Latest / How Canadian Markets Work / Underwriting Explained: What Does a 'Successful' IPO Really Cost You? | Canadian Investing

Transcript

Underwriting Explained: What Does a 'Successful' IPO Really Cost You? | Canadian Investing · How Canadian Markets Work

0:00
Imagine a quiet, unhurried morning. Oh, so it's
0:05
nice. Right. You're sitting at your kitchen table,
0:07
the house is still asleep, coffee in hand, and
0:10
you pull up the financial news. And right there.
0:13
dominating the very top of the screen is a glowing,
0:17
triumphant headline. It says something like,
0:20
tech darling soars 40 % and highly successful
0:24
debut. Yeah, you see those all the time. All
0:26
the time. And you read the details, you see that
0:28
this young, innovative company priced its shares
0:30
at $20, but the moment the opening bell rang...
0:35
The market just went wild. Right. The stock pops.
0:37
Exactly. It pops to $28 a share. And, you know,
0:40
the financial journalists are writing these enthusiastic
0:43
columns. The executives are probably standing
0:45
on a balcony somewhere, popping champagne, hugging
0:48
each other. It's a great image. It is. Intuitively,
0:51
as a casual reader, you smile. You think, well,
0:53
what a massive validation. You know, what a triumph
0:56
for this young company after all those years
0:58
of hard work. It is. It's a beautifully crafted
1:00
narrative. I mean, it really feels like the ultimate
1:03
finish line for a startup. But as we peel back
1:05
the layers of that specific narrative today,
1:08
using the sources we've gathered, we're going
1:11
to see that this beautiful picture is, well,
1:14
fundamentally flawed. In reality, what we are
1:17
observing on that opening day is not a corporate
1:19
triumph, but rather a massive, highly orchestrated
1:23
systemic transfer of wealth. And it's a transfer
1:27
away from the very company everyone is celebrating.
1:29
OK, let's unpack this. Because our mission for
1:32
this deep dive is to sort of slow down and decode
1:35
the hidden, incredibly complex mechanics of underwriting.
1:39
Right. We want to use our source material to
1:41
reveal exactly how these debut prices are actually
1:44
set in the background, you know, long before
1:46
the public ever gets to push a button to buy
1:47
a share. We want to explain the actual financial
1:50
plumbing and reveal why that celebrated first
1:53
day pop that everyone cheers for is in reality
1:55
a massive and, well, entirely hidden expense
1:58
for the issuing company. Yeah. Our goal today
2:01
is to move past those superficial headlines.
2:03
We want to explore not merely what happens during
2:06
an initial public offering, but to deeply understand
2:10
why the mechanics are structured the way they
2:12
are. Exactly. how risk is allocated in these
2:17
transactions, who actually holds the leverage
2:20
when the paperwork is signed, and the deeply
2:22
ingrained structural conflicts of interest that
2:25
dictate these outcomes. Because the entire process
2:28
of bringing a company to the public market is
2:30
an intricate, high -stakes dance of risk management.
2:34
Right. So let's start with the most glaring piece
2:36
of that narrative, the celebration of the price
2:39
jump. Yes. Because before we can even look at
2:41
the plumbing of how a stock gets to the market,
2:44
We have to first understand why that joyful first
2:46
day pop is actually a terrible financial outcome
2:49
for the company. We really have to establish
2:51
the stakes here. We do. And the math from our
2:55
sources tells the true story here quite plainly.
2:58
Let us walk through a very specific example to
3:00
just kind of ground this. Imagine that same tech
3:02
company we just mentioned. They decide to sell
3:06
10 million shares to the public to fund their
3:09
next phase of growth. OK. And they agree to price
3:12
those shares at $20 each. The morning arrives,
3:16
and on day one, the stock opens at $28. Right.
3:20
Cue the champagne. Exactly. The headlines cheer.
3:23
But mathematically, if we just pause and look
3:26
at the ledger, if they had accurately priced
3:29
those shares at $28. Which the market was obviously
3:32
willing to pay. Which is clearly what the market
3:33
was willing to pay, yes. If they had done that,
3:36
the company would have raised an additional $80
3:38
million in capital. Oh, wow. $80 million. Let's
3:41
just sit with that number for a long moment.
