July 26, 2004

Google IPO price

Google's IPO price is now reported to be $108 - $135 per share (via John Battelle). This is a very high value. The price-to-earnings ratio is given as 329. Comparison: Microsoft - 56, Yahoo - 110, Ask Jeeves - 54.7, large capitalization stock average (S&P 500), about 20.

In the interests of not echoing what everyone else is saying (besides run away), I'll repost a very long mailing-list message below (by someone else) discussing the issues of IPO pricing. Everyone knows that Google's IPO price is going to be irrational. The issue is who is going to capture that irrationality premium - the underwriters or the company itself? Google is running things so that the bubble-juice goes to them, not the money-bags. I suppose it's as good a place as any.


interesting-people message

Subject: [IP]"A few of my friends still believe it's good news whenever an
IPO skyrockets.It's not-- it's the best indication that people are getting ripped off."

* From: Dave Farber
* To: ip
* Date: Fri, 07 Mar 2003 15:06:31 -0500

------ Forwarded Message From: Peter Wayner Date: Fri, 07 Mar 2003 14:18:34 -0500 Subject: Re: [IP] Dan Gillmor: Quattrone clique disgraced Silicon Valley

Dave, I don't know if you've exhausted the IPO topic, but I spent some time recently working through the IPO process. A few of my friends still believe it's good news whenever an IPO skyrockets. It's not-- it's the best indication that people are getting ripped off.

Let me know what you think.


IPO Fraud

Posted by admin on Friday, March 07 @ 14:14:22 EST

It looks like the SEC and the investment community may be going after Frank Quattrone. Some may see this as a case of no good deed going unpunished because the man brought such a flood of capital to Silicon Valley, but others probably see it as a chance to punish someone guilty for ripping off many people. I can't speak to the specifics of what Mr. Quattrone has done-- that's the job for the government, but I have watched the IPO world for long enough to complain about the process in general. Enough of my friends worked for these so-called hot companies and enough of them have been hurt by the IPO process. It's time that things change.

The big problem comes when the shares soar on the first day. In the past, most people have seen this as some wonderful, hypeworthy event. The hard workers are getting rich. The initial investors are reaping big rewards. Everyone should be happy and the press usually blathers away about the strength of the IPO market.

Alas, that's so far from the truth. Many of the people are getting ripped off because money meant to help the company achieve it's goals is heading for the pockets of insiders. Yes, many of the great Dot Com companies were silly and doomed to failure, but many of them never got all of the capital the market intended for them. We'll never really know what was supposed to happen because the money never reached the front line troops.

I believe that mispriced IPOs that skyrocketed on the first day are a real moral and legal challenge for the technology industry and the capital markets. While I'm sure that the laws have plenty of loopholes that may let everyone escape to a life a leisure, I'm convinced that capital was misdirected by this mechanism and this misdirection was one of the problems that led to some of our major market failures. There are plenty of people out of work because their companies didn't have the capital to complete their business plans.

It's easy to work through the math and discover that much of the money that investors intended to go toward a particular company went, instead, into the hands of investment bankers and their chums. Let me take you through the steps of some hypothetical company, call it ultrametabetaelectrotech or UMBET for short. The bankers at J. Plutocrat and Fils convince the umbet dudes that going public is the right step.

Here are key decision points along the journey:

* 1-- UMBET and Plutocrats file for an IPO including a document listing all sorts of reasons why this is a truly risky venture that no one in their right minds would ever buy.

* 2-- The marketplace ignores all of the warnings in (1) and concentrates on the upside. The marketplace floods the Plutocrat firm with buy orders at anywhere between 20 and 100 a share.

* 3-- The fils at Plutocrat look at this order book and decide that they could sell 1 million shares at $40.

* 4-- The fils at Plutocrat ignore this reality and price the shares at $20.

* 5-- The dudes at UMBET decide to go along with this pricing. The company will get $20 million minus the 7% commission paid to Plutocrat. Each of the managers at UMBET don't really care what the price is because they each have 10 million shares in their pocket. The market will assign a fair price afterwards no matter what the initial price happens to be.

