Practical considerations for conducting a Series I IPO

Tess Cameron & Peter Kolchinsky

Tess Cameron is a Principal in Strategic Finance at RA Capital. Peter Kolchinsky is RA Capital’s founder and Managing Partner.

November 12, 2021

Biotech board members and management teams are increasingly asking how their companies can benefit from what RA Capital and others call a “Series I” IPO process (also known as a data-driven or logic-based IPO). A Series I deal follows a rigorous price discovery process and awards meaningful allocations only to investors who demonstrate their conviction unambiguously with the timing, size, and price of their orders. The principles behind this approach expose the myths that too often steer a conventional IPO process. Series I deals are specifically designed to prioritize a company’s interests. (You can read our rationale and see the step-by-step process in detail here.)

Two principles define a Series I IPO:

honoring insider allocations in exchange for price discovery, and
ensuring that the CEO decides allocations to new investors.

There’s more to it, as you’ll read below, but those two rules are foundational.

To date, at least a dozen companies have successfully followed some version of the Series I process. If you’re getting ready to go public, you might have some practical questions about how Series I IPOs work. Here we’ve compiled recent questions asked by biotech CEOs who are considering the process. Tess Cameron, RA Capital’s Principal, Strategic Finance, and Peter Kolchinsky, RA Capital’s founder and Managing Partner, give candid answers. (If you’re not a finance guru, fear not - we’ve linked definitions to key terms.)

And if any of these responses leave you with more questions, you’ll likely find every answer you need on our dedicated Series I page. Have a question we haven’t asked? Email us and we’ll add it to the list.

Q: Will running a Series I process dissuade some investors from doing proper diligence because they assume they won’t get an allocation in our deal no matter what they do?

A: Short answer? No one worth allocating to will be dissuaded.

Conventional IPOs reward so many investors with small, flippable amounts that no one really has to do much diligence. Each group needs to appear to do diligence so management thinks they care about the company, but many are really only feeling out how hot the deal is. If they sense it’s hot, they line up waiting for their flippable allocation and then flip it, sometimes for a gain and sometimes for a loss. Many won’t hold the stock for long because they were never interested in a fundamental position in the first place.

The most common reason we hear for why CEOs allocate small amounts of stock to many investors (instead of larger amounts to the few who want them most) is that management thinks they are giving lots of investors a starter position to build on in the open market. Later, when investors flip out of those positions and management asks why, investors can say “Because you cut my order back,” even though a flippably small position is exactly what the investor wanted all along. In this way, conventional IPOs create the conditions for speculation and dishonesty.

Fundamental investors who could have been interested in a meaningful position may not be incentivized to sink a ton of time and resources into doing diligence for a conventional IPO because they know there’s no opportunity for them to win a large allocation. These serious investors exist amidst the mob of speculators, but it’s hard to tell who they are, because speculators can pretend to have high conviction by giving large orders without any fear of actually being allocated an amount that is too large to flip.

By running a Series I process, you only risk losing speculators (which might include otherwise fundamental investors who don’t have high enough conviction in your company to put in a large order). Instead, you’ll attract serious investors who will do proper diligence, since you are offering them an opportunity to build a meaningful position.

Q: Who really makes the allocation decisions in a Series I IPO? I know you say management does, but - really? Are bankers on board with this?

A: We mean it - management is responsible for making allocation decisions, thereby determining who the company’s new shareholders will be. As a CEO, you should make sure investors know from the beginning that you are running a process that will allow you to prioritize meaningful allocations for only a few new shareholders. Sure, you’ll take advice from your bankers, board, and anyone else whose input you value, but management is in the best position to integrate all that feedback into a recommendation that is best for the company and its shareholders. It’s essential to set this expectation early (e.g., during bake-offs).

While bankers ought to convey your approach to prospective investors before you meet them during Testing-the-Waters (TTW) meetings, not all of them have learned how to convey a logic-based approach to investors. It goes against tradition. So it will likely be up to management to let investors know how you will be making allocation decisions - ideally in advance so the outcome comes as a surprise to no one. Let investors know that you are exclusively looking for high-conviction orders (e.g., early orders; >$10M true demand) from groups with strong track records who demonstrate and communicate a genuine understanding of your company’s value proposition.

What does that sound like? It can be as simple as: “We plan to keep allocations to new investors in the IPO pretty chunky, so are looking for investors who really want to establish a sizable position. We may fill orders in full (so don’t inflate your orders) and won’t allocate less than $10M. If you think that this might be appealing to you, we hope you’ll let us know of your interest and order size as early as possible.”

Reassure investors that it is management who calls the shots, not bankers, board members, or major shareholders. If investors still say they feel worried they will waste time meeting with your company, that’s probably because they know that your process will reveal their lack of conviction and intent to speculate in your IPO (meaning they were planning on wasting your time and now are worried that they might be wasting their own time). Those are not the investors you want.

Q: How do I know which investors are “high-conviction” investors?

