Recently, I had a lunch with somebody who owns a business, and he casually asked me about why business owners want to have their companies going public.
I guess, IPO fever is in the air, probably driven by the IPO and post-IPO news of GoTo and its price run-down and run-up again.
Though there are many reasons for such decision to sell the company shares to public to fund-raising, yet, I answered his question that “liquidity” is the key word. Liquidity is most valuable. Having stock ownership of a business is one thing, but the real question, is it:
- Marketable illiquid?
Please note that we don’t have marketable liquid since an interest or item that is liquid, logically it should be marketable.
According to The International Glossary of Business Valuation Terms, 2001, and the ASA Business Valuation Standards, 2009 , American Society of Appraisers (Financial Valuation: Applications and Models, 4th Edition, 2017, James R. Hitchner, page 395-396), we could read that
Liquidity : The ability to quickly or readily convert property (asset, business, business ownership interest, security, or intangible asset) to cash or pay a liability without significant loss of principal and without significant cost.
Marketability : The ability to quickly convert property (asset, business, business ownership interest, security, or intangible asset) to cash at minimal cost that reflects the capability and ease of transfer or salability of that property.
Further, Hitchner gave the example of its application to the following commonly identified assets:
So going public will mean to transform the stock of a company from ILLIQUID to be LIQUID (assuming there is an active secondary market after the IPO event), and of course, this transformation of corporate action brings with it the costs (reading Considering an IPO? First, Understand the cost (accessed on 5 June 2022, https://www.pwc.com).
Additionally, the company should consider “leaving some money on the table” (which in many financial researches, this is termed as IPO Underpricing puzzle) (joke: we need money to make this “party” more exciting for everybody!).
Our casual chat was flowing to IPO Offer Price. As this IPO offer price (or called IPO Pricing) will involve securities company (perusahaan sekuritas), there are two main questions to answer, that is
- How many shares to be issued; and
- At what price?
Each company has its own target proceeds of capital it wants to raise through IPO, which will be bigger if the company business needs money to fund its future investment. The first question above about the shares is what called “free float”, and this should be determined first in many instances. The company together with securities company need to ensure that the number of shares to be offered are large enough to ensure liquidity in post-IPO. In general, we will be talking about approximately 20% free float (vs minimal requirement from Indonesian Stock Exchange of 7.5%, see as wellTerkait Free Float, BEI: IPO GoTo Telah Sesuai Dengan Aturan (cnbcindonesia.com)).
https://www.cnbcindonesia.com, accessed on 5 June 2022.
As a note, there is corporate income tax deduction of 3% if the free float could reach 40% (Government Regulation – Peraturan Pemerintah No. 30 Year 2020).
Once the number of total shares to be offered (=sold) is determined, then total amount raised up will depend on how much the IPO Price is set up (which in Indonesia, normally we see the book building process).
So in general, we could say, we have two IFs, they are:
- IF the number of IPO shares is set first; or
- IF the target IPO net proceeds are set first.
Both of them are inter-related, but this is more about from where we want to start first.
Let me put them in equation to make it more understandable from where the final relationship in setting IPO Price Offer is coming.
Let me use some notations:
- NS_existing = Number of existing (or Pre-IPO) shares
- NS_new_issue = Number of shares to be issued to public (IPO shares)
- V_Pre-IPO = The equity value of the company prior to IPO
- V-Post-IPO = the equity value of the company after the IPO
- P_offer = the Price offer of the newly issued shares to the public
- F-underwriter = Underwriting fee
- %_public = the percentage of share ownership by new [public] shareholders
- IF THE TARGET IPO NET PROCEEDS is set first
We see from the above derivation of equation that prior to the setting the IPO Price Offer, the company needs to compute total new shares that will be offered to the public.
- IF THE NUMBER OF IPO NEW SHARES is set first
From the above equation that:
P_Offer is equal to the Equity Value of the Company per existing share MINUS Underwriting Costs per existing share, this makes sense since it will mean that it is the existing shareholders that will bear all the costs of the IPO. The new shareholders will not be willing to shoulder these IPO costs, and this will necessitate that the IPO Price Offer setting requires that Equity Value per share (Prior to IPO) be deducted first with all IPO Costs.
Either using the approach if (1) the target IPO net proceeds are set first or if (2) the number of IPO new shares is set first, both approaches requires that the company equity value be determined first. There are a couple of methods that could together be used in determining the company equity value, most notably, the Discounted Cash Flows method and Benchmarking (market multiple) method.
However, IPO is not just about the IPO Offer Price, but more than that is the Structuring of the IPO itself. Here we will concern over whether the shares going to public is primary or secondary shares, the dual-share structure, which might have different voting rights. For example, under dual-class voting IPO structure, the issuer’s share structure will have Share Serie A (giving one vote for one share) and Share Serie B (giving multiple voting rights for one share). Some of the most successful start-scale up companies that went public, for example, Baidu, Facebook, Google, Groupon, Lyft, Pinterest, Snap, TripAdvisor, and Zynga) in their IPO, have dual-class shares being issued, this will lend the founders a door to control the business by holding share interests with multiple voting rights.