Day Stock Price Appreciation is Not the Correct Measure of IPO Success

Zynga went public last Friday.  The company raised $100M and was valued at around $7B off TTM revenues of about $1B (see S-1 here).  This puts the Zynga’s valuation in the same range as Electronic Arts, a company founded in 1982 and whose TTM revenues are 3.6x times larger at $3.6B.  One might easily say:  “Wow!”

But because the shares did not rocket upwards on the first day of trading the media portrayed the IPO as lackluster.  Consider, for example, some of these headlines:

• Game Maker Zynga Finds Barren Fields in IPO-ville (San Jose Mercury News print headline)
• Zynga IPO Goes Splat-ville (Forbes)
• For Zynga’s IPO a Pump and Slump (New York Times)

I’d argue that the Zynga IPO was a tremendous success.  Why?

• The company is now public and has established a liquid market for its shares.  This, over time, will benefit existing shareholders who want liquidity and will facilitate future fundraising for the company.
• The company received $100M in capital which it can use to fuel future growth.
• The share price did not rocket upwards on day 1.

Wait a minute, doesn’t everybody judge the success of an IPO by the first-day pop in valuation?  Yes, most people do.  But they’re wrong.  If you look at things from the company’s perspective, the day-one share price “pop” is clearly not the right metric.

Let’s show this by pretending the stock did double to $20 on the first day of trading.  In this case, the company would have sold 100M shares for $10 that were, at its turns out, actually worth $20.

Who wins and loses in the first-day double scenario?

• The company loses, because it gave away $100M.  Had the shares been properly market-priced at $20, it could have either raised $200M or issued half as many shares (reducing dilution for existing shareholders).

• Employees lose.  This one’s tricky because people think they are happy.  “Hey, my 10K shares were worth $100K in the IPO and now they are worth $200K!”  The reality is that they were worth $200K all along and employees only believe the price “doubled” because they were psychologically anchored to a price of half their value.

• The institutional investors who bought in the IPO win.  These people are the usual customers of the investment bankers who underwrite the offering, and quite possibly their buddies from b-school.

• Anyone else able to get access to some shares in the offering wins.  I’m not sure what happens today, but back in the bubble if you were CEO of another company and had a discretionary account with an underwriter (who was hoping to get your future business) you might well have been allocated some shares in the IPO which were sold on the first day for a nice profit.  (Recall the Meg Whitman issue, where she allegedly netted $1.8M through this practice.)

As my friend Crispin Read once said:  “if you work in a donut shop, you get free donuts; if you work in a bank, you get free money.”  In this example, the $100M gap between the aggregate sale price of the IPO shares and their value at the end of day one  is the closest thing to free money you can find.  And its allocation is controlled not by the company, but by the bankers and presumably to their advantage.

I understand the common counter-arguments to my viewpoint, but disagree with them.

• If IPO shares don’t pop, then no one will want to buy them.  Hum, seems to me as if billions of shares are traded everyday without the expectation of one-day pops.  Somehow, investors buy all those shares.

• IPO firms are risky and thus  buyers should expect a higher absolute return.  Yes, I can buy this.  So perhaps a buyer will need to expect a 15-20% first-year return to compensate for this additional risk.  That’s quite different from a 50% first-day return.

• The IPO shares are actually worth more on IPO day then they were previously.  Indeed, a liquidity premium should apply to the shares — but this should be reflected in the IPO price.  Buyers in the IPO are buying shares that will be publicly traded, and they know it.

• Thin floats and lock-up periods will make the shares more volatile than “normal” companies in the first six months and thus some discount should apply.  While both of those are true, they again well known and should be priced into the IPO price itself.

I’m not sure what the right first-day pop is.  There is an argument that a 0% pop is ideal — it means the shares were perfectly priced in the IPO roadshow, no free money was created that can be handed out by the bankers, and the company raised funds at the optimal price.  I suppose that’s too idealistic.  My gut feel is that success looks like a 10-20% pop — which, by the way, is still huge compared to typical stock-market investment returns.

But I am certain that the media tradition of weighing IPO success by the size of the first-day pop is misguided.  In the end, if every IPO pops 50% on its first day it simply means that IPO shares are being systematically undervalued, which then prompts the question of who wins and who loses as a result of that undervaluation?