When social network LinkedIn (NYSE:LNKD) decided to go public, it did what some of its underwriters had suggested: A low float IPO. What is it exactly? When LinkedIn was in advanced discussions to go public, one of the important decisions was how much stock to sell. It could sell 1%, 5%, 10%, or much more of the company to external investors in order to generate cash. All options have their pros and cons, but in the end, LinkedIn decided to do a low float IPO, selling only a very small portion of the company.
Why Low Float?
There are many different reasons, but one of them was for the company to be valued at a higher price. I hear some of you say that it should not affect the company’s valuation. You would be right in theory. However, the sky high pop in shares following the IPO seem to suggest another story.
Generally, when I buy a stock I look at different valuation metrics such as the P/E ratio. That means I would value a share of LinkedIn at the same price no matter if it floats 1% of the company or 90%. Why? If 90% of the company is sold to the public, it also gets a 90% share of the current and future earnings. It’s exactly the same thing as 1% and 1%. I don’t understand how this would not be the case.
The crazy part is that many investors will buy stock without even looking at valuation metrics. If you have 10,000 investors who want to buy LinkedIn because it is the next big thing, they will likely buy the stock no matter what the IPO price is. It is similar to putting up a market order with no limit. That skews the market and makes recent IPO’s these days very difficult to buy.
A Concrete Example
Imagine a store that had 100 apple pies for sale and was thinking of selling them for $5. That would make the merchandise worth $500, right? What if the store knew that 10 of those customers were willing to buy the pie no matter what the price, simply because they think the world of it? Instead of selling 100 pies, it could sell 10 on the first day for $20 each. Not only would those pies get sold (for $200) but it would also let all other potential buyers think that the pie is actually worth $20, not $5. It’s all psychological, of course, but it would mean the company would not only have $200 in cash but also $1,800 worth of pie in store that could be sold in the following days.
A similar phenomenon is currently occurring in the markets as LinkedIn sold less than 10% of its shares, leaving investors scrambling to buy the rare shares. Soon-to-be public companies Zynga and Pandora (NYSE:P) are planning on using the same tactic to receive a higher valuation.
Generally this strategy works mainly with retail investors who do not study valuations as much. That is why the main companies doing this are strong brands that expect the “average” retail investor to want to buy without studying the valuation thoroughly. Sign of a bubble? Perhaps. It’s certainly frustrating to see these companies selling for such high prices.