The IPO Discount (or Pop) - What It Means and How Much Is Too Much

Following up on our last post on the recent ServiceTitan IPO, we briefly discuss a subject that deserves its own essay (or even a book). ServiceTitan priced its IPO at $71 but the first trades occurred at $101/share, a 42% increase known as the IPO pop. Investment bankers refer to this percentage as an IPO discount, which is the discount that buyside investors in the offering received versus the initial trading price in the public market. Equity capital markets bankers typically claim that the appropriate IPO discount is 15-20% but clearly this IPO significantly overshot that discount.

So why are venture capitalists, public equity investors and the issuing company and its management and employees so concerned about the IPO pop? If you have invested ahead of the IPO, as have all the venture investors, management and employees, you immediately see that your shares could have been sold to public investors at closer to $101/share than the $71 IPO price. This is obviously a massive discount and makes longstanding VCs such as Bill Gurley, formerly of Benchmark, quite angry.

The reason he is angry is because nCino priced its IPO at $31 and the stock immediately traded to $83, representing a ~170% IPO discount! That situation seems like a clear example of a bad deal for pre-IPO investors, resulting in massive dilution.

However, there are a few mitigating circumstances for why pricing an IPO at a discount enables the issuing company to trade well in the days and weeks post-IPO.

First, often a small stake in the issuing company is sold in an IPO. In the case of ServiceTitan, we pointed out previously that only ~10% of the shares were sold. Therefore, the dilution to pre-IPO investors is relatively low and these investors, who generally do not sell in the IPO due a lockup agreement, have their own shares trading at the higher trading price. Because the lockup agreement is generally 3-6 months, the pre-IPO investors are really playing for a longer time horizon to sell their shares so strong trading months post-IPO is most important.

Second, the investment banking syndicate is attempting to attract long-term investors who will hold onto the stock post-IPO for several months and ideally several years. The idea is to price at a discount that attracts these mutual and pension funds to invest at IPO and then build a larger position over time as the stock performs.

Of course, the second point leads to a key criticism of the IPO process. Investment banks and buyside public investors participate in a repeated game where equity offerings occur frequently. One argument is that these parties are incentivized to cooperate since IPOs can vary in quality, and therefore the lead banks may offer larger discounts to encourage banks to participate in less desirable offerings, knowing that they can reduce the discount on future offerings with greater demand. The issuing company only goes public once so some argue that they are at the mercy at the sellside and buyside as to the IPO offering price and company valuation. While this repeated game outcome may have some truth to it, given the number of syndicate banks and their desire to compete with each to win a lead role, it seems that issuing companies should be able to select the lead banks whom they best believe will price an IPO where the company receives its target level of net proceeds, pre-IPO investors and employees see strong post-IPO trading, and public investors seeking a long-term position can enter into the stock at an appropriate discount.