Who really benefits from IPOs?
If you think the average investor benefits the most from IPOs, you’re dead wrong.
IPOs are known as a great way for investors to diversify their investment portfolios and participate in value-creating entrepreneurship. When a new company goes public, many investors get excited about the chance to make more money overnight — if the stock takes off.
But when it comes to actually seeing the big returns investors hope for, only a select few actually benefit from a company going public. The retail investor is distinctly excluded here — they are the last people who get access to shares for sale, and the last people to squeeze out some semblance of value.
We see the IPO as a flawed investment opportunity because of its exclusivity and high barriers to entry. The everyday investor is locked out from ever gaining access to the value that so many elites enjoy with every IPO.
So who actually benefits from the current structure of the IPO landscape?
- Investment banks typically get a percentage of shares to distribute to their clients, and will keep a percentage of the total amount of money raised from the IPO.
- Angel investors get in during early funding rounds and typically want to help the company in exchange for their investment, which may translate to a seat on the Board of Directors.
- Venture capitalists also invest in a company early in its operations in exchange for an equity stake. They will typically cash out their investment during the IPO with help from investment bankers.
- Company founders already possess shares of stock in their company, and stand to make huge returns if the price goes up during an IPO.
IPOs can be profitable, but they’re extremely expensive
It can cost as much as $1.9 million to launch an IPO. This cost comes from a number of places: underwriting fees, regulation and compliance concerns, and lawyers all come together to add up a huge bill.
These aren’t one-time costs, either. There are ongoing disclosure requirements — at the expense of time, money, and privacy. And you can’t forget the fees tied to auditors as well as the regulators that comb through all public-facing documents and quarterly reports a company is required to distribute.
But some companies still go through this costly process because they stand to make much more money on the other side. Successful IPOs generate the money that helps companies build infrastructure, expand R&D, and pay off debt. With access to shares of stock, companies can offer stock packages to their employees or potential candidates to make a job offer more enticing.
The average business is left out of the IPO process
There are over 32 million businesses in the US, but only 4,000 of them are public. That being said, there are a lot of profitable companies a retail investor will never have a chance to invest in.
The reality is that small and medium-sized businesses don’t have the resources to go (and stay) public. Instead of raising capital via a public offering, they use traditional methods to raise capital, like bank loans or a new line of credit.
Numerous businesses have found alternative routes for raising capital, like private funding. Consider that private assets under management totaled over $5 trillion in 2017, up from just $1 trillion in 2000. Initial coin offerings (ICOs) were also a popular crowdfunding method in the crypto space, but they fell out of favor due to their unregulated nature.
The average investor gets shut out too
Early funding rounds aren’t accessible to the average investor. These people are shut out from participating alongside accredited investors and investment powerhouses.
A company will typically go through a series of funding rounds before its IPO, and the first of these is called the seed round. A company decides how much it needs to raise, and will determine how much that amount is worth in their company. If $1 million in funding is worth ten percent of the company, then the company has a $10 million valuation. But what if that funding isn’t enough for them to truly gain momentum? Then they start another round of funding if they have the traction and revenue to support it.
If the company is lucky enough to make it to the next round (called Series A), investors will determine the company’s total worth based on valuation models like the market multiple or cost-to-duplicate. Then they invest money based on their projections and the company’s potential for growth.
So where’s the value-add? Suppose you invested early in a company and took a 10 percent stake for $1 million. The company grows tremendously and shows huge potential for the future. With such strong projected growth, their valuation is now at $50 million. Your initial investment of $1 million turned into $5 million, an impressive return on your initial investment.
So how would you cash out? Through an IPO!
After seed funding, these rounds progress to Series A, B, C, D, and E. It’s one of the ways that investors can get a major return on their initial investment, especially if they got in early with the company — that’s when potential for growth is biggest.
But early investing isn’t free of downsides. It is very risky to invest in a company that may not deliver — a risk many angel investors and VCs are willing to take a chance on.
By the time a company files for an IPO, this growth is nowhere near as large.
There needs to be better access to investment opportunities
Early investors get a round of private funding before the IPO ever takes place. They get to buy shares at a lower price than retail investors, who can only purchase stocks on the day of the IPO.
At 81-c, we believe that everyone should have access to value in order to create the life that they deserve. For businesses, this means giving them the opportunity to reach investors they wouldn’t normally be able to reach. For investors, this means opening up the borders and lowering the barriers so everyone can invest. That’s where IPOs fall short — private investors get all the perks.
We think that financial inclusion is better achieved through security token offerings (STOs) than initial public offerings. STOs have a low barrier to entry, so anyone with an internet connection and the will to invest can participate. STOs use the power of blockchain technology to make investing a secure, compliant, and highly liquid process for everyone, regardless of affiliation or accreditation.
In the next chapter, we’ll cover why IPOs aren’t the best decision for companies, and why many companies get burned when they go public.