Wednesday, April 20, 2011

The Nature of IPOs

The ZipCar IPO went berserk.  Why do IPOs sometimes soar in price?

During the heyday of the 1990's everyone who had an idea and a startup company wanted to do an IPO.  IPO, IPO, IPO!  It was all that everyone talked about.  Create a company, get listed on the exchange, and do an Initial Public Offering.

And in those go-go days of the "dot com" era, companies would offer stocks at an IPO for $50 a share and see it top $100 a share by the end of the day.  Everyone was buying stocks!  Buy, Buy, Buy!  After all, it was the go-go 1990's and as the Motley Fool told us, you can't go wrong buying stocks!

But what did this all mean?  And why did the stock prices spike so quickly?

When you do an IPO, you sell off part of the company - to raise capital to expand the business or whatever.  And in an efficient IPO, you want to sell off the parts of the company at a price that brings in the most amount of cash for the company.


Well, not exactly.  You see, there are ways that you can put more cash in YOUR pocket, while screwing your own company, and one way is to under-value your IPO.

Say you are the founder of InventCo, and decide to do an IPO.  You hold, say, 20% of the company's stock.  You price the stock at $50 a share for the IPO.  On the day of the offering, the price goes ballistic.  Of course, you sell off a big chunk of your shares, and finally "cash in" on all of your hard work. 

The idea that your company is under-funded as a result, doesn't seem to bother you.

And this is exactly what happened, over and over again, during the excesses of the "dot com"era - IPOs left money on the table that the company could have used to expand and survive.  But instead, institutional investors got in on the sweetheart deals and got the stock for cheap.  They hyped the snot out of the stock, the price soars, and everyone who was a founder or an initial investor, sells out.

And who buys these stocks at the inflated prices?  Oh, well, you know, stock-picking chumps like you and me

And we bought them, like I am sure people are buying ZipCar, because of the hype and the brand name recognition - and not because of some detailed financial analysis that showed that the company doesn't know its own value.

I saw this again and again - people borrowing money on credit cards to buy stock in or whatever.  It doubled in value the first day - surely it will keep going up, up, up, right?

Well, not exactly.  Once the dust settled on the "dot com" era, it became abundantly clear that most of these companies had no real workable business plan.  Or if they did, it was not unique and could be readily copied.  Or it was unprofitable and showed no signs of profit.

And eventually, all the silly-talk and the happy-talk died down and people started dumping these stocks as they sobered up and realized they had bought a pig-in-a-poke.

And the big dot com crash happened.  And who got burned the worse?  Yea, the little guys.  Chumps like you and me who thought they could time the market or stock-pick their way to success.

Let that be a lesson to you!

But a lesson not so well learned.  ZipCar, which I wrote about before, recently did an IPO and left millions of dollars on the table.  Institutional investors and the founders no doubt made out - and sold out at the inflated prices.  And you the chump who bought, what did you get?  You basically paid off the staggering debts of a concept company that has an easily copyable business model and has yet to show a profit - and has already purchased its only other money-losing competitor.

Where is the upside in this?  While the concept "works" in certain cities, it doesn't work in others.  Zipcar might work in Manhatten (not without troubles, New Yorkers are notoriously, well, abrasive) and hippie enclaves like Ithaca, New York.

But Syracuse?  Rochester?  I doubt it - too diffuse, not enough income, not left-leaning.

What about sprawl cities like Houston, Dallas, or Denver?  Unless there is a ZipCar parked within walking distance of your home, you ain't going to use it.  And ZipCar only makes sense if you live in a city where you can walk to most things - where you don't NEED a car on a daily basis to commute anyway.

And when you think about that, it describes the staggering majority of Americans today.  ZipCar can work, in a very few places.  Maybe downtown Miami.  Key West?  I suppose.  Some college campuses - yes, but those are very high-risk drivers.

So the idea that this company will grow out of its troubles is, I think, flawed.  And if it shows signs of making money, the concept will be copied, diluting the concept and the profitability.

There is already talk that the regular car rental places are experimenting with hourly car rental concepts. 

And that's the rub right there.  ZipCar really isn't a "car sharing service" so much as it is just another variation on car rentals, which have been around since the invention of the car.

And that's worth $28 a share?  All I can say is, it better become wildly profitable fairly quickly to justify that share price hike. 

And if it doesn't?  Well, hello dot-com bubble, part deux!