Thursday, October 5, 2017

Complicated Cons - the IPO

Complicated cons are hard to figure out, so most people can't figure them out.  And since they are often legal, nothing much can be done about them, other than to guard yourself against falling for them.

In a previous posting, I mentioned in passing:

"Throw in a non-protectable business plan and low barriers to entry and, well, you've got a serious problem.  Well, you would have a problem if your goal was to make money.   But the way these "new-tech-that-aren't-tech" companies work is not to make profits for shareholder but to make capital gains for founders and early investors.   It is nothing short of a legal con game."
As I noted before, you can do an IPO and steal money from investors - all perfectly legal.  It isn't really stealing, as stealing is against the law.   So long as your prospectus honestly says what you are doing, it's OK.  Investors are assumed to know better.   So if your prospectus says, "Our goal is to use investor money to go to Vegas and gamble and hire hookers and snort cocaine until all the money is gone" you are perfectly fine, if you end up doing just that.   Hey, you didn't lie about it, didya?

Similarly, you can start or run a company and put in the prospectus or annual SEC reports that you don't think the company has any shot at making it in the long-term, and is in fact, insolvent, and you can still sell stock, take deposits, or whatever - much as Mr. Elio has done with his three-wheel car company.   Hey, he never promised you a rose garden, and in fact, said quite the opposite.   Your fault if you believe the hype and not the SEC filings.

When I was at the big odious law firm (for all of six months) I didn't understand this.  Being naive, I assumed the point of an IPO was to "raise capital" for a company to buy machines and build factories.  After all, my background was in heavy machinery - ball bearing and air conditioning factories which had been in business for nearly a century - and used capital to buy machines and factories and hire people.   This "new paradigm" had me stymied, because it never occurred to me it was all a fraud in a manner of speaking.

We would do an "initial round of funding" for a "dot com" company and when they broke out the champagne in the conference room, the Senior partners would get the hapless dolts who ran the company to sign off on our legal bills - often 10% or more of the amount funded.  The Venture Capitalists ended up owning most of the company, which may have had a neat idea for some computer gizmo thingie website at one time or another.

The VC's weren't interested in the computer thingie, though, other than as a means of hyping the value of the company.   The company would then make a big splash in the press.  The funding alone merited a "press release" and several more would come down the pike.  The nerdy computer geek principals of the company would go on the financial and tech channels to be interviewed about their "ground-breaking product" and everyone acted like they were the next Steve Jobs or Bill Gates.

They would also go to the "tech conventions" and consumer product shows like SXSW or CES.   Lots of well-placed articles in the paper and "buzz" over the company would be generated.    They let this build for a while, perhaps fudging a few quarters of reports to show profits (or at least showing slowing losses) and then they'd "drop" the IPO.   The tension in the market was so high by then that people went nuts to buy the stock.   All they had heard about for months was the company we were hyping.   Surely this has to be a good deal!

And that's where I got confused.   They would sell off 5% of the company for maybe a billion in stock sales.   They already had a few billion on hand, why did they need another?   Moreover, the day of the IPO, the stock price doubled which meant that the institutional investors and "friends" of the company who subscribed at the IPO price, doubled their money within minutes.

"This makes no sense to me!" I said, "the company is leaving cash on the table here - they could have raised twice as much money by raising the IPO price!"  I was hushed up and told to go work on a Patent or something.  I was too dumb to even conceive that the entire thing was a con.

The point of the IPO wasn't to raise capital to buy ball-bearing grinders, but to create a marketable commodity in the company's equity.   The Venture Capitalists and the company founders now had a means of selling their shares of stock to the general public for far more than they could have gotten in private sales.    And they sold, too.

The small-time players who worked for the company for stock were "locked" from selling early-on, so that the big players could cash in.   Those little people were able to sell out later on, hopefully before the company went belly-up.   The founders of the company either realized what was going on, or were utterly clueless - often wondering why their precious company and great product were being trashed just to make a few bucks.  Some of these tech geeks were actually true believers and didn't realize their "idea" was just a pretext for the whole scam.   In a way, it was like the classic "bust-out" scheme of Tony Soprano and his ilk.