A: Realize that you are basically guaranteed to hear every investor say nice things to you about your company and describe the thoughtful ways in which they invest. What is their incentive to do otherwise? Have you ever met an investor who DIDN’T say they were “long-term oriented”? So don’t just listen to what investors say. Examine how they act. Look at their 13Fs. Consider whether the allocation they want would preclude a quick flip.

Here are some telltale signs of a high-conviction order:

early

roadshow)

large

¹

reasonably price-insensitive

track record

shows sincere interest

Q: Why do you argue that only large allocations (>$10M) matter? When a prospective investor who has done solid diligence has to be turned away based only on the fact that their fund is small and therefore even $5M is a big check for them, this is a problem for me.

A: There are small funds out there that may be really into you. However, there are also lots of small funds that recognize that their small size gives them an excuse to claim that small orders are indicative of their conviction and that take advantage of that fact to win allocations that they then flip. A fund need only have $100M of US-listed securities to be subject to 13F filing requirements. So just about any small fund you talk to is likely to be big enough for you to judge them by their 13F record. If you see they have a track record of holding positions in companies like yours, that’s a positive sign.

At the end of the day, if you price a Series I correctly, you’ll leave plenty of real demand on the table to absorb any shares you may have misallocated to speculators. So if a small fund manager really wins you over, there’s no rule that says that the CEO can’t exercise their judgement to fill a <$10M order. But consider the risks that less proven managers may pose. A small fund with less of a track record may be hit with redemptions during a difficult market, which would obligate them to liquidate their positions, including yours. A large fund is more likely to weather bad market conditions. So is your duty to give a small fund’s manager a break or to look out for your company?

Q: Isn’t part of the reason to do a Series I IPO to boost the step-up from the crossover round? Yet I’ve observed that Series I deals don’t always result in a higher step-up than a traditional process might. Does that mean they failed to do what they were supposed to?

A: When there really is a ton of genuine demand for your stock, a Series I will do a better job of discovering that investors consider a higher price to be fair than a conventional IPO will set, so you may benefit from an above-average step-up. But if there is low demand, a Series I may very well set a fair IPO price below the level that a conventional IPO would have. The upshot is that a Series I IPO is far less likely to break deal price than a conventional IPO.

True price discovery is not only about maximizing a step-up. It’s about finding a market price at which you have credible investor demand. (We suggest looking for a price at which the book is 2X covered between insiders and credible investors). If the book is covered well beyond that by credible demand, you likely have room to upsize or increase price. Watch out when someone enthusiastically tells you “The book is 7X covered!” to suggest that the stock should trade up. These “gross coverage” numbers often include massively inflated orders from both fundamental investors and speculators who all know that they will be cut back.

An IPO that trades down on day 1 has been overpriced² or else grossly misallocated (e.g., large real orders were cut back to accommodate small flippable allocations to speculators). Is your stock breaking its IPO price the end of the world? No. But it can be demoralizing for employees and for your fundamental investors who invested super pro rata (who may feel that you intentionally or naively let speculators interfere with proper price discovery)³. You also may not be able to exercise your full greenshoe since the bank may use it to defend the stock below deal price.

A common reason for the IPO step-up to be more modest than management may have expected is that market conditions have deteriorated since the crossover round. For example, any company that completed its crossover round towards the end of 2020 or in January 2021 when biotech markets were strongest would have been lucky to properly price their IPO at any step-up at all later in 2021 after the biotech sector turned sharply down (as opposed to overprice and break deal price, as quite a few did).

There’s no escaping the harsh realities of the market. It’s just a question of whether you acknowledge them in the IPO or soon thereafter. Investors seeking to invest a lot in the IPO would rather that reality be priced into the IPO rather than afterwards.

In difficult markets, investors get wise to how the conventional IPO process results in overpriced IPOs. For example, 2021’s difficult market conditions are driving some insiders to make clear that their orders are contingent on IPO allocations being chunky, even specifying sometimes that they don’t want new investors getting less than $10M (i.e. no speculators welcome). In other words, insiders are asking for a Series I because they know it arrives at a fair price reflective of true demand and is therefore more likely to hold up post-IPO.

Q: Why does the stock for so many Series I IPOs pop on day one? Does this mean they were priced too low?

A: Pops on relatively low volume represent trading noise and do not offer any evidence that the company could have raised hundreds of millions of dollars at a higher price. This applies to all IPOs. If a stock trades up sustainably on consistently high volume suggesting that there was hundreds of millions of dollars of real demand at higher prices, then it’s possible that the company could have done its IPO at a higher price.

Because Series I IPOs typically have true excess demand such that some investors are willing to bid higher than deal price, it’s logical that they’d have some pop. This can make the stock’s opening dynamics look very positive, which attracts another group of momentum players who say “This stock must be working; let me jump on this trend!”, driving the stock up even further.

Extended periods of time trading well above IPO price will shift shares from the investors management has selected (since they can logically be expected to trim their positions) to others - possibly speculators drawn to a momentum trade, who could be just as quick to dump if the stock wavers. This is particularly damaging in deteriorating market conditions and can explain why even a Series I IPO can’t guarantee that the stock will always trade above IPO price.

