It's taken only six weeks, and already the first unicorn has put its hat into the listing ring, in a year widely expected to be one of the most eye-catching ever in terms of VC exits into the public arena.

Slack, the professional messaging and communications pioneer that made emoji an acceptable office language, has filed for a float that could value the company as high as $10 billion. While the fact it will be a direct listing instead of a conventional IPO, following in the footsteps of Spotify, has generated several headlines, that won't be anywhere close to the scrutiny the company will receive when it hits the market on opening day. How will it price? Will the stock go up or down? And, crucially, where will it end up?

However, what happens on day one doesn't always reflect where a stock might be on day 101.

Take two of the most-coveted VC-backed IPOs of the past year: Eventbrite and Dropbox. Both companies' stocks soared on opening day, rising 59% and 35%, respectively, in the first session of trading. However, now that the celebration is over and the bell has fallen silent, those share prices have come tumbling down. From a high of nearly $38 per share a week after listing, Eventbrite stock now trades below the $30 mark. Dropbox shares have followed a similar trajectory—even dipping below the pre-float price of $21 in December, although it has recovered since then.

So why, then, does the first day of trading get all the focus if it does not reflect long-term outcomes? And why on earth are we so obsessed with "pop"?

The underprice is right

While the tech wave has certainly brought IPO pops to the forefront in recent years, it is not an entirely new phenomenon. Indeed, the idea of having your shares deliberately underpriced—on the surface something that appears to be burning exiting investor cash and your own proceeds—is quite often a tactic to entice public market investors to back a company with no prior history of public trading.

"With an IPO, you are initially going to the public and the market. From their side, there is the risk of the unknown," Martin Steinbach, global IPO leader at EY, told PitchBook. "It's kind of a risk discount or incentive to buy because you are a newcomer."

On top of this, going public puts a company in a shop window with a number of potential other investments and asset classes. And while it may have been the apple of venture backers' eye, for public investors, it's just another item on the shelf. And factoring in a pop can make it stand out.

"As a new company, you are competing with alternative investments," Steinbach explained. "If you launch a new TV and you're not a well-known brand, you launch with a discount to approach the market. This is something of a parallel in capital markets and why we have these pops in general."

For a number of VC-backed companies, too, achieving a pop can also provide a day in the media spotlight they would otherwise rarely have. "An IPO, for the significant majority of companies that make it a listing, is going to be their most significant marketing event they ever have in their entire existence," said Barrett Daniels, IPO services leader at Deloitte. "To have a nice pop and get that good press and the excitement from the public markets that comes with that is highly valuable and worth the money that is generally left on the table as a result."

Of course, that depends on how much money is left on the table. A 20% share price rise on a 10% float might mean the company leaves a few million behind, but as Daniels explained, if the goal is to be a $100 billion business, that is a drop in the ocean.

However, much larger-percentage pops pose serious questions to the banks.

As an example, in 2016, Nutanix shares spiked a ridiculous 130% on opening day, closing around $37 compared with an initial price of $16. And while the company has performed well on the exchanges since, it means the $237 million it raised could—and probably should—have been in the $500 million-plus bracket.

Peaking too soon

But as examples such as Snap and Blue Apron show, even a modest pop doesn't guarantee long term success. A 44% spike on opening hasn't stopped the shares of Evan Spiegel's company to slowly dwindle below the $7 mark, having priced at $17 per share. And perhaps the less said about Blue Apron, the better.

For Steinbach, avoiding this comes down to aligned interests across the board when a company is going public, particularly focusing on the mid- to long-term. VC investors may be unhappy leaving money on the table on opening day, but they are not fully divesting; investment banks usually require existing backers to sign lock-up agreements that keep them in for a certain period, meaning their returns are tied to the successful long-term performance of their listed portfolio business. Incoming investors want a risk-adjusted pop; however, they also want—unless they are flipping—long-term performance.

"But you're not alone in the world," Steinbach said. "There is a market, and you are part of it. And if the market moves down, you have to recognize this and adjust the performance metrics. You can't influence the market as a single company; you're just a part of it."

He added: "Having that context of where your competition is at is key when judging IPO success. If you think about your peer group, you need to be ‘better' than it both in positive times and negative times. So, if the peers are down by 10% and you're only down by 5%, that's a positive. It depends and should be viewed case by case."

Supply and demand

A discussion about pop, however, needs to understand the market it is operating in. Different exchanges have different listing requirements that can inform whether a double-digit pop is feasible or not.

"A 10% free-float is fairly common for tech IPOs in the US," said James Clark, head of life sciences, primary markets, at London Stock Exchange. "You're offering a restricted supply of available shares, which may contribute to the price pop on opening day; it's perceived a positive indicator of market interest. For example, a roadshow where you build your book might have demand for up to 40% of all available shares, but you'll only have a free-float of 10%. That means there might be up to four times the amount of interest in your shares than the number you're offering, and that hopefully will mean lots of trading on opening day."

By contrast, markets outside the US have, in many cases, much larger minimum requirements for free-floats. Euronext, for instance, can require a minimum free float of up to 25% depending on company size, while the 25% applies to all listings on the Premium and Standard Segments on the Main Market at London Stock Exchange (though there is no fixed free float requirement on the LSE's Alternative Investment Market). By contrast, NASDAQ requires only 1.25 million shares to be publicly traded after an IPO. On the New York Stock Exchange, it is just 1.1 million, which can be a tiny fraction of the overall share capital.

With the supply not as restricted, a more harmonious balance between demand and availability is realized. “[A 25% free float] will support broad demand from the market and helps companies to maximize their fundraising," explained Clark.

This puts IPOs widely considered to be opening-day "failures," such as UK-based Funding Circle, into perspective.

"There was a lot of talk about how Funding Circle performed straight after opening, but it's important to note, they had a 30% free float as fundraising was a key objective," Clark said. "They would have soaked up all the demand for the stock with the listing. From that perspective, the opening day performance needs to be seen in a particular light." Indeed, the company's share price had fully recovered by the end of October, before succumbing—like everyone else—to the year-end sell-off.

Regardless of how success is measured, given the number of blockbuster IPOs in the pipeline, people will be paying more attention to the public markets—and to pops—than before. Just remember, when you're watching trading on opening day, to take into account why it was priced that way and where it was listed, before declaring 2019's upcoming slew of IPOs successes or failures.
 

For more on VC, check out the latest editions of our European Venture Report and PitchBook-NVCA Venture Monitor.

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