Securities Law Blog

James Mackintosh’s Streetwise column in the September 26 Wall Street Journal, “The IPO Needs Reinventing,” imagines a pre-funded IPO process for tech “unicorns” that resembles the current SPAC (special purpose acquisition corporation) business model to fix what he sees as a broken traditional IPO process.

Mr. Mackintosh’s view appears to have been triggered by the recent $680 billion SPAC IPO by Social Capital Hedosophia Holdings Corp., a blank-check business combination shell company. SPACs have been an integral part of the public equity market ecosystem during the past 12 years as an alternative to private equity as large Wall Street investment banking firms have increasingly underwritten them. In a SPAC IPO, investors commit their cash upfront to a blank-check shell company, but do not know what their money is going to be spent on when they buy the SPAC's shares - hence, the “blank-check” designation given by the SEC. If and when a target is found, investors have the choice to pull out by voting against the acquisition and get their money back under the SEC's rules governing blank-check companies. So far this year, SPACs have been in favor with $7.6 billion having been raised, according to Dealogic, the most since the record $12 billion raised by SPACs in 2007. Not every blank-check company, however, has met with success in consummating an acquisition or developing an active trading market.

Focusing on the drawbacks of traditional IPOs

 Mr. Mackintosh first contends that the problems with the traditional IPO process that ultimately create an unattractive on-ramp to going public are:

•  underwriters have an incentive to underprice new issues to reduce their potential losses in a firm-commitment underwriting;
•  the too-low price creates excess demand for the shares, so banks have to ration the supply and give bigger allocations to their best clients who do well from the “first-day pop” in price;
• the IPO involves months of stressful “form-filling”;
• an IPO brings an influx of new investors unknown to the company's founders; and
• employees are typically restricted from selling shares for a six-month lock-up period.

Applying the SPAC model to the traditional IPO process

In Mr. Mackintosh’s view, the Social Capital Hedosophia founders have found a potentially better way for tech unicorns to go public. The founders apparently plan to set up multiple blank-check companies, with trading symbols from IPOA (used by Social Capital Hedosophia) to IPOZ, and identify tech unicorns for each one to complete a reverse takeover of the pre-funded shell to gain a stock market listing without the traditional IPO drawbacks like inherent economic conflicts of interest and the high regulatory costs associated with becoming a public company. This would be accomplished by generally using the SPAC business model in which:

• the big shareholders of the blank-check company would get to know the target company and the price would be set by negotiation between the company’s board, its big shareholders and the target company to avoid the stock price discount that investment banks impose in a traditional IPO and the resultant first-day pop phenomenon;
•  lock-ups would be better customized, with some employees able to sell right away, while founders and late-stage venture capital firms might be still locked in;
• the Social Capital Hedosophia founders might not allow an opt-out shareholder in IPOA to participate in IPOB, C or D to reduce the likelihood of a blank-check company's shareholders voting against an acquisition or opting out; and
•  the blank-check company shareholders would be expected to stick with the company after the acquisition, which avoids so-called staggering the deal by selling out as soon as the share price jumps, giving the company desired long-term investors and stock stability.

Not exactly a perfect solution

Mr. Mackintosh nevertheless remains wary of the Social Capital Hedosophia project, wondering whether this is just another sign of the willingness of investors to put their trust and their money into financial experiments (think the dot-com boom). Mr. Mackintosh does note the Social Capital Hedosophia founders’ tech credentials, presumably understanding that their knowledge and contacts in the industry give investors some background to predict future performance.

From a blank-check investor’s standpoint, there may be some question as to the fairness of their level of investment considering they are giving up flexibility by handing over their cash now, without any meaningful insight into the target company, and then expected to commit for the long term.  Additionally, the founders of Social Capital Hedosophia are entitled to a fee at the time of the acquisition equal to 20% of the cash raised, payable in equity, compared to a typical underwriting discount of 7% charged by underwriters in a traditional IPO (although the founders have agreed to provide post-listing advice through their private equity group and are subject to the risk of losing their entire investment if the company does not find a shareholder-approved acquisition within two years and is liquidated).

Best option: Fix the existing IPO

In concluding his column, Mr. Mackintosh bluntly states:

“The willingness of investors to back Social Capital Hedosophia shows how fed up they are with the traditional IPO.”

With that statement, Mr. Mackintosh suggests fixing the existing IPO process in three ways:

• lock-up periods on shareholders should be smarter;
• investment banks should incorporate a variant of the auction process into their price setting where investors bid for stock and say what they are willing to pay (as used by Google in its 2004 IPO and offered by WR Hambrecht & Co.) to reduce underwriting costs to the issuer including the impact of the “first-day pop”; and
• IPO issuers should have more say over the type of investor who gets stock, reducing the investment banks’ ability to help their individual clients. 

Despite a somewhat dim view of the role of conflicts of interest in investment banking pricing – as if IPO issuers are no more than lambs led to the slaughter – Mr. Mackintosh sets aside the usual excuses to bring clarity to the current structural state of the IPO market. Unlike so many other commentators, we find it refreshing that Mr. Mackintosh does not blame the state of the market on overregulation or on lack of investor receptiveness to tech IPOs due to occasional disappointments or their dual-class capital structures.  The reinvention of the IPO is an evolving discussion and we look forward to reading more from the author of this column.