3:44
It's staggering. It is. I mean, that is not a
3:46
minor rounding error. That is enough capital
3:48
to build an entirely new research facility or
3:51
hire thousands of employees or, I don't know,
3:54
acquire a competitor. Exactly. If you think about
3:56
this in terms of everyday life, let's compare
3:59
it to selling a house you've spent a decade renovating.
4:03
OK, I like that. Right. So imagine you decide
4:05
to sell your home. you agree to sell it to a
4:08
buyer for $200 ,000. But the very next morning,
4:12
before the ink is even dry, that exact same buyer
4:16
walks across the street, finds someone else,
4:20
and instantly flips your house for $280 ,000
4:23
without doing a single bit of work. Like, without
4:26
lifting a paintbrush or planting a single flower,
4:29
you wouldn't throw a party and celebrate a successful
4:32
debut. No, you would be entirely devastated.
4:34
Right. You'd realize you just left $80 ,000 of
4:37
your own hard -earned equity on the table. And
4:39
taking that a step further, the crucial realization
4:42
here is that this $80 million in our corporate
4:45
example It did not just vanish into the ether.
4:49
Yeah. Where did it go? It went directly into
4:51
the pockets of whoever was fortunate enough to
4:53
buy that initial allocation at $20. Yeah. The
4:57
people who then simply turned around and sold
4:59
it to the eager public at $28. Ah. Which means
5:03
the real power in this dynamic isn't the company
5:05
itself. No, not at all. The real power belongs
5:08
to the entity handing out those initial highly
5:11
lucrative allocations. So if we are looking for
5:14
the architect of this transaction, we are looking
5:17
for the middleman. Yes. The dealer standing directly
5:20
in the center between the issuing company and
5:23
the investors, the underwriter. The underwriter
5:25
is the absolute center of gravity for the entire
5:28
process. And because they orchestrate the sale
5:31
and handle the shares, we really have to look
5:33
closely at who is actually bearing the financial
5:35
risk if things go poorly. Right. If the market
5:38
suddenly turns cold and those shares do not sell,
5:41
someone is left holding a massive, expensive
5:44
bag. That ultimate risk of failure dictates the
5:48
entire structural agreement between the company
5:50
and the underwriter. Because risk is never free.
5:52
I mean, the more risk a financial institution
5:54
takes, the more control they are going to demand
5:56
over the process. Exactly so. And the industry
5:59
has three primary ways this risk is allocated.
6:02
Let us start with the most basic structure, which
6:04
is called a best efforts underwriting. Best efforts,
6:07
okay. The mechanics here are exactly what the
6:09
name implies. The dealer simply agrees to try
6:12
their absolute best to sell the securities to
6:15
the public on behalf of the company. Right. So
6:17
just giving it a shot. Exactly. They will market
6:20
it. They will make the phone calls, but they
6:21
make no guarantees. If they cannot sell all the
6:24
shares, the unsold portion simply remains unsold.
6:27
Oh, wow. In this scenario, the risk sits entirely
6:32
and uncomfortably. with the issuing company.
6:38
This structure is typically reserved for smaller
6:40
or perhaps slightly riskier speculative offerings
6:43
where the dealer is completely unwilling to guarantee
6:46
the final outcome. But if I am looking at the
6:49
global standard, say, a massive billion dollar
6:51
tech unicorn going public, they are not going
6:54
to accept a best efforts handshake. No, definitely
6:56
not. A company of that size with thousands of
6:59
employees and massive capital needs, they want
7:01
absolute certainty. They want to know the money
7:03
will be in their bank account on Friday, regardless
7:05
of what the broader market does. Absolutely.
7:08
The market engineered a solution for that exact
7:11
need for certainty. And it brings us to the second
7:14
most common structure. The firm commitment. Firm
7:18
commitment. Yes. In a firm commitment, the underwriter
7:21
fundamentally changes their role. They do not
7:23
just promise to try to sell the shares. They
7:26
legally commit to purchase the entire issue of
7:29
shares themselves. Wow. Using your own money?
