Slack's unusual offering likely won't have a first-day pop. Here's why most IPOs still factor in a pop, even though they can cost startups billions

• Investors and analysts are questioning the value of the traditional initial public offering process and the sharp jump in company shares that typically accompanies it.
• That rise, or pop, in a startup's shares on their first day of trading can represent millions of dollars in money that the company left on the table - and billions of dollars in the aggregate.
• Some companies, including Slack, which is set to go public Thursday, are forswearing first-day pops by pursuing alternatives to the standard IPO process.
• While some investors decry pops, other investors and analysts think they and traditional IPOs serve good purposes and the alternatives aren't any better.
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If Pete Flint had to do it over again, he would have gone with a smaller pop - and maybe no pop at all.

The pop in this case is the jump in a company's stock price that that often happens on its first day of trading after an IPO. Startups and their investment bankers often factor in a pop when they price an initial public offering. Such a price rise can help promote the company and its stock and help the firm curry favor among potential long-term investors, the thinking goes.

When Flint took Trulia public, he followed his bankers advice and priced in a pop of 30% to the real-estate startup's public offering. But these days, he's doubting the conventional wisdom when it comes to the need or desirability of a pop.

"The reality is that one year post-IPO, [investors] have completely forgotten what happened on the day of the IPO," Flint said. "The investors have forgotten, and you'd rather have the extra cash in the bank."

Flint's not the only one questioning the wisdom of first-day pops and the traditional IPO process these days. Work messaging software maker Slack, for example, is set to go public Thursday using a direct listing process, an alternative to the standard IPO that generally doesn't involve expectations of an instant pop in the stock price. 

Read this: Slack's $17 billion direct listing could be the IPO game-changer Silicon Valley has been waiting for. But others say it's a techie delusion.

And last week, prominent venture capitalists Bill Gurley set off a debate on Twitter when he decried the pop in shares of CrowdStrike and Zoom when they went public recently. CrowdStrike's stock opened trading on its first day at $63.50, a whopping 87% higher than its IPO price of $34 a share. Zoom's stock, meanwhile, opened trading at $65 a share after pricing at $36, and ended the day at $62 a share.

That $26 a share difference between Zoom's IPO price and the first-day closing price of its shares represents more than $600 million in extra cash the company could have had in its coffers if it had priced its shares closer to the price investors at large were willing to pay for them, Gurley said.

"Imagine if a [chief financial officer or] CEO gave away a half a billion dollars? Or simply squandered it. How would that be viewed?" Gurley said in a tweet. "This is similar, but it's institutionalized, and therefore everyone is numb to it. And the press views a "pop" as success, which is just poor financial comprehension."

 

IPO pops have been around for decades

The IPO pop isn't a new phenomenon. On average, startups have generally seen significant jumps in their share prices going back to at least 1980, according to data from Jay Ritter, a finance professor at the University of Florida who closely studies the IPO market.

During the last stages of the dot-com boom, pops were a much bigger problem, in terms of the money startups were leaving on the table, than they are today, according to Ritter's data. In 1999, for example, the average stock closed up a whopping 71% over its IPO price on its first day of trading. In 2000, the average stock ended its first day of trading up 56% about its IPO price. Collectively startups that went public in those two years lost out on $67 billion thanks to the first-day pops in their stocks.

By contrast, from 2001 to last year, the average startup saw its shares rise 14% above their IPO price on their first day of trading, according to Ritter's data. And over the course of those 18 years, the companies left $65 billion on the table due to such pops - or $2 billion less than in the two dot-com boom years alone.

But there are signs that the pop problem is getting worse for startups. The average first-day rise jumped to 19% last year from 13% the year before, according to Ritter's data. The amount companies left on the table hit $6.4 billion, the second highest amount since the dot-com days and nearly double the amount from 2017. Thus far this year, the average first-day pop has been 24%, which is the highest level since 2000, Ritter said.

The traditional IPO is a significantly costly process for startups Ritter said. On average, the money that startups leave on the table due to their IPO pops combined with the amount of fees they pay their investment bankers adds up to about 5% of the value of those companies, he said. That total amount is often equivalent to an entire year's worth of revenue for those firms, he said.

