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Healthcare IT from the Investor’s Chair 4/4/12

April 4, 2012 News 4 Comments

From a recent HIStalk post:

Facts and Background 
Shares in mobile healthcare communications Vocera jumped almost 50% in their first three days of trading after Wednesday’s initial public offering, opening at $16 and closing Friday at $23.40.

Opinion 
The company either priced its shares incorrectly or intentionally undervalued them to create positive press from the price run-up. Either way, investors and not the company pocketed the $41 million price difference in the 5.9 million shares offered. Still, the company was smart enough to up the originally planned $12-14 price. A $100 million IPO yield is impressive for a company that isn’t all that widely known and that lost money in FY2011.

Sorry, Tim, not sure I totally agree with this assessment. 

With the benefit of hindsight, Vocera and its underwriters did under-price its IPO, but there’s no way to predict how a company will trade once it’s public. See my earlier post on the full mechanics of how companies go public here, but recall that the underwriters (led by JP Morgan and Piper Jaffrey in this case) had to take their best guess on how much investors would pay for Vocera stock at the time of pricing. The initial filing range is an even broader guess (albeit an informed one, based on how comparable companies are trading).

As the roadshow continued, there appeared to be more buyers than sellers (the offering was over-subscribed) so the underwriters raised the pricing range. Throughout the roadshow, JP Morgan built an “order book,” where each investor (typically mutual, pension, and hedge funds) indicated how much stock they would buy at any given price. Clearly the Vocera IPO was multiple times oversubscribed, which is the goal.

The art of pricing (and it does seem to be more art than science) is using that information to set the initial offering price. Too low and you’ve left money on the table (as VCRA apparently did). Too high and not enough funds purchase once the stock trades in the aftermarket and instead simply dump their shares rather than build a larger position. This results in the stock trading down and embarrasses and annoys all parties involved.

The trick here is balancing supply and demand precisely and in real-time and with very imperfect information (as investment funds don’t always reveal their intent, either). It’s interesting in that it’s one of the few businesses where the price of the product is directly affected by the customer to whom you sell.

That said, it’s also worth noting that underwriters have multiple incentives, and it’s not always clear who the client is in these situations. On the one hand, because they’re getting a 7% fee, they have a definite motivation to maximize the initial stock price. By pricing at $16 rather than $23.40, they missed around $3.5 million in fees.

On the other hand, any given fund can easily pay 10x that in commissions any given year, so there are those who feel that banks have an obligation to take care of their trading clients more than their underwriting clients. Suffice to say, there’s more than a little dynamic tension between different parts of the firms, but in my experience, pricing for a successful offering trumps the desire to maximize the fees for the specific deal under consideration.

As an aside, I believe the positive press effect is less the case now than during the dotcom days and not a motivator for either issuing companies or their underwriters.

One way of avoiding this phenomenon of under-pricing IPOs is by using what is known as a DutchAuction, which arguably creates the most efficient price. In 1998, an investment bank called WR Hambrecht began trying to use this method to price IPOs, calling it OpenIPO. With the notable exception of Google, it never really caught on. (I’ll try to do some research as to why for a future note, but I assume typical issuers remain risk averse and prefer the tried and mostly true IPO method.)

Because insiders rarely sell at the time of an IPO (and be careful if too many are doing so), it’s not as if management or the venture capitalists involved have a personal stake here, either. Further, in the long run, pricing the IPO with perfect accuracy just isn’t viewed as that important relative to the benefits of assuring a successful offering with a healthy balance sheet, good research sponsorship, and long term investors for the future .

Ben Rooks, founder of ST Advisors, spent ten years as an equity analyst, six years as an investment banker, and is now much happier (and adding more value) as an independent advisor to HCIT companies. He loves questions and feedback on his column. Incidentally, ST Advisors is pleased to count Vocera as a former (but not current) client.

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Currently there are "4 comments" on this Article:

  1. Ben, I think you are being generous to the investment bank in this view. Below is the link to a broader set of explinations although in more MBA speak

    http://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-get-underpriced/

    Quotes from the article are below:

    “Academics have found that I.P.O. underpricing is ubiquitous. Jay Ritter has documented underpricing over the years. According to Professor Ritter, the average underpricing for I.P.O.’s in the United States was 14.8 percent from 1990 to 1998, 51.4 percent from 1999 to 2000 and 12.1percent from 2001 to 2009.

    Over the last 50 years, I.P.O.’s in the United States have been underpriced by 16.8 percent on average. This translates to more than $125 billion that companies have left on the table in the last 20 years.

    I.P.O. pricing is also a worldwide phenomenon. In China, the underpricing has been severe, averaging 137.4 percent from 1990 to 2010. This compares with 16.3 percent in Britain from 1959 to 2009. In most other countries, I.P.O. underpricing averages above 20 percent.”

  2. Having been through this a few times, I completely agree with Ben. If the stock goes up significantly when it starts trading, the company makes somewhat less than they would have at the IPO but is in a good position to issue more shares later at a higher price. And the market and early investors will look favorably on the stock. If the stock goes down, or if it trades below the IPO price any time during the first year or so, investors think they got shafted and the market and media think the stock was over-hyped. So the former is definitely preferable.

  3. Interesting…I went through this ‘insane’ exercise a long while ago and came to the conclusion that slightly underpricing is better than slightly over pricing. Way under and way over are to be avoided at all costs.

    Now for even more fun, lets talk about software pricing…







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