7:32
Using their own capital, yes. Yeah. And then
7:33
they take on the task of reselling them to the
7:35
public. OK. So the moment that agreement is signed,
7:38
the risk completely shifts away from the issuing
7:40
company. It lands squarely heavily. the dealer
7:43
shoulders. If the dealer cannot resell those
7:46
shares, they own them. Ouch. Right. Because they
7:50
are absorbing this immense financial risk, they
7:52
demand the power to price the offering in a way
7:56
that aggressively protects their downside. Makes
7:58
sense. And just when you think you have a handle
7:59
on how risk is balanced, the sources introduce
8:02
a third structure, which is a distinctly Canadian
8:06
phenomenon, right? It takes this firm commitment
8:08
concept and just pushes it to an absolute extreme.
8:11
What's fascinating here is a structure known
8:13
in Canada as the Bought Deal. Bought Deal. It
8:16
takes the mechanics of the firm commitment and
8:19
accelerates the timeline to a breathtaking degree.
8:22
In a bad deal, the dealer approaches the issuing
8:25
company and legally commits to buy the entire
8:28
issue of shares at a set price, often overnight,
8:31
before they've even marketed it to a single potential
8:34
investor. Wait, I really have to pause and push
8:36
back on the logic of that. We are talking about
8:39
highly regulated, risk -averse financial institutions,
8:43
right? Why on earth would a major bank gamble
8:47
tens of millions of dollars on a massive overnight
8:50
position without knowing if anyone actually wants
8:52
to buy the shares the next morning? It sounds
8:54
a bit wild, doesn't it? It sounds less like strategic
8:57
investment banking and more like walking into
8:59
a casino and putting everything on black. It
9:01
does resemble a massive gamble from the outside.
9:04
However, the underwriter is highly compensated
9:07
for taking on this rapid extreme risk. Oh, so?
9:10
To make this overnight leap, they agree to buy
9:13
the shares from the company at a very steep discount
9:15
to the current market price. For the issuing
9:18
company, the appeal is instant. absolute certainty
9:22
without a long distracting marketing period.
9:26
They go to sleep and wake up with their capital
9:28
secured. Right. For the dealer, they take on
9:30
the severe risk of the market moving against
9:33
them while they sleep, but they secure a deeply
9:36
discounted price. And that discount is the safety
9:38
net. Exactly. That massive discount acts as a
9:42
buffer. It practically ensures they will generate
9:44
a significant profit when they finally distribute
9:47
the shares, even if they have to sell them slightly
9:49
cheaper than they originally hoped. Okay, so
9:51
we are following the money here. If the dealer
9:53
is taking on all of this immense risk, whether
9:56
it's a firm commitment or a massive overnight
9:58
bought deal, they obviously have to get paid
10:01
handsomely for providing that buffer. Yes, they
10:03
do. But, you know, if I pull up my brokerage
10:04
account as a retail investor and I manage to
10:07
participate in a new offering, I never see a
10:10
commission fee listed on my trade... It just
10:13
looks like a completely free trade. I am paying
10:16
$20 a share, and that's it. But knowing Wall
10:19
Street, these banks aren't orchestrating billions
10:22
of dollars of capital movement out of the goodness
10:24
of their arts. Assuredly not. So if there is
10:27
no front -end fee on my screen, they have to
10:29
be baking their profit directly into the structure
10:32
of the share price. They are. And the fee is
10:35
entirely built into the transaction through something
10:37
called the underwriting spread. The spread. Yes.
10:41
Let us return to the map from our sources. If
10:44
the public price of the share is $20, the underwriter
10:48
does not hand a $20 bill to the company for every
10:51
share. They might pay the company, say, $19 .10
10:55
per share. That difference, the $0 .90 per share,
10:58
is the spread. It is their profit margin. Now,
11:01
this is not entirely hidden, but you have to
11:03
know exactly where to look. It is disclosed deep
11:05
inside the... prospectus. Right. And for anyone
11:08
who hasn't had to read one, the prospectus is
11:10
that massive, incredibly dense, legally binding
11:13
disclosure document that a company must file
11:16
before going public. That's the one. It details
11:19
every conceivable risk, financial metric and
11:22
structural element of the business. It is the
11:24
document. Yeah. And buried within its pages,
11:26
you will find a line item detailing the net proceeds
11:30
to the company. Net proceeds. That is where you
11:32
uncover the spread. But to the end buyer, just
11:35
staring at a flashing everyday trading screen,
11:38
that 90 cent extraction remains completely invisible.
11:41
Wow. And I am looking at the cover of one of
11:44
these prospectus documents from our sources right
11:46
now. And I rarely just see one under writer listed.
