As the name suggests, an Initial Public Offering, or IPO, is the process by which a company goes from private to public by selling stocks to the general public.
One of the main reasons companies go public is to raise funds and have more liquidity on hand. They can reinvest the capital in the business’ infrastructure or expand the company. Another added benefit of an IPO is that you can increase your chances of attracting top management candidates by offering them perks such as stock option plans. Not to mention that being listed in major stock exchange markets like Nasdaq or NYSE gives credibility.
Once the company goes public, the stocks the investors bought are no longer “paper money.” They now can sell or liquidate their stock in exchange for real money.
Let’s take Snapchat as an example since they went public recently, and managed to raise $3.4 billion at a valuation of $24 billion. They priced their IPO at $17, meaning that anyone in the world can now go to an online brokerage site, such as TD Ameritrade or ETrade and buy shares in Snapchat under the trading symbol SNAP.
In reality, however, the IPO process isn’t very democratic, and it favors large institutional investors (venture capital, hedge funds, private equity and ultra-rich individuals known as angel investors).
We can illustrate this by going over the Snapchat price before the IPO.
If we look at data from Pitchbook, we can see that the Seed Round (Series A1) valuation for Snapchat was only $5.3 million. Compare this to the post-IPO valuation of $24 billion.
Snapchats Cap Table
Looking at Snapchat’s cap table, we see that their pre-IPO price for Series A1 was $0.01, and $0.21 for Series A. Compare that versus the current post-IPO price of $17.00!!!! This is exactly how startup founders become billionaires, and how early investors become millionaires!
To put things in perspective, a Series A1 investor received a 169,900% (1,699x) return on their investment after five years, when Snapchat had an IPO. A Series A investor received a 7,900% (79x) return on their investment after five years.
If you had invested $100 in Snapchat’s Series A1 or A, your $100 would now be $169,900 (Series A1), and $7,900 (Series A).
If you had invested $1,000, your money would now be $1.7 million (Series A1), and $79,000 (Series A).
If you had invested $10,000, your money would now be $17 million (Series A1), and $790,000 (Series A).
This is what Angel Investors and Venture Capital funds do. Except instead of investing $10,000, the average Angel Investor invests a minimum of $25,000, and the average Venture capital fund invests $3 million.
When it comes to raising money using traditional investment methods, startups are incentivized to keep the number of investors as low as possible, resulting in only people with the most money being able to invest.
As a result, regular people who don’t have a minimum of $25,000, miss out on these opportunities of making money pre-IPO and have to wait until a private company goes public to buy its shares.
IPOs are not without risks, though. More often than not, there is little data on the company so it can be hard for investors, especially angel investors (rich individual investors), to predict how the stock will behave in its initial day of trading and the near future. Add to this the fact that most IPOs are for companies that are going through provisional growth periods and you’ll understand the uncertainty that lingers above their future value.
Maybe these are some of the reasons why the number of companies going public has declined in the first half of 2016. Or maybe it’s because change is upon us.