Day one spikes are distracting. But the goal is not to avoid a pop. The goals are to avoid the stock breaking deal price in the days and weeks after the IPO and to set the company up with engaged shareholders who will be attentive to the company.

Q: Will a company that runs a Series I process be more successful in the long run?

A: In the longer term, a company’s fundamentals - its data - are what will determine the fate of its stock. Speculators create noise but don’t help a company, and a Series I simply keeps speculators out of the last “manually priced” financing a company will ever have to do.

Think of running a conventional IPO as taking a risk that some shareholders will feel fooled or taken advantage of - you can do that once, but it’s harder to do twice. A Series I is honest and transparent; no one gets fooled. However, no company IPOs more than once. So one can argue that a company can IPO any way it wants because that company will never have to IPO again.

However, the biotech community is small. Investors engage with companies based on their experiences with other companies. So when investors have a good experience with one Series I, seeing that they were able to win a meaningful allocation in a company they really liked by participating in proper price discovery, they’re likely to continue to engage with each subsequent company that says it’s doing a Series I.

In terms of financial return, a Series I process may reveal that investors really are willing to pay more than bankers might have guessed, which will result in less dilution for founders and insiders participating sub pro rata in the IPO. At the same time, if a company is in a weak position, it’s possible that a Series I might end up discovering a lower price for the IPO than a conventional IPO would, which will mean that insiders participating super pro rata in the IPO will generate a higher return in the long run from a Series I than a conventional IPO.

Considering the advantages that a Series I offers to a strong company, it’s hard to see why a company that believes it is strong would elect to do a conventional IPO.

When a company says it’s not doing a Series I, that’s akin to saying, “If you tell us you're sincerely interested and want a big order, we’ll use that information to jack up the price. In the end we'll still allocate little to you, preferring to spread shares across lots of speculators, which will increase the risk that the stock will break deal price. So you might not even want to buy much in the IPO - instead, leave dry powder to absorb the shares that we know will be dumped by speculators.” It’s such a silly message to convey that one has to wonder why any company would choose to do a conventional IPO when others are doing a Series I.

Q: Won’t it be difficult, uncomfortable, and time-consuming to run a price discovery process on my own? Will investors be willing to have such frank conversations with me?

A: Running a Series I process requires extensive preparation and forces continual assessment of pricing and demand throughout the IPO process. It’s harder than going along for the ride in the standard process. But it will give you a much better sense of where you stand with your investors, which will forever inform your view of their behavior and prepare you for the future.

The conventions baked into a traditional IPO assume distrust. Investors are encouraged to fib about demand and management is encouraged to betray their most loyal, committed investors (cutting back insiders and new, high-conviction investors to make room for speculators). That’s no way to make a public debut.

Conversely, the Series I process forces management teams to have what may be uncomfortable conversations with investors who are not used to having to reveal their real demand or price sensitivities. But it is exactly that discomfort that helps you understand who is and is not a high-conviction investor.

Management teams that have conducted such a logic-based IPO tell us they have built lasting relationships with their new investors because of these conversations. This is how trust is built.

Considering an IPO? Try a logic-based approach. Review RA Capital’s roadmap for running a rigorous price discovery and allocation process and consider for yourself all the data supporting "Series I" logic over myth-based conventional IPOs here.

Please click here for important RA Capital disclosures.

¹ The best way to learn about a real order size or an investor's lower bound is to ask. Have the CFO or member of the pricing committee follow up directly with the individual who took the meeting to see if they confirm their interest and lower bound. You'll learn a lot from someone who puts in a $25M order and says, “We really want all of it - please don’t cut us back!” versus someone who says, “We'd be fine with $5-$8M,” signaling that they are hoping for a flippably small order, which is a signal to exclude them from the allocations.

² If to fill the book management has to allocate to investors who only want small, flippable orders, then it means that the IPO was overpriced. Had it been priced lower at a price that was more attractive to fundamental investors, management would have been able to fill the book with chunkier orders without resorting to allocating small, flippable amounts to anyone. That would have likely averted anyone selling at the IPO price and therefore the stock would not have broken deal price.

³ An IPO is a unique type of financing in that it’s the only round that has the manual price discovery expected of a private round and yet gives investors no visibility into who they are investing with. Therefore, in an IPO, investors have to trust management to conduct proper price discovery and set price at a level that reflects real demand from fundamental investors. In the case of a private round, investors typically see who else is in the round before they close and can make their participation contingent on a credible lead investor, meaningful insider participation, etc. And in the case of a follow-on public round, the deal price is anchored to a daily traded price (usually a <10% discount to where it recently traded), so investors can judge for themselves what the broader financial markets consider a fair value before putting in orders even though they can’t know who else is investing in the follow-on. Even if speculators participate in a follow-on, their impact on the deal price is modest. So a Series I process solves for IPOs suffering the worst of private financings (manual price discovery) and public financings (lack of transparency into sincerity of interest of fellow participants setting the price).