11:49
No, you usually don't. Right. I usually see a
11:51
whole cascade of different banks, sometimes a
11:53
dozen of them just stacked on the front page.
11:56
If the deal is so lucrative and that spread is
11:58
so profitable, why would the lead bank share
12:01
the wealth? Why form a syndicate instead of keeping
12:03
it all for themselves? Well, a syndicate, which
12:05
is typically organized and led by a primary bank
12:08
known as the book runner, it exists for two very
12:11
practical risk mitigating reasons. First, as
12:14
we discussed, in a firm commitment, the bank
12:17
is actually buying the shares. The capital requirements
12:20
and the sheer financial risk are immense. Yeah,
12:23
that makes sense. By forming a syndicate, They
12:25
spread that fatal risk across multiple balance
12:29
sheets. If a deal goes catastrophically poorly,
12:32
no single bank takes a legal hit. Right, spreading
12:35
the risk. And the second reason. Second, it vastly
12:38
expands the distribution reach. Each firm in
12:41
the syndicate brings its own distinct loyal client
12:45
base, its own army of brokers, and its own institutional
12:48
relationships. Oh, I see. This ensures the shares
12:51
are marketed to the widest possible pool of institutional
12:55
and retail investors, ensuring a much smoother
12:58
sell -off. OK, so we have the mechanics down.
13:01
We know how the underwriter gets paid through
13:02
the hidden spread, and we know how they share
13:04
the immense risk across the syndicate. But that
13:07
still leaves the biggest mystery. How do they
13:09
actually decide that $20 is the magic number
13:11
for the debut price? This brings us to the very
13:14
core tension of this entire deep dive. It does.
13:17
It is arguably the single most critical high
13:20
pressure moment in the entire timeline of an
13:22
IPO. And to understand it, we really have to
13:24
look at how that price is discovered. All right.
13:26
Let's use the detailed scenario outlined in our
13:29
sources. We have a software company based in
13:32
Vancouver. OK. They are a classic success story.
13:35
They are 12 years old. The founders have survived
13:38
the startup grind. They are highly profitable,
13:41
they are backed by venture capital, and they
13:43
are finally ready to ring the bell and go public.
13:45
A great position to be in. Exactly. The Syndicate
13:48
of Underwriters looks at comparable public companies,
13:52
analyzes the financials, and sets a preliminary
13:55
estimated price range of let's say $18 to $22
13:58
a share. What is the mechanism for locking in
14:02
the final number? What follows is a grueling,
14:05
intense process called book building. Book building.
14:08
Yes. And it's facilitated through what is known
14:10
as a road show. The underwriters take the company
14:13
executives, usually the CEO and the chief financial
14:15
officer, and they travel extensively. Right.
14:18
They move from city to city, going into private
14:20
hotel conference rooms and boardrooms, marketing
14:23
the deal to massive institutional investors.
14:25
We're talking big players here. The major players.
14:29
massive pension funds, massive mutual funds,
14:32
hedge funds. During these pitches, the underwriters
14:36
are actively collecting non -binding indications
14:39
of interest. Okay. They are quietly asking these
14:43
massive funds, based on what you've heard, how
14:46
many shares would you be willing to buy, and
14:48
at what specific price. They're literally building
14:51
an order book, constructing a private highly
14:55
detailed demand curve. Okay, let's say the underwriter
14:57
finishes this exhausting roadshow, they close
15:00
the book, and they discover that the demand is
15:02
absolutely astronomical. The book shows that
15:05
these massive institutions want to buy five times
15:08
the number of shares that are actually available
15:09
at $20. A great problem to have, supposedly.
15:12
Right, but this is where I see a massive logical
15:14
dilemma. If they have five times the orders they
15:16
need at $20, they could easily price the stock
15:19
at $24 and still comfortably sell every single
15:22
share they have. Yes, they could. So wait, why
15:25
on earth would the underwriter advise the Vancouver
15:27
software company to price it at $20, intentionally
15:31
leaving millions of dollars of the founder's
15:33
equity on the table? Well, the financial industry
15:36
has a very practiced, standard set of justifications
15:40
for this intentional underpricing. I'm sure they
15:42
do. First, they will argue that underpricing
15:45
is a necessary mechanism to reward the institutional
15:48
investors. These funds did the hard work of analyzing
15:52
the company, dedicating their time to the road
15:54
show, and providing honest demand data. Second,
15:59
they will argue it ensures a strong, healthy
16:01
aftermarket. If the stock performs well immediately,
16:04
it creates a halo effect. Right, good PR. Exactly,
16:07
which benefits the company immensely if they
16:09
ever need to return to the public market to raise
16:11
more capital in the future. And finally, they
16:13
argue it provides a vital cushion to prevent
16:16
the ultimate nightmare scenario. A broken deal.
