As published in VentureBeat:
Recent tech IPOs have been anything but predictable.
LinkedIn, which initially filed to price its IPO in the range of $32-$35 before ultimately pricing at $45 per share and is now trading over $100 per share, has rewarded IPO buyers. Meanwhile, Chinese social networking site Renren, which filed its IPO at $9-11 before pricing at $14 per share but is now trading at about $10 per share, has been a loser for buy-and-hold IPO buyers.
This kind of volatility begs the question, how good is Wall Street at predicting longer-term winners at the time of an IPO? Is a “hot IPO” – one that attracts huge investor interest and prices well above its initial filing range – a harbinger for strong stock returns over time?
It turns out Wall Street investors are not very good at predicting longer-term stock price performance at the time of an IPO – in fact, they’re terrible at it.
In the following chart provided by Morgan Stanley, all tech IPOs since 2004 above $30M have been plotted so that the x-axis shows the percent change from the mid-point of the initial filing range to the ultimate IPO price. Hot IPOs are on the right of the chart, while cold IPOs – those that price below the initial filing range mid-point – are, conversely, on the left. The y-axis then plots one-year stock price return from IPO price.
Source: Morgan Stanley
Amazingly, the chart reveals that there is absolutely no correlation between hot IPOs and one-year stock returns (nor cold IPOs and stock returns, for that matter).
Realizing this, all the focus lavished on hot IPOs by the press and the VC community seems misplaced. Remember also that existing investors typically don’t sell much, if any, of their stakes in IPOs and are usually “locked up” – prohibited from selling stock until 180 days after an IPO, making the IPO price even less important to venture investors.
Here are two theories for why IPO demand and longer-term stock price performance are so uncorrelated:
Limited history with public investors. By definition, IPOs represent the starting point of the relationship between a newly public company and public investors. Important factors for investors such as reliability and capability of management, market size and competitive dynamics are difficult to assess with no historical results to lean on, and opinions will vary wildly.
Information scarcity. The SEC forbids companies that have filed for IPOs to communicate publicly about the offering before it takes place. While the information available to prospective investors tends to be thorough, face-to-face time with management is limited during IPO roadshows, so even professional, institutional investors are challenged to put the available information into a usable context.
After several years of near-frozen equity markets, many entrepreneurs are understandably excited about the prospect of going public in the months to come. But knowing that a hot IPO has no impact on a company’s longer-term share price should allow the would-be public company leader to focus on what really matters in an IPO:
The IPO is a financing. My partners and I often remind CEOs considering taking their companies public that an IPO is a financing and not an exit. In that regard, while it might be nice to raise heaps of money via a hot IPO, a high IPO price puts the same pressure on a company as does a high-priced venture round – more expectations and less room for error. This is not to say a cold IPO is desirable, but CEOs who focus on building their IPO syndicate with investors they believe understand the story and are in it for the long term are doing themselves a big favor.
Confidence in the next few years. Too often we see company leaders excited about pursuing an IPO based on strong confidence in the next one or two quarters. This is setting the bar too low; companies should go public only when they’re confident they can deliver on a longer-term growth plan. If a CEO lacks visibility on how to grow the business over the next 2-3 years, the company is not ready to go public.
So what does a hot IPO mean? Hot IPOs may get more press coverage initially, but the data clearly shows that a hot IPO offers no guarantee of future success as a public company. Management teams and investors alike will do better to focus more on the longer-term opportunity. Then, maybe we’ll begin to see more correlation between IPOs and long-term stock performance.