Dryer Installations, Circle IPO, and Capitalization
“This installation was a piece of cake.”
The installer smiled as I signed paperwork. It was only about 15 feet from my driveway-side door to the basement stairs. I asked him about more challenging deliveries.
“Last week we installed a $4,000 washer/dryer set on the third floor. Circular staircase- wasn’t sure if we could make it. The son didn’t like carrying his laundry down to the basement.”
We laughed and agreed that families have different expectations about kids.
Stakeholders have different expectations about initial public offerings (IPOs). I’ll use Circle’s recent IPO to explain the stakeholder views and decisions about raising capital.
Circle’s IPO: Big Stock Price Gains
Circle.com provides “near-instant, low-cost, global stablecoin transactions.” The Circle Payment Network enables “financial institutions to achieve seamless, near-instant, global money movement across previously fragmented networks.” Circle is the most licensed stablecoin company in the world, and the firm operates to increase digital payments.
Yahoo Finance reports that:
“Circle and its shareholders sold 34 million shares—14.8 million by the company and 19.2 million by existing investors—at $31 per share, above the marketed $27–$28 range. The deal attracted demand reportedly 25 times greater than the available shares at the pricing cutoff, underscoring investor enthusiasm.” (bold italics added)
The company raised nearly $1 billion and had a 168% first-day gain. The stock was at $133 at the market close on June 13th.
The prospectus states that “the IPO raised $996 million after underwriting fees of $59 million. Of that total, $434 million flowed into the company’s treasury, and the balance of $562.5 went to a group of large shareholders who sold at the offering.”
Great news for the company, right?
Well, that depends on who you ask.
Stakeholder Views on Circle
Circle.com can help us answer the question: Are all stakeholders excited when the stock price goes way up right after an IPO?
Early investors
Existing shareholders sold millions of shares to the public. Investors who funded Circle through private equity or venture capital funding may be thrilled because they can liquidate shares held for years.
According to CNBC: “Private investors are desperate for exits, so they can distribute back to their investors,” said Lise Buyer, founder of IPO consultancy Class V Group, though she said she isn’t certain of the company’s motivations. “It probably reflects a multiyear drought in IPOs and a strong desire by early investors to get some liquidity.”
Employees
Similar situation with employees. Employee stock ownership is a big carrot for workers, and team members may want to sell shares to diversify into other investments, buy a home, or simply retire.
Senior Management
This group needs to think strategically, and a big price increase after the IPO means that the IPO price was too low.
According the Fortune:
“The upshot: The company and insiders combined left a gigantic amount of money on the table by agreeing to a price far below what investors were willing to pay… that ‘left on the table’ figure was the seventh largest in the history of all IPOs since 1980.”
How much money did Circle leave on the table?
“Had the shares fetched the $107.5 close on June 6 instead of the $31 (excluding fees) paid in the presale by the likes of mutual and hedge funds, the company and insiders combined would have collected $4.144 billion. Hence, as of the second day of trading, the IPO had left a staggering $3 billion on the table.”
Ouch.
Investment bankers are smart, capable people that want to IPO to succeed. Pricing an IPO is an art, not a science.
How Investment Bankers Determine the IPO Price
Here are some common metrics that bankers use to determine the IPO price.
Comparables
Assume that stocks in Circle’s industry trade at a price/ earnings (PE) ratio of 30. That means that the stock price is 30 times earnings per share. Circle’s IPO should not be priced to generate a PE ratio far higher than 30.
Discounted Cash Flow (DCF) Analysis
Circle generates cash inflows and outflows. Bankers can discount the inflows and outflows using a discount rate to determine the current worth.
Market Conditions
This may be the biggest factor in Circle’s rapid price increase. IPO volume has been sharply lower in the past few years, and investors are anxious to invest.
Measuring the Financial Impact
One way to measure the impact of raising less money is the debt-to-equity ratio:
(Total liabilities / stockholder equity)
I’ll use simple math to explain this point. Let’s assume that Circle has $5,000,000 in liabilities and $1,000,000 in equity before the IPO. The company raises $1,500,000 through the IPO, and equity increases to $2,500,000. The debt-to-equity ratio is:
($5,000,000 liabilities / $2,500,000 stockholder equity) = 2.0
Now assume that Circle only raises $1,000,000 through the IPO, and equity increases to $2,000,000. The debt-to-equity ratio is:
($5,000,000 liabilities / $2,000,000 stockholder equity) = 2.5
The bottom line: When less equity is raised, the debt-to-equity ratio increases. The company has more liabilities for every dollar of equity, meaning that the company is more leveraged. Higher leverage can make it more difficult to raise capital moving forward.
Many tech companies don’t carry debt, since they don’t have consistent earnings to make debt payments. However, tech firms may take on debt as they scale.
Food for thought.