16:18
A broken deal? Where a stock opens, the market
16:21
balks, and the price immediately plummets below
16:23
its issue price, staining the company's reputation.
16:26
OK, those reasons sound logical on the surface,
16:29
almost protective of the company. But our sources
16:31
point out a much deeper, far more systemic structural
16:35
criticism regarding where the underwriters' true
16:38
loyalties lie. Yes, they do. And when we critically
16:41
examine the structural incentives at play, a
16:44
very different picture emerges. Consider the
16:47
nature of the relationships. The underwriter
16:49
has a recurring, continuous, highly lucrative
16:52
relationship with their institutional buyers.
16:55
Right. They work with them all the time. Exactly.
16:57
They are selling different offerings to these
16:59
exact same massive pension funds and mutual funds
17:02
week after week, year after year. Those funds
17:05
generate enormous ongoing commissions for the
17:07
bank. However, the underwriter only has a one
17:11
-time transactional relationship with the Vancouver
17:13
software company going public. Just that one
17:15
IPO. Yes. Once the IPO is done, the company is
17:19
unlikely to need those specific services again
17:21
for a very long time, if ever. Which casts this
17:23
entire wealth transfer in a completely different
17:25
light. It really does. If we connect this to
17:28
the everyday listener tuning in right now, if
17:31
you have ever sat at your computer and wondered
17:33
why... As a retail investor, you can almost never
17:37
get your hands on shares of a hot IPO at the
17:39
original offering price. This structural conflict
17:42
is exactly why. Precisely. The allocation of
17:45
those highly demanded, intentionally underpriced
17:48
shares is entirely discretionary, right? The
17:51
underwriter has total control over who gets them.
17:54
Complete control. And that allocation is essentially
17:57
a highly valuable favor. It is a gift of instant
18:01
built -in equity, handed directly to their best,
18:04
most favored institutional clients to solidify
18:06
their ongoing business relationships. It is the
18:09
definition of a structural conflict of interest.
18:12
The underwriter is sitting in the middle, attempting
18:14
to serve two masters, the issuing company they
18:17
are advising and supposedly protecting, and the
18:20
massive institutions they are selling the shares
18:21
to. And the pricing mechanism, as we see time
18:24
and time again, consistently transfers wealth
18:26
from the former to the latter. Wow. But even
18:30
with all this careful engineering and all this
18:32
intentional underpricing designed to guarantee
18:34
that opening pop and keep the institutions happy,
18:37
the public markets remain unpredictable beasts.
18:40
Very true. What happens if the underwriters miscalculate
18:44
the mood of the market? What if, I don't know,
18:46
macroeconomic news breaks that morning and the
18:49
stock actually starts to crash on day one, threatening
18:52
to become that nightmare broken deal you mentioned?
18:54
They must have a mechanism to stop the bleeding.
18:57
They do, and it is a highly specific legally
19:00
regulated mechanism known as the over allotment
19:03
option, though it's more commonly referred to
19:05
on Wall Street as the green shoe option. Green
19:07
shoe option. OK, let's really slow down and look
19:09
at the mechanics of the green shoe, because the
19:11
way they engineer a price flow here is fascinating.
19:14
How does this actually work in practice? Well,
19:16
when the underwriters and the company initially
19:18
structure the legal paperwork for the deal, they
19:21
include a provision that legally permits the
19:23
underwriters to sell up to 15 percent more shares
19:26
to the public than the company originally offered.
19:29
OK, let me stop you there. So let's go back to
19:31
our 10 million share offering. OK. Under the
19:33
Green Shoe Provision, the underwriters actually
19:36
go out and sell 11 and 1 half million shares.
