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Finance 104: The Aftermath of the IPO

Life in a Public Company Has its Ups and Downs

“Fortunately, we’re not a public company. We’re a private group of companies, and I can do what I want.” – Richard Branson

Your company has just gone public! Are you going to buy a yacht, a fleet of Lamborghinis, or a small Caribbean island? Why not all three?

Chances are, you’re not going to do any of those things because you made exactly zero dollars on the IPO. What’s that? No riches? What was the point, if not to make you filthy rich?

As we saw in the previous episodes, the point of the IPO is to raise cash for your company, not for yourself or your coworkers. The proceeds of the IPO are intended to fund company growth, such as new R&D projects, bigger facilities, or more staff. The people who invested in your company want the company to do well. They don’t give a $@# about you.

The Golden Handcuffs

That’s why you probably signed a “lockup agreement” right before your IPO. This is a contract between you and the bank that acted as your underwriter. The contract spells out exactly how, when, and even if you can sell the shares you own. It’s legally binding, and it prohibits you from selling your shares anywhere around the time of the IPO. What’s up with that?

Three reasons: economics, psychology, and stability.

You’ll naturally be tempted to sell off some of your shares on IPO day because it means an instant “liquidity event” (read: great stonking wodges of cash) for you. Even if you don’t sell them on opening day, you might unload a bunch of shares within a few weeks of the IPO. It’s hard to resist that kind of temptation. That’s what the shares are for, right?

The trouble with that is basic supply and demand. If you flood the market with your own shares, that will add to the supply, which decreases demand, which lowers the share price. Your brand new shareholders really don’t want to see that happen, especially not right after the IPO. They just poured millions of dollars (if they’re large institutional investors), or dozens of dollars (if they’re individuals) into your stock. They made a big bet on you. And the first thing you do is dump yours and depress the prices? Not a good way to please your new best friends.

Even more important than the economic effect is the psychological effect. If you, as a well-informed company insider, are selling shares instead of buying them, what message does that send? You must know something the others don’t. Investors are always looking for an inside tip, a tell, a head fake – anything – to indicate which way the share price is going to move. If they see you jettison your shares, they’ll dump theirs, too, and it all goes downhill from there.

The third reason has to do with stability. You and your colleagues have built up your lemonade stand to the point of a successful IPO. You’re corporate rock stars, and the new shareholders are your biggest fans – for now. They don’t want to see you leave. So, to make sure that you stick around and continue to do your job instead of browsing real estate ads and picking out leather seat options for Rolls-Royces, they prevent you from selling any stock. For a little while, anyway.

You’ll be figuratively chained to your desk until your lockup agreement expires, which might take somewhere between three months and a year. Even if you quit the company, you still can’t sell your shares, so there’s no incentive to bail out to that desert island. It’s the most effective method investors have of preventing the entire executive staff from walking out on IPO day, leaving them holding a hollowed-out company with no leadership. Better put that island on layaway.

When your lockup does expire, you’ll finally be able to sell some or all of your own shares. (You can always buy shares; the lockup doesn’t restrict that.) Even then, you’ll be operating under different rules than everyone else. Because you’re a company insider and presumed to have special, secret knowledge of the company’s financial situation, you’ll have to telegraph your moves to the wider public before any share transactions. In practice, this means filling out forms and publishing an official announcement a few weeks ahead of time that you intend to sell X number of shares on a certain day. That gives the investor community a heads-up that you, an insider, are selling. They will then read the tea leaves, sacrifice a few goats, and try to divine what this all means. Their conclusion is usually dire, and it will depress the share price right before you sell. Better call up the car dealer and ask to switch to the vinyl seats.

The outcome is especially bad if you’re selling all your shares at once. It’s even worse if you do so on the very first day your lockup expires. And it’s worse still if your colleagues all do the same thing. The last thing the investor community wants to see is the CEO, CFO, and CTO all unloading their shares the very first chance they get. What terrible things are going on inside the company?

