When a company holds its initial public offering, or IPO, some will call the IPO the “initial profit opportunity” as it can be an opportunity for pre-IPO investors to sell their stock and generate significant profits. This post will discuss what investors in private equity funds need to know about IPOs.
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As discussed above, after the GP invests in a portfolio company, it will later exit the investment. One of the primary ways GPs exit their investments is by selling their stock on the public market after a portfolio company holds its IPO.
For more background on IPOs and the IPO process, please see the following posts”
- IPO 101: An Overview of the Initial Public Offering Process
- IPO 101: Pros and Cons of Going Public
- What is a Successful IPO? – Updated
- IPO 101: IPO Lockup Periods
- Understanding the Over-Allotment Option, or Green Shoe, in an IPO
Here’s what an LP needs to know about the IPO of a portfolio company:
An IPO may or may not be an “exit” for the fund.
Before a company holds it IPO, it is known as a “private company”, or as a “privately-held company”. This means that the company doesn’t have to disclose its finances publicly, and the investors acquired their stock in private transactions. After a company holds its IPO, it is transformed into a public company and its stock starts trading on a stock exchange, such as the New York Stock Exchange or NASDAQ.
When a company goes public, a company usually sells only a small portion of its shares in the public offering (usually 5% to 25% of its outstanding shares of stock). After the IPO, one concern is that the shares not sold in the IPO could flood the market, depressing the stock price. As a result, the investment banks managing the IPO (called “underwriters”) routinely require most or all of the company’s pre-IPO stockholders to agree to not sell their shares for 180 days after the IPO. This 180-day period is known as the “lock-up period”.
However, in some cases (typically where demand for the IPO is very high), the underwriters and the company may allow certain pre-IPO stockholders to sell a portion of their stock in the IPO. This is often the founders and other early stockholders, but may also include private equity funds that were pre-IPO stockholders. In these cases, the private equity fund may sell some of its shares in the IPO.
Let’s look as some examples to see how this works.
Eventbrite. Eventbrite (an event management and ticketing website) priced its IPO on September 19, 2018, selling 10 million shares at $23.00 per share. The company sold all of these shares, and none of the Company’s pre-IPO stockholders (including funds managed by Sequoia Capital, Tiger Global and T. Rowe Price) sold any shares. Note that this information is public and can be found by researching the company’s IPO on the SEC Edgar website (https://www.sec.gov/edgar/searchedgar/companysearch.html).
Upwork. Upwork (a global freelancer platform that enables businesses and freelancers to collaborate remotely) priced its IPO on October 2, 2018, selling nearly 12.5 million shares at $15.00 per share. Of the shares sold, the company sold ~6.8 million shares (55% of the shares sold in the IPO) and pre-IPO stockholders (known as “selling stockholders”) sold 5.7 million shares (45% of the shares sold in the IPO). The company’s pre-IPO investors included venture capital funds affiliated with Benchmark Capital, Sigma Partners, Globespan Capital Partners, FirstMark Capital and Focus Ventures. Funds affiliated FirstMark Capital and Focus Ventures accounted for the bulk of the selling stockholder allotment, while most of the other venture funds did not sell at the IPO, which means they are restricted from selling their shares on the public market for 180 days.
Dropbox. Dropbox (a file hosting service) priced its IPO on March 22, 2018, selling 36 million shares at $21.00 per share. The company sold 26.8 million shares (75%) , while selling stockholders sold 9.2 million shares (25%). The selling stockholders were the company’s founders and certain other early stockholders. Other pre-IPO investors, including prominent venture capital firms Sequoia Capital and Accel, did not sell any shares in the IPO.
The bottom line is an IPO is a transforming event for a company, and can mean liquidity for a private equity fund. However, most of the time the fund will be prohibited from selling its shares during the 180-day post-IPO lock-up period.
Beware the Lock-up Expiration
As mentioned above, the underwriters managing the IPO routinely require all pre-IPO stockholders that are not selling in the IPO to agree not to sell their shares for 180 days after the IPO. While this 180-day period is the industry norm, in some cases the lock-up period might be reduced to 120 days or even 90 days in rare cases. Each of the companies discussed above, Eventbrite, Upwork and Dropbox, had a standard 180-day lockup period.
