After reading an article about the upcoming Initial Public Offering (‘IPO’) of Roots Ltd., a Toronto based clothing company, Mermaid, a friend of mine, called to ask for my thoughts. She was familiar with the Roots brand, had shopped there over the years, and wanted to know if this beaver sporting Canadian retailer presents a good investment opportunity? So I checked it out.
‘IPO’ refers to the first sale to the public of company issued stock. Prior to an IPO, the company is not listed on a stock exchange, and it is virtually impossible for Joe /Jane Investor to buy stock of a private company. Although private companies do have shareholders, they are few in number and there does not exist any sort of market where their shares may be bought and sold.
Be Wary The Hype
A whole mess of companies ‘go public’ every year. And for the biggest of the bunch, there’s extraordinary hype. Why the hype? To generate investor interest. The more interest, the more buyers, the higher the price climbs, the more money made by the company, insiders, and underwriters, so the thinking goes.
Who’s responsible for the hype? The company that is going public plays a role of course. But the bigger role is played by investment banks who ferociously vie for a piece of the action. And when we’re talking about a company that presents juicy profit opportunity, the big boys come to the table: JP Morgan, Goldman Sachs, RBC Capital Markets, Barclays, and the like. And they talk up the company like it’s the greatest thing since Muhammed Ali. Master salesmen, these bankers are.
Journalists also play a role, and so they should. When Roots or Snap or Blue Apron morph from private to public status, it’s a matter of public concern. And when media presents a balanced take on a company’s current business and future prospects, this helps investors weigh the pros and cons of whether or not to add shares to their portfolio. But when media cheerleads, this is where you have to be careful. This is where you have to recognize noise for what it is and not get swept up by the hype.
How Do Investment Banks Make Money On An IPO?
The company going public often uses more than one investment bank to underwrite the IPO. Here’s how it works: the banks and the company agree upon a price at which shares of the company will be purchased. This happens before shares are actually listed on a stock exchange, i.e., before shares are made available to the public.
Profit is to be made on the difference between the purchase price paid by the banks and the price they sell the shares to the public. For example, let’s say Roots Inc. goes public at $15/share. This means that the banks bought the shares at $15.
Now let’s say that investor interest has been stoked in the lead up to the IPO, bids come pouring in, and the stock ends the day at $22. So, banks made a profit here of $7/share. If they sold one million shares, that’s $7m bucks.
Still, IPOs are by no means a slam dunk for investment banks as they do take on significant risk. Facebook was enormously hyped prior to its IPO. In retrospect, for good reason. But in the beginning, it looked like a dud.
One of the largest IPOs ever, more than half a billion shares traded on the first day. The opening price was $38, rising to $45 during the day, and closing at $38.23. Shortly thereafter, share price dropped to about $18 and wouldn’t see $38 again until 15 months after the first day of trading.
What The Company Does With The Money
Plain and simple, companies go public to make money. The idea being to raise funds by selling shares to the public. Companies often use IPO proceeds for one of two reasons.
First, to raise money that is reinvested in the company’s infrastructure or expanding the business, the underlying purpose being to accelerate growth leading to higher revenues and profit.
Second, the IPO is an exit strategy, a way for founding shareholders to cash in their chips, so to speak, and sell all or part of their shares to the public.
Is one reason better then the other? Well, you can’t really make this call without knowing a companies specific situation. When management reinvests most or all IPO proceeds into the business, this tells me that they’re aligning their personal financial interest with that of new shareholders, and they’re committed to growing the business.
That said, I wouldn’t touch an IPO based exclusively on founding shareholders cashing out. As a shareholder, I want to know the company is working for the benefit of all shareholders, not merely to enrich the founders.
Roots is Flawed
Roots Inc. has been around as a private company since 1973. After decking out Canadian athletes in Roots apparel for the 2010 Olympics in Vancouver, the company’s brand recognition soared, not just in Canada but globally. And in 2015, the company sold a majority stake to Searchlight Capital LP, a private investment firm based in New York.
Here’s the thing about private investment firms: their purpose is to increase the value of companies in which they invest. A good thing? Maybe. Really depends on your perspective. Because ‘value’ is subjective. And investment firms are all about financial value, how much money is the company worth, how much profit may be generated.
In contrast, business founders are rarely so myopic in their definition of ‘value’. Not looking to turn a quick buck, founders have a long-term outlook, and take personal interest in relationships with their employees, customers and their reputation. They care.
Based on available information, Searchlight is typical, taking Roots public in order to cash out. How do I come to this opinion? Well, when companies file for an IPO with the Securities and Exchange Commission, they craft a lengthy document known as a prospectus. And in their prospectus, Roots baldly states that money raised will not be used to assist with expanding the business. Instead, and this is chutzpah for you, Searchlight will be selling its shares to the public and pocketing the proceeds.
Outraged at the nerve of Searchlight? Don’t be. This is how the game sometimes works. But the thing is, you don’t have to play. Playing is optional. And unless the line of suckers who want to buy shares at any price on the first day of trading is endless, the only people virtually guaranteed to be smiling when markets close will be those employed by Searchlight.
Moths To A Flame
Will thousands of people still buy Roots shares on their first day of trading? You bet they will. Because the hype will only grow in the weeks and days leading up to the companies reincarnation as a public company. And some people will read about the ‘opportunity’ in newspapers or listen to talking heads on business news programs and they’ll trust what they read and hear.
As I said to my friend, Mermaid, maybe investing in Roots will turn out well for early investors. Maybe it won’t. We really don’t know. But for me, the unknowns of a relatively small clothing company don’t inspire confidence. And the known of a private investment firm selling their shares to Joe/Jane investor and pocketing their money convinces me to watch from the sidelines.