All lockup agreements are public knowledge, so investors know ahead of time when you’ll be able to sell, even if you don’t actually apply to do so. Thus, the share price might tend to dip a few weeks before the expiration date, in expectation of an insider sell-off. If you and your colleagues hold on to your shares past the expiration date of the lockup, great! The share price will probably rebound. Investor confidence will be restored, and everything’s back to normal.

The Paperwork

Once you’re public, your business accounting will be done in public view. You are now operating out in the open, with a whole new set of financial and accounting rules. Once again, that’s to protect shareholders from any shenanigans you might be tempted to hide. You took their money; they get to see how you’re spending it. That’s the deal.

Among a thousand other details, this also means you have to publish your comprehensive financial results every three months (i.e., quarterly). In the U.S. this is done by filing SEC Form 10-Q. It’s like filing your personal income taxes (IRS Form 1040), but much more detailed. Along with all the numbers, there’s also an essay section. You’re expected to provide some verbiage about how the last quarter went and what you foresee happening in the future.

As you might expect, you need to be very cautious about your wording here. Thousands of investors will obsessively over-analyze your 10-Q like it was the Lost Gospel of the Albertian Order, looking for any hints of a rise or fall in your business prospects. Share prices typically jump up or down on the day a company’s 10-Q is released. (Different companies release their quarterly results on different days; they’re not all synchronized.)

Some firms won’t release their 10-Q until late in the afternoon, after the stock market has already closed, to give investors a bit more time to read and digest its contents before the market reopens the next day. Really shrewd (not to say unscrupulous) companies might even delay releasing their results for a few days, hoping that some global cataclysm will help them bury their bad news. Had a disastrous quarter? Wait until there’s a hurricane.

Pressing the Flesh

Another charming ritual of public-company life is the annual shareholders’ meeting, often held in a hotel ballroom in your company’s hometown. The idea is for shareholders to meet the company executives in person (that’s you), ask questions, and generally check up on their investment. There will be refreshments, but it’s not a party.

The annual shareholders’ meeting is like the quarterly 10-Q, but live. You and your fellow executives will present a carefully scripted and rehearsed presentation that paints a rosy picture of the company, while scrupulously avoiding any statements that aren’t provably accurate. This is where you break out your best PowerPoint template with the expensive clipart and the best customer testimonials. The idea is to get everyone in the audience nodding enthusiastically about your company and your ability to convert their shares into gold.

If you’ve had a few successful quarters, and the last year has gone well, and the share price is up, the meeting should go fairly smoothly. Your investors will generally be fat, dumb, and happy because you’re making them money. On the other hand, if the share price has been flat lately, or even if it has risen but not as rapidly as some other companies’ shares, your shareholders will be cranky. They’ll stand up and ask pointed questions about your competitors, your competence, and your ancestry. It’s like a courtroom cross-examination without the legal niceties. Companies have been known to hire armed guards. Attendees at a shareholders’ meeting can ask any questions they want, to anyone they want, and your job is to field them as gracefully as possible. Hope you can think on your feet.

The Two-Headed Monster

All companies are supposed to make money, but now that you’re in a public company, you’re effectively running two separate enterprises simultaneously. One makes products to sell to customers, just like before. The other is a money-generating machine for a bunch of shareholders. Those two are unrelated. Turning a profit by selling goods and services doesn’t necessarily generate cash for shareholders, or vice versa. One job is probably more fun than the other, but only the latter one can land you in jail for doing it wrong. It’s like juggling a softball and a chainsaw.

At the risk of stating the obvious, your investors are interested in making money. They are probably not your customers and haven’t ever used your product. There’s very little overlap in the Venn diagrams of your “normal” customer base and your shareholder base. Since anyone can buy shares in your company, plenty of your shareholders will have no idea what your company does or how your industry works. They probably bought the shares because someone in a necktie told them to. It’s simply an investment for them, and its only “utility” (in the economic sense) is to generate more cash. You are their cash cow. Moo.

