SecondMarket Is Screwing IPO Investors

I spent the morning reading two posts from Fred Wilson and Chris Dixon on the state of technology IPOs. Both have accurately identified the current state of IPOs: companies are being accurately valued.

I think the main story here is that most of the people buying shares during the IPO roadshows aren’t getting the great deals they are hoping for (or used to). The most common play is to buy pre-IPO stock and then flip those shares the day they go public (or soon after) for a profit. That’s not happening though. Do investors deserve that pop? Probably not. In the previous bubble, the absence of a secondary market meant that it was easier for large price discrepancies to take place. In other words, they offered a price arbitrage opportunity.

But unfortunately that play isn’t available anymore as secondmarket is generating “fair” valuations through increased liquidity. The result is that many of the clients who were investing with Goldman and other banks are going to gradually shift their funds to large private market transactions or even late stage venture investments. Why would investors get involved during an IPO roadshow when the price isn’t going to pop? There’s no incentive.

While I don’t think Goldman’s clients are going to go running for the door, the signs are pretty clear: the secondary market is going to continue to explode. There’s one caveat: if Fred Wilson’s guess about private market valuations being higher than public market valuations is accurate (he states “I believe that some of these companies had private financings at our above these current market caps”), the signs actually suggest that there’s a bubble in late-stage investing.

You’d be better off purchasing shares after an IPO than on second market (unless you want bragging rights to say you own a hot private company’s shares). The one exception is companies like Facebook, which had years of secondary market transactions. Just two years ago, you could have bought Facebook shares at $20 billion and flipped it at an $80 billion valuation before an IPO even takes place. That also means people who are acquiring shares of Facebook right now at lofty valuations may actually end up not getting the reward they were expecting.

The upside: there are still plenty of ways to make money in this market (transaction fees/market making is clearly one of those ways)! It also appears that early-stage investing is the only way for lower-cap investors to get in on these deals since late-stage investors are blowing up valuations. The downside: very late-stage and roadshow investors are not going to get the pop they were hoping for. The secondary markets have eliminated much of the upside opportunity for them.

Let me know your thoughts in the comments as I’m curious to hear what you think about the state of the market!

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  • Tristan

    Few points:

    First, in response to:
    “Do investors deserve that pop? Probably not. In the previous bubble, the absence of a secondary market meant that it was easier for large price discrepancies to take place.”

    ->Doesn’t this undermine your entire argument that this is an issue? Hedge fund clients of bulge bracket banks making money on a one day pop that bankers are assuring them is built into the IPO price isn’t in anyway beneficial to actual “investors” nor is it a value add for the company to experience high volatility in their shares. Why is it “unfortunate” that that flip isn’t available now? Bankers typically place the shares with those clients that will churn through trades which generate fees for banks and avoid those funds that are long term holders with less cash to spin.

    “In the previous bubble, the absence of a secondary market meant that it was easier for large price discrepancies to take place. In other words, they offered a price arbitrage opportunity.”

    ->So the fact that companies are raising money through a public offering at a market cap closer to their actual value is a negative? These companies are in most cases putting the capital they raise to work building their company and driving continued growth and they are able to do so on much better terms (% of equity sold for the same $ amount) if they don’t go out at a valuation that is well below actual equity value.

    Last point:
    “the signs actually suggest that there‚Äôs a bubble in late-stage investing.”

    ->I don’t see how the two are connected and would simply appreciate an actual explanation. A decline in price does not unquestionably imply that a “bubble” exists (whatever that term even means anymore).

    • Nick O’Neill

      Hi Tristan,

      Thanks for the comments. I’ll answer them in order:

      First, perhaps stating that this is an “issue” is a misnomer. It’s only an issue for the rich insiders who were beneficiaries of these pricing inefficiencies. Overall I think this is a great thing for the market.

      Second, raising money at a fair valuation is only negative for those rich insiders I’m referencing. It’s best for the companies that are now getting a fair valuation. This is also most significantly a benefit for entrepreneurs!

      Third, perhaps my post is filled with misnomers :) If there is excess capital going into late-stage companies at valuations that are above what they could have bought at at a later date, I’d say there’s technically a “bubble”. All “bubble” means is that there are inflated prices across a market sector/segment. If Fred Wilson’s hunch is correct, that valuations were higher at the late stage vs post-IPO stage, then there definitely is a late-stage bubble.

      Honestly, I think that will work itself out as capital seeks greater returns by moving toward earlier stages (bringing greater liquidity at earlier points in the lifecycle of the business).

      Let me know if this makes sense :)