Minicase: Matt.com was founded in 2009 by two graduates of the University of Wis
ID: 2384209 • Letter: M
Question
Minicase: Matt.com was founded in 2009 by two graduates of the University of Wisconsin with help from Georgina Sloberg, who had built up an enviable reputation for backing new start-up businesses. Mutt.com's user-friendly system was designed to find buyers for unwanted pets. Within 3 years the company was generating revenues of $3.4 Million a year and , despite racking up sizable losses, was regarded by investors as one of the hottest new e-commerce businesses. The news that the company was preparing to go public therefore generated considerable excitement. The company's entire equity capital of 1.5 million shares was owned by the two founders and ms. Sloberg. the initial public offering involved the sale of 500,000 shares by the three existing shareholders, together with the sale of a further 750,000 shares by the company in order to provide funds for expansion. The company estimated that the issue would involve legal fees, auditing, printing, and other expenses of $1.3 million, which would be shared proportionately between the selling shareholders and the company. In addition, the company agreed to pay the underwriter a spread of $1.25 per share (this cost also would be shared). The roadshow had confirmed the high level of interest in the issue, and indications from investors suggested that the entire issue could be sold at a price of $24 a share. The underwriters, however, cautioned about being to greedy on the price. They pointed out that indications from investors were not the same as firm orders. Also, they argue, it was much more important to have a successful issue than to have a group of disgruntled shareholders. They therefore suggested and issue price of $18 a share. That evening Mutt.com's financial manager decided to run through some calculations. First, she worked out the net receipts to the company and the existing shareholder assuming that the stock was sold for $18 a share. Next, she looked at the various costs of the IPO and tried to judge how they stacked up against the typical costs for similar IPO's. That brought her up against the question of underpricing. When she had raised the matter with the underwriters that morning, they had dismissed the notion that the initial day's return on an IPO should be considered part of the issue costs. One of the members of the underwriting team had asked: "The underwriters want to see high return and a high stock price. Would Mutt.com prefer a low stock price? Would that make the issue less costly?" Mutt.com's financial manager was not convinced but felt that she should have a good answer. She wondered whether underpricing was only a problem because the existing shareholders were selling part of their holdings. Perhaps the issue price would not matter if they had not planned to sell.
Please show the figures that the financial manager came up with. Then answer the financial managers question. When is underpricing a problem? Is the issue only because of the existing shareholders? Would the issue price not matter if they had not planned to sell?
Explanation / Answer
Assuming that the common stock was sold for $18 per share i.e. Issue Price of the IPO, then net receipts to the company and to existing common shareholders are as follows:
Number of equity shares on offer in IPO= 500000 + 750000= 1250000 shares
Proportion in which IPO-related incodental expenses to be shared between company and the existing three shareholders is 60 : 40 [i.e. for company, it is 750000 shares / 1250000 shares= 0.60]
Net Receipts to the company= proceeds from sale of 750000 shares in IPO @$18 per share - all the IPO-related incidental expenses = $13,500,000 - ($1,300,000*0.60) of legal fees, auditing, printing, and other expenses pertaianing to IPO - Underwriting Fee expense @ $1.25 per share of spread * 0.60 = $13,500,000 - ($1,300,000 * 0.60) - ($1562500 * 0.60)= $11,782,500 =====> $11,782,500 / 750000 equity shares= $15.71 oer share of common stock
Net Receipts to exiting three shareholders= proceeds from sale of 500000 shares in IPO @$18 per share - all the IPO-related incidental expenses = $9,000,000 - ($1,300,000*0.40) of legal fees, auditing, printing, and other expenses pertaianing to IPO - Underwriting Fee expense @ $1.25 per share of spread * 0.40 = $9,000,000 - ($1,300,000 * 0.40) - ($1,562,500 * 0.40)= $7,855,000 =====> $7,855,000 / 500000 equity shares= $15.71 per share
As mentioned in the: case the company was raking up sizable losses in its business despite yearly revenues of $3.40 million after 3 years since inception. Just 3 years of history and track-record. that too of losses, is far too less for a company to go for an IPO i.e. It is too early to go for an IPO, especially with such a track-record..
Secondly, with losses in business, its EPS must also be negative thus rendering an adverse P/E ratio i.e. negative ratio and more so: why should incoming new common shareholders bear the burden of such losses which are already incurred in the past before their entry into business an that too by paying a high cost in the form of high issue price oer share of $24.00. Such losses represent erosion / outflow from equity capital of the existing equity shareholders for un-recovered expenses for which ideally equity shareholders need to take a hit because they are the risk-bearers and providers of risk capital to the company in expectation of higher rate of return on their investement into company's business.
It is fortunate enough for the company and its existing shareholders to recieve some sort of interest, though not firm orders, from investors in the capital market for their shares offered in IPO. Pricing of an IPO issue should ideally be based upon Intrinsic Value per share which is arrived at after DCF analysis of future expected Free Cash Flows discounted @ suitable opportunity cost of capital for business ventures with similar business risk-profiles i.e. hurdle rate or the expected rate of return. In this case, the company being very young i.e. a start-up, the future cash flows can be adverse or good i.e. negative or positive or maybe even positive witn increasing trend, with different probabilities attached to each of the outcome; we can use Expected Outcome in our DCF analysis for valuing of shares; even if we use DCF analysis by discounting Expected Free Cash Flows, the PV or Intrinsic Value of this company's share would work out lesser than $18.00 per share. In this case, moreso, the net receipts per share of $15.71 is still higher as compared to Book-Value per share which must be on lower side causing the IPO issue price [measured in terms of P/E ratio] to be already expensive.
Under-Pricing would be a problem in case of well-established business entity having a successful track-record with rich and healthy free cash flows on consistent basis for past many years and where the Book-Value per equity share is very high due to higher amount of accumulated retained earnings. In such as case, while valuing equity shares for obtaining Intrinsic Value per share using DCF analysis, the discount rate would be comparatively lower due to higher probabilities of favourable Expected Outcome i.e strong free cash flows in future years; wherein all the company-specific risk factors, industry-specific risk factors and systemic risk factors related to economy are already factored into.
Also, as per prudent investors' investment principle of Margin of Safety as suggested by Benjamin Graham [Guru of world-renowned investor, Warren E. Buffett] in his book The Intelligent Investor, investors would not only look to buy shares at cheaper P/E multiples but also buy them at a lower price after factoring in the principle of Margin of Safety for protection and conservation of their principal capital investment against future unforeseen risks and adverse business outcomes.
If we consider average Net Margin for online retail industry in USA, it would be somewhere in the range of 2.50% to 5% depending upon the type of product and /or service dealt with. Even if we assume 5% of annual revenues of $3.40 million for this company as net profit margin for coming future years= $170,000 i.e. not actual but expected future earnings ===> $170,000 / 2250000 equity shares = $0.075 of forward EPS post IPO issue scenario..
Against this demanding $24.00 would be asking for a very high P/E multiple of 317.65 times, from new investors in capital market which is very unreasonable.