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Why disclosures fall short
Throwing everything into the disclosures makes an already dense and impenetrable S-1 even denser, and it only superficially covers regulatory risk. What translates into the market is a watered-down expectation for the IPO sellers and a much larger margin of safety for the IPO buyer.
How buyers price risk
Take rough numbers. A company on a $100 billion run rate that would have cleared at a $2 trillion market cap in a clean sheet IPO lands at one trillion or less. Hedge funds, pension systems, and long-only mutual fund complexes have a fiduciary responsibility to their sources of capital, so they justify each risk by asking for a lower and lower price.
Finding the clearing price
That is how a market clearing price gets found, and it can come in far below what anybody expects. Once the risks are priced, the noise is cleared and the company can simply run its business as a corporation.
Why do IPO filings list so many risks?
Under Section 11 of the US Securities Act of 1933, a company and its directors can be held liable if a registration statement contains a material misstatement or leaves out a material fact. Lawyers respond by listing every risk they can foresee. A risk factors section is required in a prospectus by SEC rules. As a result, filings often run to hundreds of pages.
How does risk lower what a company is worth?
In discounted cash flow valuation, an investor adds up a company's expected future cash and discounts it back to today. A riskier company is discounted at a higher rate, which shrinks the present value. Even a small change in the rate moves the result a great deal when the cash lies far in the future. Growth companies with distant profits are therefore especially sensitive to the rate chosen.
Why are IPOs often priced below demand?
Economist Kevin Rock argued in a 1986 paper that IPOs are underpriced to attract uninformed investors who would otherwise avoid the shares. Professor Jay Ritter of the University of Florida has documented that US IPOs gained an average of roughly 15 to 20 percent on their first day over several decades. The gap is money the selling company does not collect. Economists call that gap money left on the table.
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