Merkado Barkada
October 16, 2024 | 8:20am
Because it helps me follow the money! Long-time readers know how important the distinction between primary and secondary shares can be for something like an IPO or a strategic investment, but for new readers or for those who are new to investing and reading financial disclosures maybe a little explanation is in order.
> “Primary” definition: Primary shares are “new” shares that are issued by the company out of its authorized capital stock. The money paid by investors for primary shares will go to the company. A primary share sale increases the company’s outstanding shares.
> “Secondary” definition: Secondary shares are “used” shares that are held by an investor. The money paid by investors for secondary shares will go to the shareholder(s) selling the shares, not to the company. A secondary share sale doesn’t change the company’s outstanding shares.
> Cash-out vs cash-in: A primary sale (generally) monetizes the company’s valuation to raise more cash that the company can use. New cash comes into the company that it can put toward paying down debt, building new facilities, or launching new products. A secondary sale (generally) is just a market transaction that doesn’t alter the company’s business in any way. A secondary sale might alter the governance of a company by changing the configuration of the company’s board of directors, but it doesn’t have any impact on the company’s financial statements.
> So why is primary so good? In an IPO, I use the sale of primary shares as a signal of potential growth. If the company is selling a large portion (>25%) of secondary shares it makes me question the future growth potential of the company if existing shareholders are so willing to exit at this price. Of course, we cannot enter into the minds of those selling shareholders to know their true motivations for selling, but I don’t give selling shareholders the benefit of the doubt. At the end of the day, if I’m taking the enormous risk that comes with buying IPO shares, I want to know that my money will be put to work to make more money for me and my fellow shareholders in the future. I’m not usually interested in providing a parent company with an easy exit or buying an oligarch another supercar as one might in a secondary sale.
> Is this a hard rule? No, of course not. In the REIT space, for example, there may be valid reasons (time/cost) for a parent company to sell secondary shares of a REIT to increase the public float rather than conducting a public follow-on offering. It’s also quite common for the over-allotment option in an IPO to be made up of secondary shares being sold by one or more of the IPO’s existing owners, but this amount rarely exceeds 10% of the offering and is done so often that it’s honestly hard to draw much (if any) signal from it. For my money, there’s more “signal’ to be drawn from the over-allotment option being primary as well, like we saw with the Alternergy [ALTER] IPO.
MB BOTTOM-LINE: The primary/secondary thing is not a debate like whether halo-halo should come with pinipig (it shouldn’t and deep down you know it), or whether you should call a cat by saying “swswswswsw” or “pspspspsps” (it’s neither: you click your tongue three times and yell: “MEOW MEOW!” in a gratingly annoying tone). There’s not a group of Secondary Stans out there waiting to pounce on anyone still laughing at the 33% secondary Medilines Distributors [MEDIC] offering. You won’t win friends and influence people by knowing this difference, but I think it is important to understand in order to get a better idea about what a transaction is ‘saying”. Are the owners going all-in alongside the new buyers, or are they offloading bags onto a new bunch of suckers? Does the company have the ability to turn new cash into greater earnings, or is the management team out of ideas, and the market already too saturated, for new money to boost profits? I use the primary/secondary question as part of a “balance of factors” analysis. It’s one of several things that I look at when evaluating an IPO. It’s not the only thing, and it’s not even the most important. But it’s significant to me, as a long-term investor, as it helps me confirm/validate other parts of the business plan in the prospectus and get an overall feeling for the management team’s ability to grow the business for the benefit of all shareholders.
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