Follow-on Offerings

Monday 03/09/15

Last week I wrote about initial public offerings, if you missed it you can read it here. This week I want to discuss the process of raising capital in the secondary market.

What is a Company Really Worth?
“Everything is worth what its purchaser will pay for it.”
-Publilius Syrus

Last year Facebook purchased Whatsapp, a mobile messaging app, for $22 billion (That’s billion with a ‘b’). Whatsapp generated $10.2 million in total sales in 2013 (yes, that’s million with an ‘m’) and lost $138.1 million dollars in that same year. While you can doubt the logic on the part of Facebook over this purchase, you’d have a hard time disputing the worth of Whatsapp. Let’s say that Whatsapp was desperate to raise money and was willing to give away shares in their company at a price that valued the company at $100 million. If you had no knowledge of the upcoming deal you might be hesitant to invest, sounds pretty risky, the company is burning through cash and barely even does $100 million in sales. However, if you had a crystal ball and knew that Facebook was planning to acquire the company for $22 Billion the next day, you’d be wise to invest everything you had.

Markets are complex and everyone places a variety of different values on a public company. People bought/sold shares in Facebook for $81 on Friday and later that same day others bought/sold shares for $80; the $1 difference in share price represents nearly $3 billion in value, coincidentally $3 billion is about how much profit Facebook earns in a 1 year period. There was no major news about Facebook or drastic changes to its business model that day, it was pretty much an average day.

Follow-on Offerings
A follow-on offering is an offering of stock to the public which has already been issued previously. That is, if a company is already publicly traded and they decide to issue more stock, it is known as a follow-on offering. There are two main types of follow-on offerings--dilutive and non-dilutive.
A dilutive follow-on offering occurs when the company creates new shares to sell to the public. This type of offering is dilutive because it increases the total number of shares thus reducing the value of existing shares. For example, if a company has 1,000 total shares and it trades at $10 per share it is valued at $10,000 (1,000 shares x $10 per share). If the company issues 100 additional shares it is still worth $10,000, so the share price (in theory) should correct to ~$9.09 ($10,000 ÷ 1,100 shares). Of course, market participants may see the capital raise as beneficial to long term growth and may not punish the stock as a result.
A non-dilutive follow-on offering, also called a secondary offering is when company insiders decide to sell shares to the public. These types of offerings are non-dilutive because they don’t increase the total number of shares. However, it does change the makeup of the holders of the shares. Instead of just a few stable long term holders you may now have a variety of shareholders with varying time horizons.
I believe that the share price approaches a more realistic price as more shares are unlocked from the company because more people are determining the price of the asset and each of their votes are worth less. This follows the wisdom of crowds phenomenon: large crowds of people can more accurately assess the number of jelly beans in a jar by averaging their results than nearly all of the individual guesses. When there are more shareholders available to guess the value of the stock it will trend closer to a rational valuation in my opinion. IPOs with low floats tend to be more volatile and the stock price can more easily be manipulated in the short term. A great example of this is GoPro. GoPro became a publicly traded stock in the summer of 2014 and because of its low float and high popularity the stock began soaring. Figure 1 on the right shows the rise in GoPro’s stock price and marked on that chart is where insiders began dumping additional shares onto the market. GoPro originally IPO’d with 17,800,000 shares and in October unlocked another 5.2 million shares followed by another 10.36 million shares the next month. GoPro is now worth only about a 1/3rd of what it was at its peak only a few months ago.
This process of purposefully restricting the float in the IPO, ramping the stock with analyst upgrades and constant promotion in the financial media then dumping the shares onto the public has become increasingly common in the last couple years. I find it best to stay away from these hugely popular stocks especially when insiders can’t seem to sell enough. I wrote about these types of bubbles back in April of last year. Since then many of the stocks I discussed have fallen sharply as more shares have been made available to the public. Many view the stock market as a casino because the financial media only seems to cover the wildest most popular stocks, but careful long term investors can be rewarded by avoiding companies like this and focusing on strong companies backed by solid fundamentals. It may not be as flashy and exciting, but it can save you a lot of stress.