That means you’re now serving two separate and disjoint customer groups that have unaligned motivations. To satisfy the first group, you can make product changes, alter pricing, or pull various other levers to accommodate your “real” customers. But you can’t directly affect your own share price, so you have little control over the second group’s satisfaction. The same things you do to make the first group happy – lowering prices, for example – might easily make the second group unhappy. Which group do you cater to? Whom do you serve?

Selling Yourself

Making the shareholders happy is important, but why? After all, your company already had its IPO, so it’s done making money on the stock market, right? So what if your share price plummets and all those shareholders go broke? Isn’t that someone else’s problem now, unrelated to how you run the business?

Well… yes and no. As we saw earlier, your company probably didn’t sell all of its shares on IPO day, just a big percentage of them. There are still a lot of shares in reserve. In effect, the company is its own biggest shareholder. Which means, of course, that the company could sell off a few more shares to make some extra money. It’s in the company’s interest that the share price go up. It’s not just good PR, it’s a good investment.

In fact, when share prices go down, companies sometimes engage in a “share buyback,” in which they purchase their own shares on the stock market. This does a few things. First, it displays confidence. If investors see that the company is spending its own cash to buy its own shares, it sends a strong signal that the shares are worth more than the cash, and that the company believes it’s a good investment. Second, it tightens the “float,” the number of shares available to other investors. Any company-bought shares are effectively out of circulation. That reduces the supply, which increases demand, which increases prices, so the company is doing a big favor for the current shareholders. Finally, a buyback can halt (or at least, slow) a downward spiral in share prices. If nervous investors are selling off shares, and the company buys them up just as quickly, it prevents those sellers from depressing the share price.

Dilution

If the share price looks attractive, the company can decide to raise some cash by selling more shares of itself. It’s kind of like a second (much smaller) IPO. Indeed, it’s often called a “secondary offering” or a “follow-on offering.” The idea is simple, but there are some drawbacks.

When you had your IPO, you decided what each share of the company would buy, as a percentage of the company. If you issued one million shares, then each share was (and still is) worth one one-millionth of the company. Simple. The dollar value of that share may go up and down by the second, but it’s still one one-millionth of the company.

But what happens if you now release more shares from the company coffers? Now there are more shares in the stock market pool. If the company decides to release (or “issue,” in financial parlance) another 100,000 shares, then instead of exactly one million shares circulating among investors, you’ve got 1.1 million shares. You’ve added to the supply, so ipso facto, you’ve decreased the demand. You have “diluted” the share pool.

Dilution is a mixed blessing. On the downside, it tends to annoy existing shareholders. Before, each share they’d bought represented one one-millionth of the company. Now it’s worth 10% less than that. You’ve taken away some of the value they paid for, without asking them and without offering any compensation. That’s a sure road to shareholder uprising and ugly lawsuits. You can assuage their ire, however, if they (believe they will) benefit in the long run. A secondary offering generally means the company is raising money for some good cause, like a massive expansion, a big acquisition, increased headcount, or other signs of corporate growth. If the dilution is handled gracefully, it can benefit both the company and the individual shareholders.

There’s another way to sell company shares without diluting the share pool, and that’s by taking them from your employees. You and some of your coworkers might decide to sell your massive hoard of shares back to the company (after your lockup expires, of course), which then sells them on the open market. This doesn’t increase the total number of shares, it just moves them from private hands (yours) to public hands. In accounting terms, you’ve shifted numbers from the “shares outstanding” column to the “float” column. There’s no dilution, yet there are more shares available to trade.

Moving Forward

After your lockup agreement has expired and you’re able to sell your shares, after your boss has already dumped his and depressed the share price, after the company has diluted the pool by issuing more shares than it initially offered, after a know-nothing analyst downgrades your company and its stock, after you get hit with a huge tax bill for the theoretical value of your shares, and after the economy tanks and you watch helplessly while your share price spirals downward – after all that, you might make a few bucks.

You may not get that fleet of color-coordinated Lamborghinis, but you’re still ahead of the game. Was it worth all the extra effort? That’s for you to decide. Buona fortuna!

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