Why the S-1 is the Most Indispensable Part of IPO Due Diligence
2018年11月13日
Matt Conger
Two-character combinations of a letter + a number are very emotionally evocative. How many of these do you know?
C4
G4
F1
S1
Fans of action movies, private planes, and race cars will know the first three on the list (respectively). But what about the fourth one? The S-1, or F-1 for foreign filings, is the key to understanding how IPOs work.
Initial Public Offerings, also known as IPO’s, are frequently emotionally-charged events when private companies decide to list on a public stock exchange, with many investors rushing to get a piece of newly available hot stocks. However, IPOs carry a tremendous amount of risk, and because of that, there is a great deal of due diligence an investor must first conduct before investing in the company. It makes the S-1, or prospectus, the most important document to review.
The S-1 is the registration statement a company planning to go public files with the Securities and Exchange Commission (SEC). The document discloses essential items such as the amount of money the company is looking to raise, the general intended use of the funds, historical financial statements, the risk associated with the company, and perhaps a view of the competitive landscape.
Lead Left
Reading the S-1 and the amendments that follow can also give investors clues as to the quality of the stock offering. For example, on the cover of the prospectus is where the named underwriters organizing the deal are listed. It can speak a lot to the quality of the deal as the well-known investment banks are likely to bring to the hot IPOs. The underwriter that is on the left-hand side of the cover is referred to as the lead left. They are the ones that will work most closely with the company to set the stock’s IPO price and build the shareholder base.
Additionally, they are the ones that will be responsible to make sure the stocks open at a price that is fair to both the buyers and sellers on the first day of trading. They are also accountable for stabilizing the stock should it fall below the IPO price in the secondary market, by purchasing the stock in the open market. For example, when Snap, Inc. (Snap), the company behind Snapchat, went public, the cover of the prospectus had Morgan Stanley as the lead left, followed by Goldman Sachs and a number of other large investment banks.
Deal Strength
The S-1 amendments can also speak to the strength of the deal as the number of shares or the offering range for the price may change. For example, Snap originally had a maximum offer price of $16, while the mid-point of the range was $15. It suggests that underwriters were proposing a range on the stock of $14 to $16. However, the stock was priced above the top end of the range at $17, which indicates that demand to get into the IPO was very high. Demand was so high that by the second day of trading on the public market, the shares reached a high of $27, almost 60% higher than its IPO price. The bad news is that the stock has since fallen and is now trading at just $6.82.
Red Flags
S-1 documents can also reveal glaring red flags that might deter investors. Using Snap’s prospectus as an example once again, there are some classic warning signs that some investors either chose to ignore or never bothered to read.
The most glaring problem was on the very first line of the prospectus after the title, which read “this is an initial public offering of shares of non-voting Class A common stock,” meaning none of the participants in the deal would be able to vote on company matters. The prospectus also noted 3 classes of stock: A, B, and C. The Class C stock belonged to the founders, who control 88.5% of the voting rights.
Other warning signs included the sequentially slowing growth of the number of active users as well as the company’s inability to monetize those users on the platform (noted by the average revenue per user (ARPU) of $1.05). Even today the company is struggling to grow its ARPU; even worse, the daily number of users is now declining.
Perhaps more problematic is the number of shares held by insiders, both before and after the completion of the offering. The prospectus states important dates and timelines, such as the lock-up period, which determines the number of days an insider must hold their stock after the IPO; this period tends to be around six months. After the expiration of the lock-up period, insiders are free to sell their shares in the open market. Following the IPO, insiders held 257 million shares of Class A stock, 86 million shares of Class B, and 215 million of Class C shares; the total size of the Snap deal was just 200 million shares.
There were a number of red flags in the prospectus for Snap and this is a glaring example of why an investor should at the very least skim through or glance at the S-1. Snap is now famously one of the most disastrous IPO’s in recent history.