Completing an initial public offering (IPO) is a major milestone for your company, and a journey that involves many months (and in some cases years) of hard work and dedication. As you likely know, the timeline ends with the pricing and allocation of your IPO — a process that is short in duration but one of the most important steps in your path to becoming a public company.
What do you need to know about the pricing and allocation process to help you act in the best interest of your company and shareholders? Below, I walk you through the associated primary concepts.
Bookrunners drive the pricing and allocation process
Not every bank that you selected to be on your IPO cover will be involved in the pricing and allocation of your transaction. Your “active” bookrunners will be responsible for gathering orders (“indications”) from institutional accounts, collecting feedback from the buy-side, formulating a recommendation regarding deal size and offering price, and, finally, allocating shares to investors. Involvement level among your bookrunners can vary and is typically determined by economic splits between these managers.
Know the difference between gross and allocable demand
It is important to understand the difference between the two types of demand that you will hear quoted throughout the roadshow. Gross demand reflects the total number of shares in the order book, while allocable demand is the amount of shares your banking partners feel confident in “placing” with investors to ensure a successful transaction.
Keep in mind that institutional investors often place orders for an inflated amount of shares in anticipation of being “cut back” during allocation. Allocable demand takes into account the quality of each order and reflects what is perceived to be the “real number” of shares sought by accounts.
Hit ratio matters
Hit ratio is a metric referenced commonly by the banks during the IPO roadshow. Essentially, it compares the number of investors met with the number of orders from that same set of investors. The most important meeting conversion ratio is “one-on-one hit ratio.”
The majority of your one-one-on meetings should be with high-quality, long-term focused investors who have the ability to place a large, significant order of shares. In most cases, it is crucial to have a strong conversion rate from these meetings for both the momentum and success of the transaction.
Hedge funds are not all bad
Management teams sometimes wonder why one-on-one meetings are arranged with hedge fund accounts during the IPO roadshow, or they’re surprised when the bookrunners propose to allocate a meaningful amount of stock to hedge funds. The reality is that not all hedge funds invest in a similar manner. While some firms do have notoriously high turnover, other hedge funds can be quality, long-term investors in your business. In fact, many of the top-tier healthcare investors are structured as hedge fund entities.
Understand the “green shoe”
The “green shoe” (or “overallotment option”) is one of the most commonly misunderstood topics by management teams going through the IPO process. It’s a clause in the underwriting agreement that gives underwriters the option to purchase up to an additional 15 percent of the shares offered on your transaction at the IPO price for up to 30 days after the deal prices.
How does it work? At the time of pricing, the bookrunners “layout” or allocate not only your base deal but also all of the green shoe shares to investors, creating a short position that needs to be covered within 30 days after pricing. If the stock trades well in the aftermarket, the underwriters will cover their short position by exercising the green shoe option and purchasing the additional shares from the company (or selling shareholders) at the IPO offer price (the same price at which they have sold the shares to the market). Additional proceeds are then raised by the company or received by the selling shareholders.
However, if the stock comes under pressure in the market and looks like it may trade below the offer price, the underwriters will cover their short position by buying the shares in the open market. The purchasing of shares in the open market helps support or “stabilize” the stock, but no additional proceeds are raised by the company (or received by the selling shareholders).
Only one of your underwriters (by law) is responsible for stabilizing the stock after pricing and for deciding whether or not to exercise the green shoe option within the allotted 30-day window. This underwriter is designated as your “stabilization agent.”
Trust your banking partners
Navigating the tradeoff between incremental share price and aftermarket performance can be tricky. While recommendations to price at the bottom or below the range can be disappointing, it is important to remember that your banking partners’ goal is to present you with the most successful transaction for your company. In regards to the allocation process, the capital markets teams have consistent dialogue and previous experience with many of the institutional accounts from past transactions, which enable them to make educated decisions when allocating shares. Trust their judgment.
You have a say in the process
While it is important to trust your bankers and capital markets teams, remember that management does have a say in both the pricing and allocation process. In some cases, you will be presented with multiple pricing and/or sizing scenarios for your IPO. Ultimately, it is up to you to decide what is best for your company. Also, your feedback on the accounts that you met with should be considered by the underwriters when making allocation decisions. Focus on the top 20 accounts that are getting shares, and make sure you understand the logic for them receiving your stock.
Do you need more guidance on the pricing and allocation of your IPO? Westwicke has extensive experience helping healthcare companies navigate all stages of the IPO process — and has helped many clients cross the threshold from private to public. To learn more, read our IPO Guide and reach out to us.