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Understanding IPOs

This article appeared in the December 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Knowing who can sell shares - and when - can be a big factor in some floats.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

Initial public offerings (IPOs), where companies are broken up into many tradeable units (shares) and sold to hordes of eager investors, have been around for a very long time. The first was back in 1602 when the Dutch East India Company went public.

It was a legitimate company that delivered great profits to its shareholders, but in the 400 years since that first float there have been plenty of others that have not exactly been on the straight and narrow.

One of my favourite float scam stories is that of the Electrolytic Marine Salts Company. In the late 1890s a Baptist minister, Prescott Jernegan, claimed he had received a "heavenly vision" that enabled him to extract gold from seawater. Jernegan saw the opportunity to convert his God-given skill into a profit-making scam.

But first he needed to give it some credibility, so he enlisted the aid of a lifelong friend and confidence trickster, Charles Fisher, a professional sea diver. Jernegan constructed a box he called the Accumulator and claimed it could collect gold when dropped into the sea. To legitimise his claim, Jernegan invited an unwitting jeweller, Arthur Ryan, to come and take a look.

Ryan dropped the Accumulator off the end of a pier at Narragansett Bay, Rhode Island. While Ryan waited for gold to accumulate, the accomplice Fisher donned a diving suit, swam under the pier and slipped a few gold nuggets into the submerged box. Ryan retrieved the box and confirmed the gold was genuine.

Off the back of his now apparently legitimised business model, Jernegan set about establishing a listed company and stock in the Electrolytic Marine Salts Company was offered at $1 a share. The first tranche of 350,000 shares sold out in three days and investors demanded more. Within weeks, $2.4 million worth of stock had been subscribed.

How did the story end? Jernegan and Fisher shot through with the $2.4 million without as much as a goodbye.

I need to add that the same thing could not happen today and the reason is what this article is about: restricted or escrowed securities.

Restricted securities

Restricted securities, as the name implies, are shares that have restrictions placed on them. Their owners cannot sell them until a specified period of time has elapsed, referred to as the period of escrow.

Jernegan and Fisher would not be able to pull the same stunt now because today's stock exchange listing rules would demand their shares be locked up in escrow for a couple of years. That would allow sufficient time for their gold accumulator claims to be tested before they could sell the shares.

The concept of placing the holdings of certain shareholders in escrow is an important factor in maintaining the integrity of listings and the market overall. Watching directors selling stock in the early days of a listing is not a good look, something which could potentially damage the market's perception of the company, even if its business model is a legitimate one.

Whose shares are likely to be restricted?

It is important to know that whether shares are classed as restricted or not is determined on a case-by-case basis. Typically the escrow provisions apply to businesses that are substantially speculative, or do not yet have an established track record.

But, like other stock exchanges around the world, ASX has established some pretty clear guidelines on the matter. A summary can be found in Appendix 9B of the ASX Listing Rules but the following lists those people who are likely to have their shares placed into escrow:

  • Early investors, that is investors who were issued securities or the right to subscribe for securities, before the issuer being approved to list
  • Vendors who have been issued securities in exchange for assets or services they have provided. This could include sellers of assets to an issuer, professional advisers who accept securities for their services, or promoters of the issuer's capital raising.
  • Current directors of the company.

The period of escrow varies but is typically 12 or 24 months.

ASX is unlikely to place escrow limitations on a soon-to-be-listed company if it meets certain requirements, for example if the company already has a profitable track record or has an acceptable revenue stream. Escrow limitations are also unlikely if the company holds substantial assets that are either tangible or of a readily determinable value.

One way a company will almost certainly bypass the escrow requirement is if it meets the ASX profits test (that is, unless ASX decides otherwise). The test is a series of profit-based requirements outlined in the Listing Rules. To meet this test the company must be a going concern, present at least three years of audited accounts, and clear minimum profit hurdles.

Interestingly, even if the ASX requirements are met, some founding shareholders or existing directors choose to voluntarily escrow their shares. A common reason is the belief that it will improve the marketability of the offer. For example, in this year's Spotless float both the chief executive officer and the chief operating officer placed shares into voluntary escrow despite Spotless clearly meeting the profits test.

Should restricted securities be considered in an IPO assessment?

There are a couple of things to be considered when looking at an IPO that involves restricted securities.

First, you need to ask why ASX deemed an escrow arrangement to be necessary. Study the company's business model closely, to understand why some shares are restricted.

Second, will an escrow arrangement affect the value of the non-escrowed shares? After all, a hangover of shares is created that potentially might one day be dumped onto the market when the escrow period expires.

My simple answer is no, it should not affect the value you place on the shares you are thinking of buying in the IPO. That is because (despite the difficulty in determining it) shares are worth the present value of the future cash flows they will deliver. So in that respect the whole issue of whether other shares are restricted is a bit of a sideshow.

What about the short-term price effect, when the escrow period is over? The answer is that it depends on a number of factors:

  1. Maybe the holder of the previously restricted shares will not sell the shares.
  2. If they do sell, sharemarket sentiment at the time is important. For example, when sentiment is high it is more likely there will be lots of willing buyers to support the price.
  3. How many shares might the seller be trying to sell, and how will this number compare to a typical day's trading volume for that stock?

Even after considering these issues, remember that there is one inescapable economic reality when considering the worth of any share: over the long-term, value is driven by the profits the business delivers, not by short-term trading aberrations.

If you are a trader hoping to make a quick buck from short-term price moves following the release of escrowed shares, don't get too excited. It is difficult to know exactly when any of those potentially large shareholdings are going to be dumped onto the market. That is if they come onto the market at all.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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