Since the beginning of last year, the IPO market has largely been a spectacular failure, with a number of high-profile companies falling off dramatically after first sprinting out of the gate, including Box, GoPro and FitBit. Some have pinned the blame on a poor economic environment, contending that given the uneven macro picture, coupled with all the major indexes being off by more than 5% over the last 12 months, the landscape was unaccommodating to all equities, let alone IPOs.
No question, market fundamentals and the performance of the broader economy will inevitably impact the valuation of any public company. But such talk is a bit misguided with respect to the real reason why recent IPOs have generally failed: The very process for bringing new issues to market is broken, rife with serious conflicts of interests and essentially set up to fail retail investors.
Think that’s hyperbole? Let’s look at the mechanics of the IPO process. On a basic level, it’s like flipping a house, but instead of an individual purchasing a home and waiting a year or two to allow the market to go up, deep pocketed IPO investors, conspiring with investment banks, sometimes wait only a few days (once a flurry of public buying artificially inflates the price) before converting their initial investment into outsize gains. Much like when house flipping became prominent during the run up to the financial crisis, normally it’s the general public that ends up bearing the brunt of the collateral damage.
This happens because many retail investors have a very limited understanding of how a company is taken public. Some don’t know, for instance, that an investment bank determines the issue price, not the market. Others aren’t aware that the same investment bank then turns around and provides their institutional clients – typically ultra-high-net-worth individuals and large pension and mutual funds, among others – the first opportunity to buy those shares, well before the general public gets a crack at them. Fewer probably realize the stakes for venture capital firms, who, having plowed large sums into these companies in the years leading up to their public debut, are eager to cash out their restricted stock once the six-month unlocking period expires.
Working together, all these factors stack the deck against the average investor, who is basically a dupe in this entire scheme. Many don’t realize that they are being used like this, and what’s worse, it’s as if they don’t care. What matters to them is that a hot, new IPO is about to hit the market, and they want in, and no valuation is too high, because in the short-term at least, they all go up.
If Amazon, Facebook and Google lived up to the hype and generated value long term, the thinking goes, this next one might, too. So they chase, trying to get a piece of the next big unicorn. The problem, of course, is that those companies are outliers, the exception, not the rule. Indeed, they are dwarfed by the GoPros and Twitters of the world, companies that rode a short-lived buildup of excitement only to come crashing down to earth with a resounding thud months later.
The irony is that some of the IPOs that have tanked recently are actually good companies, capable of delivering innovative goods and services that consumers want and need. Take Fitbit. It’s selling plenty of devices and fourth-quarter revenues exceeded analysts’ expectations. Still, shares are down more than 50 percent over the last year. The reason is simple: The company was never worth what investors ending up paying after it first went public.
So how do we fix this mess? In an ideal world, the six-month holding period for restricted stock would be extended to a year and investment banks would have their ability to manipulate IPO prices to benefit their institutional clients significantly curtailed. Why in this day and age can’t a company go public online using all the existing technology? The process would be fairer, more transparent and open to all investors, likely resulting in factors like earnings and performance determining valuations rather than an limited supply of stock creating artificially high valuations. Imagine that.
Until there is greater transparency and a more even playing field, would-be IPO retail investors trying to capture the next unicorn can perhaps make it simpler for themselves by just purchasing a Powerball ticket, since the end result is likely to be the same.
By Ross Gerber
Ross Gerber is CEO and president of Santa Monica, Calif-based Gerber Kawasaki, an investment advisory with approximately $400 million in assets under advisement. Clients and employees may own positions in various companies mentioned in the article, but readers shouldn’t buy anything without doing their own research.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.
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