I’ve been thinking…Exactly How is the IPO Share Price Determined?
A companion blog, A Primer on Initial Public Offerings, discusses the IPO process from five points of view: issuers, underwriters, investors, regulators and markets. This blog deals with the established mechanism of how the actual IPO share price is set. Future blogs will take a deeper dive into selected topics discussed in the IPO Primer blog.
Recall that on the eve of the IPO date, the pricing committee of the issuer meets with the lead underwriter’s syndicate manager to finalize and agree to, among other things, the recommended IPO share price and the number shares in the offering. This blog explores (i) what actions preceded the recommendations in the so-called pricing committee meeting, and (ii) what subsequent actions normally take place after the IPO is successfully completed.
When the issuer awards the IPO mandate to the chosen lead underwriter, that action starts a series orchestrated moves culminating with the issuer’s registered shares beginning to trade on either the NYSE or the NASDAQ. First, an all-hands meeting is immediately convened, and the required steps to complete the IPO are identified and assigned in writing to designated parties. Aimed primarily at the issuer, the relevant SEC’s rules are revisited by issuer’s counsel regarding the importance of confidentially during the so-called quiet periods. Next, due diligence assignments and deadlines are set, and the issuer’s counsel begins crafting the initial draft of the S-1 registration statement. By law, the content of the final S-1 is required to be accurate and complete in all material respects, and the issuer is fully liable to IPO investors for material misstatements or omissions in the final S-1, no matter the reason. There is no due diligence defense for the issuer.
It is customary for issuer’s counsel to tightly control the drafting process and content in the S-1, to coordinate the input of other professionals, and to respond to SEC comments on the submitted S-1 drafts. However, issuer’s counsel does not certify the accuracy and completeness of material information in the S-1; rather, they in part reasonably rely on written certifications from the issuer’s executives. In addition, further discussions are held among the issuer and the underwriters on (i) finalizing the set of comparable companies to be use in setting the initial range of share prices prominently listed in the preliminary S-1, and (ii) the so-called positioning of the issuer to potential IPO investors.
The issuer’s auditors are solely responsible for the accuracy of the audited financial statements contained in the final S-1. On the other hand, unaudited statements are often included in the final S-1, and these financial statements are clearly marked as unaudited. Special auditor review procedures are applied to unaudited data, and auditors can generally escape liability by, among other things, reasonably relying on written assurances from issuer’s executive that the final S-1 contains no material misrepresentations.
The issuer selects an investment bank to act as lead underwriter to manage the IPO. In my experience, among the key selection criteria are knowledge and experience with the issuer and/or the issuer’s business, relevant IPO underwriter experience and relevant industry experience of the lead research analyst. Importantly, the interests of the underwriters are not totally aligned with the interests of the issuer. To protect their interests, the underwriters not only engage so-called underwriters’ counsel to provide legal advice but also task a team of internal corporate finance professionals to perform a reasonable due diligence investigation to assure compliance with relevant securities laws. In addition, it is customary that written assurances are obtained by underwriters from issuer’s executives that the final S-1 contains no material misrepresentations. Furthermore, the issuer’s auditors are often called on to provide underwriters so-called comfort letters on various financial matters, including the handling of unaudited financial data disclosed in the final S-1.
It is fact specific as to what criteria the issuer used to select the lead underwriter, but in any case the selected underwriter works off of the IPO mandate versus a formal underwriter agreement. It is customary that the binding underwriter agreement will only be signed by the issuer and the syndicate of underwriters on the eve of the actual IPO date. However, once the IPO mandate is received from the issuer, the lead underwriter and underwriters’ counsel immediately convene the all hands meeting described above.
The Securities Act of 1933 requires IPO underwriters to act as gatekeepers for potential investors and to perform a reasonable due diligence investigation of material statements in the S-1. Legally, underwriters can only escape liability for material misstatements or omissions in the final
S-1 by asserting the so-called due diligence defense, which is that the due diligence investigation performed was reasonable under the circumstances, complied with the underwriter due diligence standard of care and custom and practice and, thus, provided the underwriters a reasonable basis to believe in the accuracy and completeness of material statements in the final S-1. In my experience, the principal areas of underwriter due diligence are (i) accounting due diligence, (ii) financial due diligence, (iii) business due diligence, and (iv) legal due diligence.
