Tuesday, May 29, 2012

My Short Life With the Big Firm

For a very brief time, I worked at a law firm that did Venture Capital Placement and IPOs.  It was an eye-opener.

Sometimes, I think I am not very bright.   After all, I don't understand things that other people seem to think are really smart deals.   For example, when I was in Ft. Lauderdale in the 2000's, everyone was buying Real Estate and jacking prices through the roof.  On paper, everyone was a Millionaire.   But it troubled me that it seemed like a Ponzi Scheme - no one actually had money, other than borrowed money based on inflated Real Estate Values.

So I cashed out my investments and got out of the game.  I didn't understand why the market went berserk, and why this would be sustainable.   And smart people told me I was an idiot, and gave me lengthy explanations as to why it was a rational market and I was the fool.   And after 20 minutes of such explanations, I was no more the wiser.  So I must have been the idiot, right?

Well, maybe I was just an idiot savant.   As it turned out, my "smart" friends are all broke, upside-down on houses, facing bankruptcy or eviction, and I am living in a house that is paid for.  Who's the fool now?

The same thing happened when I took a job with a big law firm that did IPO and Capital Placement.  There were lots of companies in Silicon Valley, and even back East, that wanted to go public or find investors.  And our firm did a lot of this work, and tried to act as hip and cool as the Silicon Valley outfits that were our clients.

I couldn't understand why this was such a big deal and how people, other than the Lawyers, made money.  We would find some small start-up company that had two computer geeks and an idea, and then "place" Venture Capital with them.  During the "closing" we would celebrate with Champagne, and as one partner told me, "Get them to sign off on the bills, before they sobered up."

Why?  Because the next day, they would sober up and realize they sold off 95% of their company for a few million dollars, the lion's share of which went to our legal fees.  The people who started the company had little incentive at that point to make it succeed.   And the VC firms often ended up with little to show for all their cash.   I could not understand why this was a good thing for anyone involved, other than the partners at the law firm.

IPOs made even less sense back then.   In that "dot com" boom era, companies would do Initial Public Offerings, where blocks of shares would be "subscribed" to friends of the Wall Street Bankers at IPO prices.  So, for example, XYZTECH company would "go public" at an IPO share price of $15.   The subscribers would then buy their shares at $15 and immediately resell them for $30, making a 100% profit in a matter of minutes.

And everyone would cheer what a wonderful IPO it was! 

But again, being stupid, I would ask stupid questions.  "If the stock was worth $30, why not price it at the IPO at $30?   The company would realize twice as much money from the IPO instead of just handing over half the cash to some insiders who happen to be friends of the Underwriters?"

And one of the Partners at the firm would shush me and tell me I was an idiot.

But it is a valid question and illustrates how these IPOs were raw deals for small investors.  Because it was the small investor who was buying at $30, not understanding anything about the business, the P/E ratio, profits, or whatever.   They were buying stocks like some folks buy tickets at the horse track - with dreams of avarice, hoping a long-shot will come in, and perhaps liking the name of the horse.   But long-shots rarely do come in.

The real answer to the question is, of course, that people on the inside get to cash out.   That is who is making money.  And the underwriting firm and the lawyers.   By underwriting the IPO, a sure stock price is determined.   And thus, the stage is set for a little pump-and-dump deal, where the stock is hyped in a "roadshow" for weeks, and talked about on the financial channels (throw a few shares at the host, he won't mind!).  Yea, you are giving half your equity from the IPO away, but those two geeks with an idea can now sell their insider shares, and cash out and become real Billionaires with real money, not just hyped-up stock that is really worth nothing.  The Ferrari dealer won't take "dot com" stock in payment.

But needless to say, asking too many pointed questions at a Big Law Firm is not going to make you popular, and I left after only a few months.   They paid a lot of money, but it wasn't worth the hassle.

That was a decade ago.  Today, IPOs are taking a different tack.   They are being offered at initial offering prices, going up slightly in value, and then tanking - for the long-term.  We are seeing this with Facebook, and also with other recent IPOs, such as Zynga, Zipcar, Groupon, and others.  Why is this?

Well, as one commentator notes, the Facebook IPO was a "Brilliant Disaster" in that, while the stock price did not shoot through the stratosphere, the original investors and employees of Facebook who sold their stocks (such as Zuckerberg himself) still cashed out at the top price.  Much of what was sold during that first day were shares owned by insiders, not just the initial subscribers.   So the subscribers may have gotten a screw-job on this, but that means more money for the insiders - and more money for the company.   If they had priced the stock at $19 and let it balloon to $38, they would have lost out on half their dough.

So, perhaps he is right - this "botched" IPO made a ton of dough for Facebook, and a ton of dough for the founders and the early investors (including Microsoft).   But the folks who bought at the IPO price got screwed.   No more doubling-your-money in 10 minutes.   No free lunch.   In fact, they probably stand to lose half their investment, if not more, if they hang on.

But this illustrates why most sound financial advisers say to stay away from IPOs.   Like Commodities trading (and BTW, Gold is a COMMODITY), or Derivatives, they are volatile markets were fortunes are made, and LOST, overnight.   Leave these risky bets to the experts - you as the small investor will inevitably be the chump that the big boys make their money from.

And it illustrates too, the old adage, "Never Invest In Something You Don't Understand."   Or perhaps, it illustrates what this old adage really means.   If you think you are "too stupid" to figure out why the Facebook IPO was such a good deal, maybe you are not stupid at all, but just asking too many pointed questions that people can't answer, without resorting to a lot of hand-waving and smoke and mirrors.

Play dumb.  Sometimes it can be very profitable.  The most fundamental questions are the most revealing.  And when people can't answer them to your satisfaction, you are not an idiot, chances are, they are just trying to deceive you.