Airbnb and DoorDash broke the IPO market; here’s a fix

By Tae Kim

The incredible first-day action in the stock prices of recent technology IPOs — particularly DoorDash Inc. and Airbnb last week — has reignited a debate that goes back to the dot-com era over whether the process is broken. Critics are blaming bankers for vastly mispricing the offerings, resulting in companies’ missing out on money they could have pocketed at a higher valuation. There’s something to that, but it’s not just about pricing. In fact, there is a simple solution that can bring better results for all stakeholders. And it explains why two promising IPO candidates have now pressed pause on their plans.

DoorDash and Airbnb soared in their trading day debuts, rallying 86 per cent and 113 per cent, respectively, from the IPO prices at which they raised funds. The spikes happened even after underwriters tried to get a more accurate assessment of demand by using a new online system that allowed institutional investors to enter order details. But it didn’t work as it failed to anticipate the overwhelming demand from the Robinhood set of retail investors.

The giddy reception was exciting to watch, but it has downsides that go beyond leaving money on the table. The elevated price levels after the first day of trading will likely mean more volatility going forward, which could distract management and employees from doing their jobs. Also, it becomes more difficult to hire new talent as stock-option grants are set at frothy levels. For these reasons, it’s perhaps understandable that two companies originally on this year’s IPO calendar — video-game platform Roblox Corp. and fintech startup Affirm Holdings Inc. — reacted to last week’s big pops by delaying their offerings to assess their options.

The holdups can’t be attributed to a lack of demand; both Roblox and Affirm are growth stories, and investors were looking forward to the offerings. Instead, the delay comes as both companies consider selling a larger amount of shares from employees and other investors, according to the Wall Street Journal. They are on to something. While price is an important input in the IPO equation, a main driver of the volatility in new stock listings is the scarcity of tradable shares. In most traditional IPOs, including for DoorDash and Airbnb, companies sell 10 per cent or less of their shares with the remainder not becoming available to sell for another six months under insider “lockup” agreements. And because the average retail investor isn’t doing a careful valuation analysis on IPOs these days, it creates a supply-demand imbalance, resulting in those initial surges.

How can companies mitigate this issue? The first and easiest solution is to offer more shares. Lockups are an anachronism from decades past when bankers believed new offerings required time before the market could handle insiders selling their shares. But it mechanically exacerbates volatility for the six-month lockup period, limiting price discovery to the more accurate supply-demand market-based price. Companies, instead, should ease lockup restrictions, allowing bigger unlocks earlier in the offering process, preferably on the first day. This will also provide a chance for their hard-working employees to reap some gains on stock they earned, enabling them to diversify their holdings.

The most elegant solution is a modified direct listing that is under consideration by the Securities and Exchange Commission. Direct listings allow companies to circumvent the traditional high-fee-laden IPO process and make all their shares available for sale to the public. The one big limitation under this method is that companies aren’t allowed to raise capital at the same time by selling newly created stock. But the New York Stock Exchange is proposing a rule that will allow companies to do so. And because most direct listings don’t have any lockups, there is better price discovery from the start.

We all learned the basic relationship between supply, demand and prices in economics class. It’s about time for IPO hopefuls and their underwriters to take the lesson to heart. The traditional way of selling stock may have worked in the past, but it may not be the best way now.