Anatomy Of An IPO

Over a year has gone by since Alibaba’s (BABA) ballyhooed IPO.

Alibaba is now a household name. Its founders obscenely rich. Its capitalization reaching an amazing $178 billion.

And because its IPO was the biggest in history and shares surged on the day of the IPO, it’s considered a supremely successful launch.

Nothing I’ve come across has challenged that notion.

But could it have been done better? Could it have generated more winners and fewer losers?

It’s time to revisit the IPO and determine anew just how well Alibaba managed it.

And the Winners Are…

The biggest decisions to be made heading into an IPO?

Timing and price.

Alibaba nailed the timing. So let’s move on and take a closer look at price.

An IPO involves four main price points…

1. The price set for institutional investors who buy all the available shares the day before the company goes public (called the IPO price)
2. The price set just before the company begins to trade on the day of the IPO
3. The price at the end of the first day of trading
4. The price at the end of the first six months of trading.

You should know that Alibaba has no control over any of these prices.

The IPO price is based on informal feedback from institutional buyers. There’s some discretion, but not much.

The price set on the morning of the IPO date is determined by the market maker (Barclays for Alibaba) and based on the orders coming in from both retail and institutional investors.

Orders can be a bid (buying shares) or an offer (selling shares). The opening price tries to maximize the trades stemming from these orders. The chosen price falls between the higher selling prices and lower buying prices submitted. (For more details on how this works, click on this quite useful explanation.)

Once public trading begins, the company hopes shares immediately rise (bullet No. 3) and keep on going up (bullet No. 4).

If shares fall on the first day, the IPO is considered a bust. It they rise, it’s deemed a success. But as we’ll now find out, it’s a lot more complicated.

These price points have quite different consequences for the five main investing groups involved in any IPO. Let’s take them one by one, starting with the founders.

Founders. They can cash in right away – on IPO day. Or they can hold on to their shares and cash in months or years later.

Jack Ma and Executive Vice Chairman Joseph Tsai cashed in right away. Ma sold 15.5 million of his shares. Tsai offloaded 5.2 million.

The shares were sold to institutional investors at the IPO price of $68.

They could have held on to their shares. If they sold them after the six-month lockup period, they would have made 26.5% more.

For Ma, that’s around $250 million more. Wow!

Obviously a bad decision, right?

Nope. Only in retrospect can one make that claim. They’d be taking a risk that shares might go down.

Ma’s billion-dollar IPO payday was guaranteed by the underwriting banks. They guarantee all shares offered under an IPO.

As it turned out, the guarantee was never at risk. Institutional demand was overwhelming.

But by not making these shares available in the IPO, Ma would have exposed his big payday to the unpredictable whims of the public market.

It was a risk he was smart not to take.

Early employees and investors. They’re usually subject to the six-month lockup period. But IPOs can be structured to allow shareholders to cash in right away from an IPO. Not surprisingly, it’s usually the biggest and most powerful shareholders who are able to take advantage.

That’s how Yahoo made its $9.5 billion from Alibaba’s IPO. Yahoo (YHOO) made more than Alibaba itself did. Alibaba issued 123 million newly minted shares. Yahoo offloaded 140.3 million shares.

Like Ma and Tsai, Yahoo could have made more if it waited. But $9.5 billion guaranteed upfront is hard to turn down. Yahoo made the right move.

As for the other employees? By waiting six months, they did better, but only if they then cashed out right away.

Since the six-month lockup period ended, shares have gone as high as $93.88 and as low as $57.39. But for a brief period from mid-August through the first week of October, shares have ranged above the IPO price.

Institutional clients. They bought at $68. The opening IPO day price was 36.3% higher. Underwriters try to make their clients at least 10% on the first day of trading. Alibaba’s IPO did much better. Shares even closed up the first day.

IPO-day investors. Not great. From the closing price of $93.89 on IPO day, shares are now trading for around $72.70. That’s a drop of 22.5%.

Post-IPO day investors. A more volatile stock than many expected. Here’s what I noticed. Share prices are now having trouble going over $86. That’s limited upside.

The significance of $86? That was the six-month lockup price. Since that six-month period ended, shares have traded over $86 for one brief five-week period only.

Parting Lessons

The IPO’s record-breaking amount benefited existing shareholders more than the company itself. The company raised only $8.364 billion. The remaining $16 billion-plus went to Yahoo and the founders.

Other shareholders did fine only because worst-case scenarios failed to materialize.

But it should be clear to you by now that the purpose of the IPO was as much to liquefy the large share holdings of Ma, Tsai and Yahoo as it was to raise capital for the company.

So, did the IPO do a good job of balancing the interests of the founders (and Yahoo) with the interests of Alibaba itself?

The company raised a boatload. The founders made huge amounts. Yahoo cashed in the biggest profits.

Everybody’s interests were seemingly served.

Yet Alibaba’s interests were not served nearly as much as they could have been.

Take away the shares from Ma, Tsai and Yahoo and Alibaba could have easily issued tens of millions of more shares at the IPO price of $68.

Structured differently, in other words, the IPO could have provided Alibaba with a few more billion dollars.

But issuing tens of millions more new shares would have greatly diluted existing shareholders. This is where the interests of the company and the interests of the biggest shareholders diverge.

Listen, no amount of shoving would have propelled the founders or Yahoo down that road.

It all turned out okay.

Alibaba’s shares have not tanked. Its cash reserves have not shrunken to dangerously low levels. Its other early investors have done spectacularly well without the cash guarantees that Yahoo and Ma got.

The ugly misalignment of interests at the heart of Alibaba’s IPO caused no extreme loss and no big losers. All is well in the IPO world.

At least for now.