In September 2020, semiconductor company Nvidia (NVDA -0.46%) reached an agreement to acquire a rival chip maker called Arm Limited from SoftBank. The proposed acquisition dragged on for over a year, but ultimately failed due to a number of regulatory antitrust concerns. Moreover, earlier this year it was reported that Arm filed confidentially for an initial public offering (IPO), further distancing itself from Nvidia.
Since abandoning the deal in February 2022, Nvidia has turned its focus to its data center operations as well as advancements in artificial intelligence (AI). This has turned out to be a good decision -- during the company's Q1 earnings call, management guided investors that Q2 revenue should be in the ballpark of $11 billion, far higher than the consensus Wall Street estimate of $7.2 billion.
As a result of this bullish outlook, Nvidia stock has rocketed to new highs. In fact, the company has joined the likes of Apple, Alphabet, Amazon, and Microsoft as a member of the trillion dollar market cap club. Despite all of this positive sentiment, there may be yet one more reason to love Nvidia stock. Just this week, news broke that Nvidia may be participating in Arm's IPO as a major investor.
Let's take a look at how these types of deals work, and why they are important -- and how this potential partnership could add even more fuel to Nvidia, making it an even more compelling buy.
How does IPO investing work?
When a company is privately held, it typically raises funds from sophisticated investors such as venture capitalists or private equity firms. These institutions buy an ownership stake in the form of equity in the company in exchange for investment capital. After a period of time, once the company has reached some scale, the investors seek out a liquidity event. This can come either in the form of selling the company to a larger competitor, or taking it public.
If the company decides to go public it will typically hire a big bank like Goldman Sachs or Morgan Stanley to underwrite the deal. The major responsibilities of the bank are to ensure the company's financials are ready to be filed with the Securities and Exchange Commission (SEC) and to perform due diligence on the company to help arrive at an appropriate IPO share price.
One of the more daunting aspects of an IPO is that the underwriters also play a role in marketing the shares of its client. In other words, trying to find buyers who may want to participate in the IPO. While IPO investing is typically reserved for high-net-worth individuals, from time to time, other companies may participate and buy into competitors' offerings.
As it pertains to Arm's IPO, rumors are swirling that Nvidia may end up playing a major role. But why would Nvidia do this, especially after its acquisition didn't pan out? Let's explore some options.
Image source: Getty Images.
Is this common?
Believe it or not, one company buying into another company's IPO is not a foreign concept. In the tech world, one of the most acquisitive companies is Salesforce.com. Perhaps one of its more lucrative deals occurred in 2020, when Salesforce invested in big-data analytics firm Snowflake. Following this initial investment, Salesforce poured another $250 million into Snowflake's IPO later in 2020. One of the big reasons why Salesforce may have done this is to establish a long-term relationship with Snowflake to help drive future business.
Following these investments, Salesforce and Snowflake formed a strategic partnership that has reaped benefits for each party. Per the alliance, Salesforce and Snowflake have built integrations that allow users to share data seamlessly and securely between the two platforms. Furthermore, the data can be turned into visual graphics leveraging another Salesforce-owned tool, Tableau. The ability to access Tableau natively allows businesses to unify key metrics and make data-informed decisions in real time. At the root of the deal, Snowflake and Salesforce are able to cross-sell respective products to its different user bases, thereby broadening the reach of each platform.
For Nvidia, an ownership stake in Arm could mean a lot going forward. As both companies are leaders in the semiconductor space, forming a deeper relationship could serve as a meaningful catalyst for future business. And an investment in Arm's IPO could very well be a good step in forming a longer-term alliance.
What does it mean for Nvidia's stock?
Nvidia stock has already enjoyed market-beating returns this year. At the time of this writing, Nvidia stock is up over 220% in 2023. In just the last five days alone, the stock is up over 8%. Most of the gains this year can be attributed to AI euphoria as well as broader macro trends such as the tech-heavy Nasdaq Composite index being up 36% year to date. However, the most recent bump in Nvidia stock is likely tied to its potential IPO investment in Arm.
It is monumentally crucial for investors to understand that any deal between Nvidia and Arm is not set in stone. During any investment, the buyer and seller must agree on a price. In the case of a start-up looking for funding, a venture capitalist will negotiate for a certain level of equity that is deemed appropriate for the amount of investment. This process sets the stage for the value of the company.
At its core, IPO investing is no different. Nvidia's strategic investment in Arm will come down to whether each party can agree on valuation. According to several public resources, including the Financial Times, Nvidia is assessing an investment in Arm at a valuation between $35 billion and $40 billion, while Softbank is looking to value its asset around $80 billion. That's a wide gap.
Nonetheless, Arm's IPO is targeted to be several months away. This gives Nvidia plenty of time to assess the deal and negotiate different terms. As seen above, strategic investments in IPO companies can lead to strong relationships between different brands and help fuel future business. Should the two chip makers reach an agreement prior to an IPO, it would serve as yet another catalyst for Nvidia stock as well as the company's long-term prospects. Shareholders should be encouraged by this news, as Nvidia stock could very well experience yet another wave of investor enthusiasm before year end.