"If you think about how hard the employees have to work for that [amount], it's surprising how blasé companies are about throwing away all that money in the cost of going public," Ritter said.

Some companies have explored IPO alternatives

Startups don't have to use the traditional IPO process to go public or price in a pop. With its direct listing, Slack is following in the footsteps of Spotify, which used the same method to go public last year. In a direct listing, employees and early investors in a startup sell their shares on the public market, rather than going through institutional investors first. Generally, there's no pop priced in; instead, the price at which they sell their shares is the market price.

Gurley and other venture investors think more companies should use the direct-listing method for going public.

"This is how 100% of IPOs should be done," he said on Twitter.

In the late 1990s and 2000s, several companies, including Google, tested another alternative for going public - the Dutch or blind auction method. In that process, investors put in bids for shares in a public offering, stating how many shares they'll purchase at a particular price. The auction managers set the price for the offering at the amount at which all shares the company wants to sell will be sold; i.e., there are enough bids at or above that price to cover all the shares the company is offering. Because a Dutch auction tends to price shares much closer to the level at which they'll trade on the open market, the process can maximize the amount startups raise in their offering.

But Dutch auctions never caught on widely and have been largely forgotten since Google's 2004 debut. Ritter blames the investment banks. For the most part, the banks have been "actively hostile" toward the Dutch auction process, because it takes away their ability to reward favored clients, Ritter said.

In a typical IPO, the banks have wide discretion over who gets to buy the startup's shares. In a hot IPO, they tend to give first dibs on those shares to their mutual fund and hedge fund clients that pay a premium for their research and other services, Ritter said. In a Dutch auction, they don't have that discretion, he said.

"The investment banks don't want their business model threatened," he said.

Pops and IPOs persist for good reasons

But traditional IPOs and their accompanying pops persist for reasons other than just banker self-interest or inertia, other market watchers said.

One explanation they give is that the alternatives to an IPO aren't well established or practical for most companies.

A big part of the reason why the Dutch auction process didn't catch on after Google's IPO is because the search giant's offering was largely seen as a disappointment. The company sold fewer shares than it initially planned and priced them at the low end of its expected range.

Direct listings will also likely struggle to go mainstream. To have a successful direct listing, companies need to have a prominent brand, a price for their shares that's already been firmed up in private markets - and no urgent need for cash, analysts said. Those factors exclude the vast majority of companies seeking to go public, they said.

"I wish there was some better process [than a traditional IPO], but so far we really haven't seen a better process that works for a lot of companies," said Reena Aggarwal, a finance professor and director of the Center for Financial Markets and Policy at Georgetown University.

Pops also persist because the standard IPO process works fairly well for most companies, analysts said. The companies themselves raise cash. The process serves as a marketing vehicle for the startups and their shares. And in most cases, the money left on the table from a pop is outweighed by other factors, analysts said.

Nobody wants to see a stock fall on its IPO

If

a startup prices its stock too high in an IPO, it runs the risk of having its shares fall when they hit the open market, as Uber's notoriously did after their debut last month. That kind of market reaction can sour investors on a startup's stock for months or even years afterward, making it difficult for the company's shares to recover, said Jai Das, president and managing director of Sapphire Ventures. Investors essentially put such a stock in a "penalty box," he said.

"Everybody says, 'Hey, this stock sucks,'" Das said. "Nobody wants to touch it."

When that happens, it can have follow-on effects, he said. Startups in such positions can have a difficult time raising more money on the public markets. The morale of their employees can decline. If things get bad enough, employees will leave and the company will often have to dole out many more stock options or shares to lure in new employees. The startup can even face lawsuits from shareholders charging that they've been defrauded.

If "the price goes down a lot, then everybody's going to be unhappy about that," said Aggarwal.

Got a tip about the IPO market or the tech industry? Contact this reporter via email at twolverton@businessinsider.com, message him on Twitter @troywolv, or send him a secure message through Signal at 415.515.5594. You can also contact Business Insider securely via SecureDrop.

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