After the 180-day lock-up period expires, all of the shares subject to the lockup are now able to be sold on the public market (except that “insiders” and certain other stockholders may be restricted by the US securities laws as to how and when they may sell their shares). The day the lock-up expires is called the “lock-up expiration date.” At the lock-up expiration date, the number of shares that are now able to be sold on the public market can be substantial. What if the owners of all of these now-tradable shares were to sell their shares on the lock-up expiration date? You guessed it, the stock price could suffer. In fact, there is academic research that concludes that there is a drop in the stock price when the lock-up ends, even though the event is known and anticipated (see, for example Field and Hanka, “The Expiration of IPO Share Lockups” (2001)).
When an IPO lock-up period expires, a private equity fund has three options for these now-tradable shares: (1) sell some or all of the stock in the public market; (2) hold some or all of the stock for a period of time; or (3) distribute some or all of these freely-tradable shares to its LPs. Let’s explore this last option a little bit more.
What is meant by the fund can distribute freely tradable shares to the LPs? Well, when it comes to public securities, most private equity funds have the right, spelled out in the limited partnership agreement, to distribute public securities to the LPs. In fact, it is fairly common for funds to distribute stock to its LPs on the date the lock-up expiration expires (this is known as an “in-kind” distribution or an “in-specie” distribution). Once this happens, the LP now has a choice to make – to sell or hold these shares. Some LPs have a policy to immediately sell any stock the LP receives from any of its portfolio funds. However, given the academic research on the negative impact of lock-up expiration dates on a company’s stock price, an LP might decide to hold any stock it receives from a fund upon lock-up expiation so the market price can rebound.
IPOs of Life Sciences Companies are Not Liquidity Events
Biotech companies, medical device companies and pharmaceutical companies have one thing in common: the Federal Drug Administration (“FDA”). These companies must go through a lengthy, multi-step process to have a device, drug or therapy approved by the FDA. This process can take many years. The process can include several “phases” of clinical trials. A startup life science company will often raise several rounds of venture capital money to fund early research and the initial phase or phases of clinical trials, and then will hold an IPO to raise money to fund the remaining research and trials. It is only after the company receives final FDA approval for its drug or device that the company’s true value will be reflected in its stock price. For this reason, venture capital firms don’t view IPOs of life sciences companies to be liquidity events; rather they consider IPOs to be financing events for the company. This means that venture capital funds will usually hold their stock in the company until the FDA approval is received.
What this means for an LP is that the IPO of a life science company will likely not lead to a distribution (of cash or stock) any time soon after the IPO.
Secondary Offerings May Offer Liquidity
If a company’s stock performs strongly after the company’s IPO, the company may hold another public offering, known as a “secondary” offering, whereby some of the pre-IPO stockholders can sell their shares in the secondary offering. These secondary offerings can be held before the 180 day lockup period expires, and so can be a way for pre-IPO stockholders to sell their shares. In a pure secondary offering, only existing stockholders sell stock and the company does not sell any shares in the offering. If the company does sell shares in the offering, the offering is known as a "follow-on offering" with a secondary component.
A Fund May be an Insider and Sales of Stock May be Restricted
Under US securities law an “insider” is any officer or director of a company, or any stockholder which owns, directly or indirectly, more than 10% of a public company’s voting stock. Because they are deemed to hold material non-public information, insiders are restricted from selling shares of the company’s stock. Sometimes a private equity fund will own over 10% of a company’s voting stock after the company holds its IPO, making the fund an insider and subject to onerous trading restrictions. It is more common for a member of the fund’s manager (the GP) to stay on the board of portfolio company after the company goes public, thus subjecting the fund to the insider trading restrictions.
What this means for an LP is that if a fund is holding stock of a public company and a partner of the fund’s manager sits on the public company’s board of directors, the fund may not be able to sell or distribute its shares of this public company. If the company is not a life sciences company (see above) and the company has been public for a year or more, then the LP should start asking the fund’s manager why the partner continues to be on the company’s board, as it is restricting the fund’s ability to exit the investment.
An LP should understand the following about portfolio company IPOs:
- The IPO may or may not be a selling (exit) event for the fund;
- IPOs of life sciences companies are mainly financing events, not liquidity events, and so a fund will typically not sell its stock in these companies until the company receives its FDA approval;
- The expiration of the post-IPO lockup period may lead to the fund distributing stock to the LPs;
- Secondary offerings may provide liquidity to a fund; and
- Insider status can restrict the fund’s ability to sell or distribute stock in the portfolio company.
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