IPO: The Epitome of Disillusionment

By Phil Cutajar - June 20, 2012 | Tickers: FB, GRPN, LNKD, SPLK, YELP, ZNGA | 0 Comments

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An Initial Public Offering (IPO) is presumed by many as a great opportunity to profit from getting in early on a growing young company. But enthusiasm for IPOs is grossly misplaced and many have been left feeling stung with mounting losses following some of the most hyped IPOs.

Record Flops 

Facebook's (NASDAQ: FB) IPO on May 18th, 2012, raised $16 billion and became the largest Internet technology IPO in history.  At the offering price of $38/share, the company was valued at over $100 billion. That’s quite an accomplishment for a company started by a college dropout just seven years ago. But within a couple of weeks the shares rapidly retreated 46% to $26/share. Facebook rebounded to $30/share, about 26% below the initial offering, but the company has been slammed with a steady stream of lawsuits from shareholders. The lawsuits allege the company shared important financial and growth projections with big banks but kept the information from investors at large.

Zynga (NASDAQ: ZNGA), the social gaming company closely linked to Facebook, suffered a similar thrashing, priced initially at $10/share, now trading around $5. In recent filings Facebook disclosed Zynga's ads accounted for 7 percent of its revenue last year, and another 12 percent came from Zynga's payment processing fees. Misery must like company.

Another high-profile loser is Groupon (NASDAQ: GRPN), priced initially at $20/share last November, now flirting with $10. In March, Groupon restated its quarterly report, stating it lost more than initially reported because it paid out more refunds than expected. In May, it replaced two board members to add executives with more accounting experience.

Wall Street Strikes Again

The Facebook scandal has seemingly revealed yet another dirty face of greedy Wall Street banks. Already suffering from poor public perception since the 2008 financial crisis, Wall Street now has a new poster child to adorn their growing collection of public scorn; Mark Zuckerberg. The sense that elite insiders and ultra-powerful investment banks prey on unsuspecting and naïve average Americans is nothing new. But the Facebook IPO has rekindled these concerns and elevated them to new heights.

There are hundreds of IPO filings every year; more than 260 in 2011 and over 2,000 filings since 2003. Facebook's IPO was different than most however, their estimated 900 million subscribers is a surreal benchmark, reflecting the tremendous public awareness of the company. Facebook has become a cultural icon of sorts, snaring a lot of neophytes who were lured into the IPO by the social networking giant's popularity.

The damage inflicted on the public perception of the stock market feeds long-lasting personal biases. These recent stingers underscore a common misconception; that anyone can make money in an IPO.

IPO Stands for Cashout

Decades ago when a company needed capital to grow the business or pay off startup debts it would file for an IPO. The capital raised by selling shares to the public doesn’t have to be paid back. In exchange the shareholders get voting rights in the company, and absent affirmation many believe the money raised from an IPO goes towards growing the company. Some of it still does, but increasingly it goes into the pockets of the founders, insiders and firms who funded the venture. And the voting rights are disappearing too.

Here are some key facts;

• Mark Zuckerberg pocketed about $1.1 billion from the Facebook IPO, and gained an additional 3% voting power, raising his voting stake to 57.3%. Goldman Sachs cashed out half of its holdings for $1 billion. Russian investor Yuri Milner sold as much as 40% of his holdings in the IPO. In fact, 57% of the shares offered at IPO were from existing shareholders. The class “A” shares sold at the IPO account for just 3.7% of the voting power.   
• Zynga’s chief executive, Mark Pincus, allegedly sold $109 million in shares at $14/share prior to the IPO, and received an additional $200 million in the secondary offering. Bing Gordon, Union Square Ventures, SilverLake Partners, Institutional Venture Partners and several company executives also cashed out tens of millions prior to or since the IPO. Zynga’s class “A” shares amount to just 2% of the voting power.
• While the founders of Groupon didn’t sell their shares at the IPO, 84% of the $1.12 billion raised in venture capital was spent as cash payouts to its 3 founders and early backers. Co-founder Eric Lefkofsky received over $300 million and Bradley Keywell received $130 million. The payouts allegedly made Groupon technically insolvent at the time of the IPO. The founders also retained 58% of the voting rights.

Nowadays most hot startups can get plenty of capital without going to an IPO. Venture capital and hedge fund money is available and anxious to be put to work. These firms actively pursue startups to invest in and find hot new companies long before they become a household name. The payback is the IPO. That’s when they get their money back, plus much more.  

Investor or Trader?

IPOs can be very tricky. Although there are quite a few losers, there are some winners too. LinkedIn (NYSE: LNKD) was offered at $45/share last August and now trades for $102/share. Rating site Yelp (NYSE: YELP) climbed 64% on day one, it has retreated some but it is still trading 40% above the offering price. Splunk was offered at $17/share in May and is now trading north of $32/share.

There is no clear pattern to IPOs. But what is clear is their volatility; 20-30% swings within days are commonplace. For day traders and short-term investors these young companies are fertile territory. But unless you are an insider or know the company really well, it is probably best to avoid them.

Long-term investors looking for consistent returns over a lifetime have very little information about these companies to act upon. Until they start filing public statements there is no way to confirm the management team is capable of growing the business, producing consistent profits, and dealing with the micro and macro economic cycles.  Absent such evidence, putting your money into such companies is equivalent to cashing out your 401K and spending the money on lottery tickets. You might get lucky, but most likely someone else wins and you will lose.

Invest wisely, my friends.

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