Wednesday, February 10, 2016

Beware of Tech Company Valuations and IPOs

The unicorn is a mythical creature that has been much talked about but rarely, if ever, actually observed.  Apparently someone applied the label to what was once equally rare: the tech startup with a valuation of over $1 billion.  At present, they seem to be everywhere.  The magazine Fortune maintains a list of unicorns (a total of 172 at present) along with their valuation as determined by the willingness of venture capitalists and others to invest in them.  At the top of the list is Uber with a valuation of an incredible $62 billion, even though it is currently a money losing operation.

Venture capitalists don’t invest in companies like Uber for the long term.  They don’t wish to wait many years while a business establishes itself, gradually becoming profitable.  Their goal is to find the next big thing and quickly cash in their investment by seeing the company go public and selling their shares at a profit.  To successfully pull that off depends on generating an enthusiasm among traditional investors to not only buy those shares, but to pay a premium for them.  They must be convinced that the shares will rise in value.

An article in Fortune by William D. Cohen, Silicon Valley’s $585 Billion Problem, suggests that all those Unicorns will have a difficult time providing their investors a way to get their money back, let alone hit the jackpot. 

“It appears that a reckoning is coming in the tech world. The combined value ascribed to the 173 unicorns by their investors is a stunning $585 billion—an especially astonishing figure given that so many of them aren’t even close to profitable. Sky-high valuations—driven in part by unicorn mania and an influx of money from nontraditional (and less disciplined) venture investors—have limited the number of potential acquirers for a lot of the buzziest companies.”

He claims that traditional investors have been fooled too many times in the past and the Initial Public Offering (IPO) pipeline is drying up.

“Time and time again during the current IPO cycle, Wall Street underwriters—egged on by ambitious CEOs, hungry venture capitalists, and favored institutional investors—have hyped one technology IPO after another. The bankers price the offerings for perfection, watch them soar on the first day of trading to deliver the coveted first-day spike, and don’t stick around to offer an explanation after the shares plunge below the first-day price.”

“Welcome to the world of zombie tech stocks—once-highflying IPOs wandering aimlessly in the wasteland of the public equity markets and understandably unloved by investors. Many have familiar names, such as Zynga (down about 75% from its IPO price), Twitter (down 30%), and Groupon (down 85%). Online craft marketplace Etsy recently traded 56% below last year’s price at IPO and 77% under its first-day close. Others that are less well-known—like Nimble Storage (67% below IPO price)—have been just as disappointing.”

If you are one of the frustrated investors who bought into the hype and are wondering what happened to your money, or if you are merely one of those who believes the markets are manipulated by the insiders to their advantage, then stay tuned.  Cohen explains how the IPO process actually works.

The first step is an agreement between the outfit wishing to go public and a financial firm or firms (think Goldman Sachs) willing to underwrite the sale of shares—usually for a fee that is a percentage of the value of the shares offered.  Underwriters assume responsibility for the shares and will possess them should they go unsold.  This financial stake by the underwriters leaves them to act in their own self-interest, which is not necessarily that of the company offering the shares, nor that of the investing public.

“The system has long been designed to benefit the Wall Street underwriters and their favored clients—venture capital and buyout firms, as well as the big institutional buyers of IPOs—at the expense of individual and retail investors, who have been brainwashed into thinking they are getting their hands on the Next Big Thing.”

It is the desire of everyone involved in the deal to price the offered shares at a value such that demand will drive the share price up after the initial offering.  This increase is referred to as the “pop.”  Company investors wish to sell some shares to get some immediate return on investment, but they don’t wish to flood the market with so many shares that supply might be greater than demand.  An agreement with the underwriters determines the number of shares to be offered (referred to as “the float “).  It is usually 10-15% of the total number of shares.  There is also a “lockup” period in which the company’s existing investors agree to not sell any additional shares.

“The big Wall Street underwriters set the rules of the game. “Morgan Stanley and Goldman Sachs will tell you it’s not a successful IPO unless there’s a 20% to 30% pop,” says John Buttrick, a partner at Union Square Ventures. ‘That’s the way they get graded with their clients: Did the stock trade up after pricing? Much of the IPO machine is focused on generating a sugar-rush spike in the trading price during the two to four weeks after IPO. After that, the market takes over: ‘Sorry, not my problem.” They profess to take a long-term view, but the data shows post-IPO stocks are very volatile in the case of tech IPOs, and that is not a problem the underwriters try to address’.”

It must be remembered that the underwriting firms also have allegiances to those on the buying side of the deal.  The big investing institutions look upon an IPO that is going to provide shares that will increase at least 30% in a few weeks time as a fantastic deal.  They know the way the game is played and buy and hold only long enough to enjoy the “pop,” before putting the shares back on the market—and help bring the pop to an end.

“Another important constituency for IPOs is the big institutional buyers of them—mutual fund firms such as Fidelity, T. Rowe Price, and the Capital Group. They like the first-day pop too, because that means they make money instantly. Twenty-five years ago Peter Lynch, when he was running Fidelity’s Magellan Fund, used to refer to IPOs as ‘sunset stocks’—as in, ‘the sun never sets on an IPO in my portfolio’.”

There is another factor that stock investors should recognize before they buy into this manufactured “pop.”  The lockup period may be only a few months.  After it ends the market continues to react to changes in supply and demand, but the supply might suddenly become quite a bit larger—yet another factor capable of driving the value of the newly acquired shares down.

In summary, the tech IPO process has involved overvaluing a company in order to make a profit for institutional investors on the pre-IPO side, for the financial firms underwriting the deal, and for the institutional investors who are fed the initial shares.  All of this depends on being able to lure unsuspecting investors into a deal in which they are likely to lose money.

A few of these tech firms actually make a go of it and prove to be beneficial to their post-IPO investors, but not enough to hide the fact that most have been a bad deal except for the insiders.

Even the firms with a good business plan are hurt by a process in which their shares are greeted with unhealthy exuberance followed by a plummet in value.

So—if you are an investor who feels the market is rigged against you—you are probably correct.

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