Picking a Price for IPOs

Imagine for a moment that you're a woodworker who specializes in making bar stools. These aren't run-of-the-mill bar stools mass-produced in a factory, mind you; they're handmade, cherrywood stools upholstered in leather. You own and manage your own storefront and make your living selling these stools.

As the owner of the business, pricing your product is a big question. Sure, there are other bar stools out there, including many that are likely very similar to yours -- stools made of cherrywood, stools with leather upholstery, and stools with both qualities. None are exactly the same, though, so there's no reason why you have to price your stools exactly the same as all the others. At the end of the day, the decision boils down to some combination of how other stools are priced, how much better you think your product is, and at what price you think people will actually take home your wares.

While there's a heck of a lot more fanfare around the pricing of an IPO, the process behind it isn't much different. Consider, for example, the recently filed IPO for Super Micro Computer, where the whole process started with a visit from a few investment bankers.

Oh, pick me, pick me!
A company like Super Micro, which finished its 2006 fiscal year (ending in June) with more than $300 million in revenue, doesn't get its first visits from investment banks when it decides it's ready to go public. On the contrary, it's highly probable that investment banks have been calling on the company for years, pitching it various strategic and financing options. The banks have also likely been reminding Super Micro's chairman, president, and CEO, Charles Liang (who, along with his wife, owns nearly 50% of the company's stock) how great of a bank they are, and why Liang should choose them if the company decides to make any IPO-related moves.

The real fun in the process starts when the company decides that it would like to pursue an IPO. This typically means that the company will hold a "bake-off," in which any number of banks will file in and out of its offices, trying to convince the company to work with them on its IPO. Though the banks with a historical relationship with the company generally have an edge in the process, a bake-off can sometimes end up with a Who's Who list of banks and bankers parading in to see the management team.

While a lot of the bake-off pitch revolves around each bank giving statistics, charts, and graphs showing how much the bankers know about the particular company, and how much success they've had in its particular industry, this is also the point where pricing often gets introduced. In the case of Super Micro, Morgan Stanley (NYSE: MS  ) , Merrill Lynch (NYSE: MER  ) , UBS (NYSE: UBS  ) , and Needham, who are listed on the cover of the company's S-1 filing, were undoubtedly involved in the bake-off process, but other major banks like Lehman Brothers and Goldman Sachs, as well as technology boutique banks like Thomas Weisel Partners and Cowen Group, may also have been in the running. Each bank pitching Super Micro would have talked about how well it has done in the technology sector, and how much it knows about the server industry in particular. The banks may also have specified what types of buyers they would recommend for the offering.

More importantly, though, many of the banks likely presented Super Micro with a set of comparable public companies, and used the trading multiples of those comparables to create a framework to value Super Micro's stock. Every bank obviously wants to win the business, but that doesn't mean that the bankers can present an unrealistically high valuation and wow the company with visions of dollar signs. After all, the bank will have to actually deliver on its promises at some point, or risk getting kicked off the deal -- not an outcome that makes an investment bank's managing director particularly happy.

Super Micro's comparable group would contain companies such as Dell, IBM (NYSE: IBM  ) , Hewlett-Packard (NYSE: HPQ  ) , Rackable Systems, and Sun Microsystems (Nasdaq: SUNW  ) . Because Super Micro has a top-line growth rate exceeding that of all the comparables except Rackable, and operating margins better than most, the bankers would likely propose that the offering would merit a premium valuation -- probably somewhere in the vicinity of Rackable's current 28 times trailing-12-month EPS multiple.

Finding the range
Once the company has chosen its underwriters, the lead underwriter will generally take the reins in the process. For a while, this means primarily drafting the S-1 filing and wading through comments and changes that the SEC gives the syndicate on the filing. As the group gets down to the end of the process, though (which could be months later, in some cases), it's time to finalize the price at which the stock will be offered.

This second pass at pricing will revisit the comparable company set that the bankers set up earlier, to see whether there have been any significant changes that would require raising or lowering the previous valuation. Current market conditions also play a role here -- if you are, say, Goldman Sachs taking MasterCard (NYSE: MA  ) public after just witnessing Vonage crash and burn, you may caution that a lower price may be required to get the deal done. The bankers may also consult with the capital markets and sales and trading departments of the bank, soliciting their feedback on the price to which the market would react best.

Consideration is also paid to the desire of institutional buyers (mutual funds, hedge funds, etc.) to make money off any purchase of the stock. With that in mind, the IPO price should leave some room for the stock to "pop" a bit on the first day. After all, if a certain bank's IPOs consistently fail to make these investors any money, they may decide to close their wallets the next time a new offering comes around.

The result of all of this work is a price range that is printed on a near-final version of the S-1, often referred to as the "red herring."

Stand and deliver
The whole process culminates in a few weeks of whirlwind travel for the investment banking team and the company's management team (typically just the CEO and CFO). The group travels to major finance centers in the U.S. and abroad, paying visits to top institutional money managers such as Fidelity, T. Rowe Price, and Franklin Resources. At each stop, the management team gives a 30-minute spiel on the company and the offering.

At the conclusion of the road show, the management team, the investment bankers, the capital markets team, and the heads of sales gather together to make the final pricing determination. The sales department will have compiled a list of all the investors that the group visited on the road show, and the indications of interest those investors gave. Investor interest is basically "we would buy X number of shares at Y price," and fewer shares at higher prices.

Integrating the supply and demand created by the indications of interest, the number of shares that the company planned to sell, and the management team's desired outcome, the group fixes a final price. This price is generally within the range proposed in the red herring, but can sometimes be below that range if there is not much demand, or above if there is a lot of demand. Once the price is plugged into the final S-1 filing, the stock is locked and loaded for its first day of trading.

The fate of Super Micro
Not every company that files for an IPO ends up publicly traded. In some cases, demand for the stock just doesn't materialize, and the banks and the company put the offering on ice. In other cases, they decide to get financing from a private placement or a venture capital firm instead, and in a few cases, a larger company acquires the firm before it completes its IPO process. Super Micro is still early in the process, but if the markets pick up in 2007 the way they left off in 2006, it may create too tempting an environment for the company to pass up.

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Fool contributor Matt Koppenheffer likes to point out that however grueling they may be, IPO road shows are great for the frequent flier miles. He owns shares of Goldman Sachs but does not own a position in any of the other companies mentioned. Dell and MasterCard are Inside Value picks. Dell is also a Stock Advisor selection. The Fool's disclosure policy is ironclad.


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