Too late, the small investor who bought 100 shares of "The Next Big Thing! Inc." realizes that the company is losing money and moreover has no realistic plans to ever make money and he sells out in a panic.   Eventually the company either goes bankrupt (like when they run out of money to pay the light bill, or they sell out the shell of the company to another company, if there is some sort of useful business model left that might wring out a tiny profit (now that it is sold for pennies on the dollar).

That's how IPOs work.   Modern IPOs, anyway.  They are less about raising capital than cashing in.   And you can tell this by the pitiful amount of stock they sell in the IPO as well as the sky-high "market cap" numbers, valuing some marginal company more than an entire country.  There is a pattern to this, right down to one or two quarters of "profitability" they show, right before they go back to drowning in red ink.   It is like they all read from the same playbook.

People buy into this nonsense out of greed.  I get e-mails all the time from people who want to make a lot of money in a short period of time, without any risk or effort on their part.  In their mind, they are "missing out" on the last big IPO, gold, or Bitcoin.  After all, all those people in the newspaper made money at it, why not them?   Why couldn't they be the one to cash in on the Microsoft IPO back in the day?

And right there is the answer.  Back when Microsoft went public, there wasn't much of a "buzz" about it, or about IPOs in general.  In fact, most Americans didn't know what an "IPO" was until the mid-1990's when the dot-com boom (and bust) occurred.  This whole deal of hyping IPOs is a recent invention, not some time-honored tradition.   And today, it is all the financial press talks about, as it is easy to write stories about, and it is something happening in the market that appears interesting, so readers will click on it.   Reporting on traffic is boring.  Reporting on a traffic accident, particularly a bloody one, is interesting and is easier to sell to readers and viewers.  The financial press is no different.

So how do you tell if an IPO is a con or not?  You really can't.   For example, with this "Blue Apron" IPO, I searched online and found countless articles breathlessly saying what a great deal the IPO will be ("5 things you need to know!") and then several articles about how the stock price tanked after the IPO.   But it is damn hard to find out how much, as a percentage of the company they sold as stock and how much stock is held by "insiders".

In previous tech-not-tech IPOs, this number is usually around 5%.   Martha Stewart Omnimedia, which turned out to be a cookbook, sold 4% to the public.  Others fall along similar lines.  Few sell more than 10% of the company to the public.   Again - and get this through your thick head - they are not trying to raise capital but to cash out.   Ferrari dealers don't take "dot com" stock in payment for a new Ferrari.  Nor do they take Bitcoin!  (no one takes Bitcoin - they just convert it to dollars and take that.  It is not a real currency).

So is the stock price tanking a bad sign for Blue Apron?  Maybe not.  The insiders can still sell shares over time, and that of course will depress stock prices (which is why most of these IPOs start out high and then drop way off in price as insiders flood the market with their shares).   Maybe down the road, some other company will buy it out to get in on this fad - and it is a fad.

We do see some parts of the pattern here, though.   Blue Apron showed one quarter of profitability in 2016, before going back to losses.  They sold 30 million shares at the IPO - about a quarter billion for a company valued at $2 Billion back in 2015.   How much "equity" the IPO shareholders actually have in the company is anyone's guess.

And they are pretty up-front about this in the IPO filing docs:
We estimate that the net proceeds from the sale of our Class A common stock in this offering will be approximately $278.5 million, after deducting the underwriting discount and estimated offering expenses payable by us. If the underwriters fully exercise their option to purchase additional shares from us in this offering, we estimate that the net proceeds will be approximately $321.0 million.

The principal purposes of this offering are to create a public market for our Class A common stock, facilitate access to the public equity markets, increase our visibility in the marketplace and obtain additional capital

Read that again -  "The principal purposes of this offering are to create a public market for our Class A common stock".   Do you get it?   It isn't quite as bad as ""Our goal is to use investor money to go to Vegas and gamble and hire hookers and snort cocaine until all the money is gone" but it ain't far off, is it?

In other words, in either instance, the founders make money - your money - and you lose money, which becomes their money.   Why would anyone want to "invest" in an IPO these days?  Why would it even be considered an investment?