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A banner announcing Linkedin Inc. listing on the New York Stock Exchange hangs on the face of the building in New York, May 19, 2011. (Mike Segar/Reuters)
A banner announcing Linkedin Inc. listing on the New York Stock Exchange hangs on the face of the building in New York, May 19, 2011. (Mike Segar/Reuters)

VOX

Supply, demand and the tactics of IPOs Add to ...

There are a number of obvious similarities between LinkedIn and Pandora Media . Both are highly popular consumer-Internet stocks that jumped in valuation as their initial public offerings unfolded and both have since retreated, to varying degrees.



A less obvious common characteristic - and one worthy of adding to the list of red flags for IPOs - is how few shares each company offered to investors in the public stock sale. Demand for the companies' stock far outstripped supply, leading to large early gains in the shares' trading.

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That raises the question of whether the stock offerings achieved more in raising capital for the company - the traditional rationale for an IPO - or hyping the stock and enriching insiders.



Let's review the way IPOs are supposed to work. In the standard case, a company that is privately owned decides to sell stock to the public and list on an exchange. The shares sold in the offering can be newly issued, with the proceeds going into the company treasury, or sold by the early owners of the company as they exit their investment.



IPO watchers generally prefer offerings in which insider selling is at a minimum, since the purpose of selling equity is supposedly to raise capital to expand the business. A dumping of shares by early stockowners looks like a rush to the exits.



But LinkedIn, Pandora, and another of this year's consumer-Internet companies, Demand Media, have a different spin on the formula. Each offered less than 10 per cent of itself in its IPO. By selling so few shares, they raised little capital. But because the shares offered were insufficient to meet demand, their stocks jumped 175 per cent, 60 per cent and 40 per cent, respectively, on their first days of trading - thereby creating the possibility of a far more lucrative opportunity for insiders to sell down the road. (If they don't sell shares in the IPO, company insiders must wait six months before selling their shares on the open market, but presumably some of the buzz from the IPO will endure.)



The small portion of shares that were offered makes these three IPOs unusual. I asked Francis Gaskins, editor of IPODesktop, to go into his database and examine the 90 U.S. initial public offerings in 2011 to see what a typical IPO company offered to the public.



The result of his research? LinkedIn, Pandora, and Demand Media were three of just five companies to offer less than 10 per cent of themselves to investors. The average amount sold in the 90 IPOs was 31 per cent, with more than one-third of the companies offering between 20 per cent and 30 per cent of themselves.



In Pandora's case, the company planned to end up with less than $100-million (U.S.). It had no specific plans for the proceeds other than the boilerplate "general corporate purposes."



I e-mailed the three companies to ask them if they could explain why they chose to offer only a small piece of themselves in their IPOs. Demand Media spokesman Quinn Daly said his company declined to comment; LinkedIn and Pandora did not respond.



Mr. Gaskins believes social media companies are particularly attracted to selling only a handful of shares because they have "a big, overly enthusiastic user base" that will buy the stock based not on traditional valuation metrics, but on love of the company. "Some people used to say, if you see something you love, buy it because it will go up in the stock market. That might be true for some stocks, but it's not true for these social-media companies."



All three of the companies are now down more than 40 per cent from their high points. In Pandora's case, the decline took just a couple of days of trading. You might say that's an argument against the idea that the companies' motivation is to make millions for their early shareholders; realize, however, that the insiders are still well ahead of the game. The average price paid for a Pandora share by its insiders, for example, is just 89 cents, compared to Friday's close of $13.40.



As for the public investors who chased after the small numbers of shares these companies made available? Many are already hurting.



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