19:39
Exactly. Wait, how do they sell 11 and 1 half
19:41
million shares if the company only authorized
19:44
and created 10 million? Are they just inventing
19:47
shares out of thin air? Not out of thin air,
19:50
but through the mechanics of short selling. They
19:52
are legally borrowing that extra 1 and 1 half
19:54
million shares. Oh, I see. By selling shares,
19:57
they do not technically yet, the underwriters
20:00
are deliberately creating a naked short position
20:03
for themselves. Now let us imagine the market
20:05
opens and the price immediately begins to fall
20:08
below the twenty dollar issue price. The underwriters
20:11
step into the open market and they actively buy
20:14
back those one and a half million shares they
20:16
shorted. I see. By stepping in and buying a million
20:20
and a half shares they are creating a massive
20:23
surge of artificial demand. It's like installing
20:25
a giant invisible trampoline under the stock
20:28
ticker on opening day. They are engineering events
20:32
absorbing all that selling pressure to forcefully
20:34
stabilize the price. That is precisely the mechanical
20:37
effect. They cover their short position and in
20:41
doing so they halt the price slide. Wow! This
20:43
is exactly why you will sometimes observe a newly
20:47
minted IPO trading oddly flat, just hovering
20:50
just barely above its issue price for days or
20:53
even weeks. Oh, I've seen that. Right. It is
20:56
not necessarily pure organic market demand keeping
20:59
the price suspended there. It is often the syndicate
21:02
of underwriters actively stabilizing the stock,
21:05
buying shares to support the price using this
21:07
fully disclosed entirely legal stabilization
21:10
tool. It is truly remarkable how much financial
21:13
and psychological management is happening completely
21:15
behind the curtain just to manage our perception
21:18
of a company's success on opening day. It really
21:20
is an intricate system. So to bring all of these
21:22
complex threads together for the listener, what
21:25
are the most crucial takeaways from our deep
21:27
dive today? Well, there are a few. First and
21:29
foremost, we have to fundamentally rethink how
21:32
we read the financial news. When you see a glowing
21:35
headline about a stock popping 40 % on its first
21:39
day, that is not a triumph for the issuing company.
21:42
It is a massive, tangible cost. It is millions
21:45
in wealth they surrendered to day traders and
21:48
institutions. Absolutely. Secondly, we must always
21:52
remember to look beyond the simplistic numbers
21:54
on a trading screen. The true cost of underwriting
21:57
is entirely invisible until you force yourself
22:00
to open and read the prospectus. Right. You must
22:03
look for the net proceeds line item. to uncover
22:06
the true spread the dealer is actually extracting
22:08
from the company's capital. Right. Look for the
22:10
net proceeds. And finally, always keep an eye
22:13
out for these structural conflicts of interest,
22:15
especially after the dust settles. Oh, definitely.
22:17
For example, you will often notice that analyst
22:19
research from the very banks that underwrote
22:21
the IPO goes completely silent before the offering.
22:24
Then suddenly, it resumes with glowing, highly
22:27
positive buy ratings right after the regulatory
22:30
quiet period ends. Just remember, those exact
22:34
same firms just earned millions of dollars in
22:36
fees from that very company and they want the
22:39
stock to succeed. You really must weight their
22:42
enthusiastic reviews with a heavy dose of reality.
22:45
Which leaves us with a lingering... Somewhat
22:49
uncomfortable thought to consider long after
22:51
we finish our discussion today. What's that?
22:53
We have outlined how the financial system is
22:55
structurally designed so that underwriters consistently
22:58
and intentionally underprice shares to benefit
23:01
their recurring massive institutional clients.
23:04
Yes. If that is the accepted reality, does the
23:06
public market effectively serve as a wholesale
23:09
discount club for the biggest financial players
23:11
entirely subsidized by the hard work and equity
23:14
of the issuing companies? Oh, wow. That is a
23:17
brilliant and frankly deeply unsettling question
23:19
to leave on. A massive financial system working
23:22
exactly as it was designed to work, just perhaps
23:25
not for the people we originally assumed. The
23:27
next time you see a morning headline celebrating
23:29
a massive IPO debut, you will know exactly who
23:33
is really holding the champagne. Thank you for
23:35
joining us for this deep dive. Keep questioning
23:37
the headlines, keep looking for the hitting mechanics,
23:40
and we will see you next time.