As the gates opened on Chinese e-commerce giant Alibaba late Thursday, it had the largest initial public offering in history. 

Shares sold at $68 apiece, the high end of its range, making billionaire entrepreneur Jack Ma, who founded Alibaba in his one-bedroom apartment in the 1990s, a staggeringly wealthy guy. 

Alibaba commands nearly all of the Chinese e-commerce market, and its appeal in the U.S. since it announced in March it would list on the New York Stock Exchange has seemed similarly all-encompassing. Still, how to explain why its projected stock price rose to such heights in just a few short months?

For most small companies, setting a valuation is one of the most difficult things to do. And while public and private businesses are entirely different animals, it might be instructive to learn about a couple of the dynamics at play that are yanking Alibaba's pricing into the stratosphere. 

What's Affecting the Price

First things first: In its filing with the SEC this spring, Alibaba priced shares between $25 and $40.

But in recent weeks, there's been an almost continuous increase in the stock price. Alibaba netted an eye-popping $22 billion from the offering, valuing the company at $167 billion. The IPO surpasses that of Facebook, which raised $16 billion in 2012, and the valuation immediately places Albaba in a league with Mark Zuckerberg's social networking company while vaulting it past the American e-commerce leaders Amazon and Ebay. 

The runup was largely due to the demand of large institutional investors that Alibaba and its syndicate of investment bank underwriters approached during is road show. These are all the public market investors, mutual funds, endowments, pension funds, hedge funds, and investment banks that sell shares to their clients.

"The price [kept] getting ratcheted up because apparently the road show went very well," says David Zilberman, a partner at venture capital firm Comcast Ventures.

The initial price valuations are based on numerous factors, including comparisons to other similar companies in Alibaba's industry and the prices at which they're trading. Placement agents, who help entrepreneurs and funds come to terms over the price, will also rely on something called a discounted cash flow analysis. Essentially, that's a determination of the current value of the company, based on projections of cash flow for the future. 

And Alibaba's cash flow numbers, before projections, are pretty high. 

"Alibaba's EBITDA is 59 percent of revenues, the highest of its peer group," says Patrick Chung, a partner at Menlo Park, California-based venture capital firm New Enterprise Associates. 

But it's not all simply a matter of financial analysis, Zilberman says. Placement agents are trying to determine demand--essentially, how "hot" the stock is going to be. In that regard, selling Alibaba's stock is not that unlike setting the price for the latest iPhone 6--how much are people willing to pay?

"The investment bankers suggest a [price] range, and it gets lowered if institutional investors don’t have an appetite, and it gets raised if they want a big allocation," say John Backus, founder and managing partner at venture capital firm New Atlantic Ventures. "Apparently, lots of institutional investors want to own lots of Alibaba stock." 

Another thing to keep in mind is that up until the IPO institutional investors hadn't actually bought the shares. They'd only given a binding indication of interest, Zilberman says, for a certain number of shares up to a certain price. Each time the share price changed, the placement agents have to go back to the interested institutional investors to inform them of the price change. The institutional investors then had to resubmit an indication of interest. 

And as the IPO got under way, there was one other artful element to the $68 share price. 

"The number 68 is a Chinese homophone which can be interpreted to mean 'road to prosperity,'" Chung says. "It's just as elegant a number to pick as when Google offered $2,718,281,828 in its IPO, the product of the mathematical constant 'e' and $1 billion."

Published on: Sep 18, 2014