KEY LESSON: Liquidity, as measured by trading volume, matters more than share price
No plan ever survives first contact with the enemy. Or, if 19th century Prussian generals do not carry much weight with you, how about Robert DeNiro “All combat takes place at night, in the rain, at the junction of four map segments.” After months, or years, of preparation, when an IPO comes, it rarely goes as predicted.
In the last chapter, we looked at several common mistake that companies make in preparing for their IPO. I think it is now time to understand the consequences of those mistakes.
In general, companies want a stable of engaged investors. People who care enough about the company to maintain a position, do their homework, and pay attention. By contrast, investors have to screen through hundreds, if not thousands of stocks. They tend to be choosy about which stocks they devote their time. Often, it is harder to convince an investor that they should spend time on a stock than it is to actually convince them to invest.
In broken IPOs, companies anger those investors. As we saw in the last chapter, this usually means setting the IPO valuation too high relative to a realistic forecast of the business.
Investors respond to this by taking their attention elsewhere. If a company is a multi-billion dollar mega cap, like Facebook, eventually investors will come back once they fix whatever drove off the investors. But for most other companies, missing their first two quarters after an IPO is a disaster. Aside from a tumbling stock price, it also drives away investors, and they probably will not come back for the rest of their careers.
At that point, many companies with market capitalizations below a $1 billion enter into a vicious, downward spiral. The stock price falls, then investors stop trading, and trading volumes plummet. The big, desirable long-only mutual fund investors limit the amount of stock they buy in a company based on the amount of time it would take for them to unwind that position. So if a company’s stock trades 50,000 shares a day, most mutual funds will not buy more than 150,000 shares or three days of volume. Different funds have different rules, some will go as high as a week, but the numbers remain small. There is another problem with this. Many funds will not bother to take small stakes in a company. They have too many other names to cover, and owning 100,000 shares in a $5 stock is not worth the time. Even if that stock doubled, what is a $500,000 profit to a $10 billion fund.
So companies are trapped in a whirlpool. They cannot get the stock price up without attracting long-only investors, but the long-only investors want trading volume in the stock before they will purchase in quantity. This pushes companies towards spending more time with hedge funds, retail and other short-term investors. In the last chapter of the series, I will look at ways to break this cycle, but the short answer is that there is no short answer, and only time and good results can save the share price.
No one warns management teams about this risk, it is one of the most dangerous aspects of an IPO, but it happens more than many want to believe.
Management teams need to remember that they have no relationship with the Street at the time of the IPO. Their venture investors have had years to get to know the management team. They probably ran full background checks on the whole team before they invested. VC boards have head ample to time to measure and judge management. By contrast, the only things public investors know about that same management team is what they read in the S-1 Prospectus, see on the web, and hear in the road-show. Those first two quarters after the IPO are the time when the Street makes their judgment. Of course, It does not feel that way to the management team. Preparing for an IPO feels like a highly invasive doctor’s visit, but the amount of information that actually trickles through to the average investor is very small.
In the next two chapters we will look at the right way to craft an IPO roadshow.
Practical Guide to This is Chapter 10 in my series “AIPOs”, you can find the beginning of the series at Chapter 1 and the previous chapter here.
Pingback: A Practical Guide to IPOs- The Eleventh Chapter – How to Tell a Story – DIGITS to DOLLARS·
Pingback: Promote Your Company The Right Way - Positive Stocks·