Do IPO’s Affect Competitive Firms?

Many tech-based companies are lined up for initial public offerings (IPOs) in 2019. Many companies such as Uber and Lyft belong to the same industry as well. Up until now, investors have not seen so many major IPOs from the same industry at the same time. The firms launching their IPOs used to be small, unproven firms who were just starting out in the market. However, now, there are blockbuster firms which have been backed by venture capitalists and have become a household name long before the IPO. As such the entire dynamics of IPOs has changed. This has forced vendors to ask many questions about the process. One such question commonly asked by investors is whether the IPO of a company has an effect on other firms.

In this article, we will try and answer this question by having a closer look at the competitive effects of IPO’s.

Firm-Specific vs. Industry Effects

Earlier it was believed that IPOs were only firm-specific events. However, now the consensus amongst financial analysts have changed. IPO’s are now believed to be affecting the industry and even the market as a whole. The effects of IPOs are basically divided into two categories, i.e. financial and informative. Some of the major effects have been listed down.

Signalling Effect

The performance of IPOs provided very important information to investors about the mood of the market. For instance, the Lyft IPO was listed at a high price. However, its stocks soon started to crumble after it was listed. This has signalled to the market that the investors are wary about the valuations of tech companies. This information was immediately utilized by investment bankers who were preparing for the Uber IPO. It was earlier rumoured that Uber was looking at a valuation of close to $120 billion. However, after the Lyft IPO, Uber is reported to have settled for $100 billion. Hence, the Lyft IPO provided valuable information to other competitive firms. Uber could have also used this information to postpone its IPO if it had found the information to be more unfavourable.

New Information Released

Apart from providing information about investor sentiment, IPO filings can also be used to obtain a lot of information about a company’s products and services as well. Until a company is privately held, it can maintain complete secrecy about the products or services that it sells. However, as soon as a company decides to go public, it is required to provide accurate information to its prospective shareholders. This information is meant to help these shareholder make a decision about their investment. However, this same information can also be used by competitors to neutralize any competitive advantage. Hence, any company that runs for an IPO ends up providing sensitive information to its competitors. Until such information is protected by intellectual property rights, it leads to homogenization of products all across the industry which leads to a fall in prices.

Monetary Barriers Removed

IPOs provide new entrants to accumulate substantial capital. For many well established incumbent firms, this could mean a sign of trouble. Many times having deep pockets is the main power that many incumbents have. They can produce better products cheaper than their rivals owing to their large size. IPO’s allow smaller firms to grow in size relatively quickly. This is the reason why the announcement of an IPO is immediately considered bad news by many competitive firms. The share price and valuation of competitive firms usually take a beating if a nascent firm is able to pull off a successful IPO.

Pricing of Subsequent IPOs

The Uber-Lyft example mentioned above explains just one facet about how IPOs affect other subsequent IPOs in the same industry. Many times these effects have nothing to do with investor sentiment. For instance, even if the Lyft IPO was successful, it would still have an effect on Uber’s IPO. This is because the financial world uses relative valuation to arrive at a fair value for a firm and its stock price. Hence, Uber’s financials would have been compared with Lyft’s in order to arrive at a valuation. The widespread use of relative valuation makes all the IPO’s interconnected.

The use of relative valuation has become more widespread in recent years. This is because tech companies do not have assets or cash flows which can be used to arrive at a valuation using the traditional discounted cash flow models.

Venture Capital for Newer Firms

The success or failure of an IPO has a profound effect on other firms even though they may not be listed in the marketplace. The investor sentiment which is displayed during IPO’s has a huge bearing on the venture capital market. This is because IPOs are an exit point for most venture capitalists. Hence, when venture capitalists see that the IPOs are faring well, they become more motivated to invest in companies that they can divest in IPO’s some time later. Successful IPO’s, therefore, spark the greed of many venture capitalist investors. Also, successful IPO’s are the reason that many of these venture capitalists are flush with cash. Once these investors have a lot of cash, they may be looking to reinvest in another startup thus perpetuating the growth cycle.

The bottom line is that IPOs are no longer isolated events. As seen above, they are capable of exercising a huge influence on all other firms in the industry.