It is customary that the underwriters only charge the issuer a 7% fee on the amount raised in the IPO; the 7% fee comes in the form of a discount, with the investors paying 100% of the IPO share price, and the issuer receiving just 93%. This is known as a success fee, and the fee is shared between the lead manager, the other firms that assume the risks of underwriting a set amount of the IPO shares, and those other firms, if any, tasked with distributing the IPO shares to initial investors. The split of the 7% fee is typically set by the lead underwriter, with little or no negotiation by the invited underwriting and selling syndicate members. Often the lead underwriter receives the lion’s share of the 7% for managing the IPO, including in part running the syndicate’s books, handling the allocation of the so-called institutional pot and negotiating with the issuer’s pricing committee on the final IPO share price and number of shares. The remaining fees are split proportionally among the firms (including the lead underwriter) on the basis of (i) the assumed underwriting risks for a set number of IPO shares, and (ii) the actual number of shares sold to initial investors.
The proposed split of the 7% underwriting fee, known as the economics of the IPO, and the proposed slate of the invited syndicate members are important discussion areas for the so-called commitment committee of the lead underwriter. It is customary that before the assigned investment banking team agrees to pitch the issuer’s board for the IPO mandate, a memo has been submitted to the commitment committee describing relevant details of the proposed IPO, including underwriter risks, and seeking approval to move forward. If awarded the IPO mandate, timely follow up memos by the underwriting team are customary to keep the commitment committee reasonably informed of material developments in the offering.
Underwriting an IPO and M&A advisory services take place in the so-called private side of the investment bank, whereas trading and research take place in the public side. The so-called Chinese Wall separates the two sides of the investment bank.
It is customary that the first S-1 submitted to the SEC includes a range of IPO share prices and the number of the shares in the proposed offering, and these are the data used in the investor roadshows conducted. The range of share prices in the S-1 is informed in part by (i) the implicit share price of recent private capital raises, and (ii) an analysis of the recent share prices of the selected comparable companies expressed as a multiple of consensus research estimates of forward net income or EBITDA. The use of so-called comp multiples requires forecasts of issuer’s forward estimates of the same data. In my experience, three estimates of forward net income or EBITDA are available, including (i) the issuer’s forecast, (ii) the underwriter team’s forecast, and (iii) the research analyst’s forecast. It is customary to apply a so-called IPO discount when using the multiples of comp companies. It is fact specific as to the amount of discount applied in setting the share price range used in the S-1.
The actual IPO share price proposed by the syndicate head to the pricing committee uses more up-to-date data, including (i) the results of the roadshow’s indication of interests and the extent to which the offering is deemed oversubscribed, (ii) updates (if any) of the research forecasts for the comparable companies, (iii) the tone of the IPO market, and (iv) the results of the bring down due diligence meeting. Once the final IPO share price is accepted by the pricing committee, the final S-1 is completed and sent the SEC with a request to accelerate their review. In addition, all parties sign the underwriter agreement. If the shares are listed on the NYSE, the new shares are sold at the IPO price to the pre-selected investors, and a so-called specialist is assigned to handle the trading in the now public shares. The task of determining the so-called opening share price falls to the specialist, who evaluates the supply and demand for the newly registered shares. When the share price opens materially above the IPO share price, the price is said to have popped.
Setting the final IPO share price is more art than science, and IPO pricing is the subject of intense criticism of underpricing from existing investors suffering what is perceived as unwarranted dilution. Recent examples of gross IPO underpricing are DoorDash and Airbnb.
In an effort to bring innovation to the IPO listing process, the NYSE and the NASDAQ separately proposed new procedures for direct listings. Moreover, the SEC on December 22, 2020 approved the NYSE’s proposal to allow a direct listing with a capital raise. See my companion blog on direct listings for a more full discussion.