Market Cap Rap
Mark Hoover, President, Acuitive, Inc.

It seems like this is a daily occurrence now. You're watching the news and the announcer says, "Flyby.com went public today, with shares rising to $187 on first day trading, which makes it the most successful IPO ever and gives Flyby.com a market capitalization equal to GE, AT&T, and Luxembourg combined." The newscaster then exchanges a wry look with the co-announcers who smile and shrug as if to say, "It's a crazy new world, but we're cool because we report on it, and therefore you believe we understand it."

Well, I'm here to tell you that from now on you can stop listening to these announcements and stop wondering about what makes Flyby.com worth more than GE, because it's not. The reason is that the metric of "market capitalization" as generally calculated is essentially worthless so soon after most IPOs. And the reason for that is that the public has not yet voted on the total worth of the company - just a small slice. In most IPOs, the company raises capital by releasing 6-8% of the company as stock for public trading. In many so-called dot-com companies, the amount released has been as little as 2-3%. When that little of a company is available for trading, an artificial low supply/high demand situation is created that can completely override little issues like the true value of a company.

Let me illustrate: Let's say I wanted to take Acuitive public. Suppose I have 10 Million shares, but I don't need to raise much money, so I release one share for public trading (maybe on E-Bay). Now, those of you that know Acuitive know that John Jaeger is a huge contributor in the company, so you may view buying a share of Acuitive as buying a piece of Jaeger. And who doesn't want a piece of John? Well, in this case, it turns out two people do, his mother and his wife Joanna. They bid fiercely with one another for the share. Joanna finally "borrows" a portion of the family beer budget and wins the bid by buying the share for $1,000,000. Based upon this, the Acuitive market capitalization would be calculated as ten billion dollars because that calculation assumes that every un-released outstanding share is worth as much as the shares available for public trading.

Now, is Acuitive really worth $10B? Of course not. I created an artificial demand situation. If I had released two shares, both Joanna and John's mom could have gotten a share with little bidding up of one another, say for $2.50. Now the calculated Acuitive market capitalization becomes a mere twenty-five million dollars. If I had released a thousand shares, John's mom and Joanna would be wallpapering their bathrooms with Acuitive stock certificates. Acuitive market capitalization - a buck eighty.

In all these cases, Acuitive is fundamentally the same company. Why does the same company have such a different apparent value under different financing circumstances? It doesn't. The point is, the market capitalization number is meaningless until there are enough tradable shares floating around in the public domain that you can be sure the public is truly "voting" on the value of the stock and not trying to corner the market. Unless and until a company and its inside investors have released 40-50% of the company, don't pay any attention at all to the "market capitalization" number.

Still, we all want a measure of the success of an IPO. How do we know if a company did well or not? There are three numbers you can use to make this judgment: capital raised, total present proven value (my terminology), and percent captured value.

Capital raised is easy to calculate. It's the number of shares offered times the initial IPO price. This is the capital that the company raises as a result of the IPO. If a company floats 4 million shares at $20 per share, they receive (minus some egregious investment banker fees) $80M, a portion of which is generally used for airfare to New York City so that the CEO can be interviewed on CNBC.

You may ask, well what about all these recent IPOs where the stock price immediately went up to $120? Does that mean the CEO can also enjoy a nice dinner in NYC? The answer is: not on the company's money. The appreciation related to the increase from the IPO price ($20) to the market price ($120) is realized not by the company, but by various financial institutions that essentially buy the stock for $20 and sell it for $120. These financial institutions are the investment bankers and their favorite institutional investor buddies. These are the people who have made out big time in the recent flurry of successful IPOs. But, if you think about it, they deserve to. The employees sweat blood 14 hours a day creating the value, and the venture capitalists provide high risk capital. No one questions their right to a piece of the pie. But the investment bankers and institutional investor "insiders" are also critical because they come in from their golf courses and massage parlors at the last minute and um, um… Well anyway, add them to the list of people who enjoy IPOs. Nobody complains too much publicly about investment bankers and the money they make for (essentially) nothing, because they are a necessary agent for releasing the value of private company holdings. And we've all benefited from that.

But they ought to at least take the CEO out to dinner.

The other measure of success of an IPO is what I call the total present proven value. You MBAs out there probably know the proper term for this. It's the present stock price times the trading float for a given stock. In other words, the total value of all the stock that's really in play. I like this number because generally it's lower if a company releases a small amount of stock, which usually results in a higher trading price, but not necessarily proportionally to the smaller number of shares released. Even this number is highly influenced by artificial demand situations. In the Acuitive examples above, it would be $1,000,000, $5.00, or $0, depending if I had released one, two, or three shares. That's still a wide range, and one has to wonder how it relates to the real value of the company, which is the same no matter how many shares I released. But at least no one would be comparing Acuitive to GE.

The final metric is captured value, which is equal to the capital raised divided by the total present value immediately after the IPO. In other words, what percentage of the value released by the IPO went to the company? To incent investment by 3rd parties, and to ensure a successful IPO, a company doesn't want to go for 100% here. But it should go for some reasonable share. I hate to rain on people's parades, but many recently "successful" IPOs resulted in only 20% (or less) of the released value ending up in the hands of the company. That's too low. The company accepted too low of an initial price. If 50% or less of the released value of an IPO goes to the company, then I think the CEOs of such companies should be a little sheepish at their CNBC interview in spite of a huge and fast run up of their stock price. The company could have used the money for acquisitions, ramping R&D, channel development, etc. The investment bankers, on the other hand, don't need more cigars and cognac.

(volume 2, number 11)

 

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