* 6-- The fils at Plutocrat start allocating the 1 million shares to others. They know from their information about the order book that the price will pop up to at least $40/share because of the demand. It might go higher. That means that every share they give someone is probably equivalent to $20 bill. As such, they allocate shares to people in these classes:

* a-- Great guys and gals.
* b-- People they owe money or favors. Politicians have been some of the lucky to get these shares.
* c-- Mutual funds that want to move money between funds.
* d-- Investors who want technology stocks and are willing to pay roughly 30% of the first day return back to the Plutocrats in inflated "commissions".
* e-- Others with malice aforethought.

* 7-- The Plutocrats tell investors that one way to get 1000 shares at $20 is to make a commitment to buy 1000 shares on the first day in the aftermarket. Investment banks like deals like this because it shows "support" for the shares.

* 8-- The IPO day arrives. The shares begin at $20. Investors start buying and run up the price to $40. Everyone is happy. Everyone talks about what a success the IPO is.

Here's why I think this hypothetical IPO was a fraud:

* The company only ended up with $20 million in the bank to support expansion and the pursuit of the business success despite the fact that many of the investors thought it should be allocated $40 million.

* People who bought on the day of issue paid $40/share, but only $20/share went to the company. They lost 50% right off the bat. Other investors flipping their shares walked away with it.

* People who bought in step (7) paid an average of $30/share and only lost $10/share to the "inefficiencies" of the IPO process. They may think they've got a great 33% gain on their investment on the first day. ("Boss, we paid an average of $30/share for this and it now trades at $40." "Simpson, I like the cut of your jib.") This is a charade. There's only $20/share left in the company. They've really suffered at 33% loss!

* The mutual funds in (6c) are robbing the investors in one fund in a family to reward another. These funds often generate outstanding returns in new funds by allocating the underpriced shares to the new hot fund in the family. The investors in the old, tired fund end up with shares priced in the after market.

* The payoff recipients in (6b) are almost sure to recognize the $20/share they receive as a pure gift. If they don't count it as a debt, the Fils at Plutocrat aren't doing their jobs right.

* There may be some truly great folks buying at step (6a), but I'll let the readers decided the probable size of this group.

* The umbet management dudes in (5) just let someone walk away company assets (shares) worth $40 a piece for a price of only $20. If that's not a breach of fiduciary duty, I don't know what is. To make matters worse, some of the lucky folks are called "friends and family".

* The Fils in step (4) ignore good faith offers of a higher price. That sounds like a breach of fiduciary responsibility to me.

Recently, the news stories focus on prosecuting people for spinning or destroying documents. That may be the right legal strategy because the legal system probably protects the underwriter even when coming up with a completely bogus price.

The sad fact is that there is a better way. Bill Hambrecht has been pushing his OpenIPO concept for some time, but Wall Street resists it. Instead of allocating shares to the lucky insiders, the system chooses the people willing to pay the most money. The cash flowing into the company is maximized and the fraud is eliminated.

I've discussed this topic with others in the industry. Some people agree, but others tell me I'm flat out wrong. There needs to be the slop in the system to reward everyone or else people won't buy the shares at all. I don't believe this. It's been well known for some time that people who buy IPO shares in the aftermarket are usually net losers, at least on average. Most savvy investors know that the aftermarket is a sucker's game. The practice of allocating shares to trusted insiders and investment friends was hurting the aftermarket before the crash and now it's completely destroyed the IPO business. There are no IPOs is because no one trusts the mechanism anymore.

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By Seth Finkelstein | posted in google | on July 26, 2004 03:02 PM (Infothought permalink) | Followups
Seth Finkelstein's Infothought blog (Wikipedia, Google, censorware, and an inside view of net-politics) - Syndicate site (subscribe, RSS)

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I think that most of what Google is doing in the IPO seems quite correct and against Wall St. standard procedures in a way. The high price-per-share is a good idea, the no-special-friends, and other minor issues. Well done on that.

However, the IPO accounts for only about 10% of the company. This is such a low free float that on the dotcom history has been pointed as one of the main reasons for the bubble in the past years: everybody extrapolates the value of the 10% public shares available on the market to the 100% of the company. "The 10% is valued at 3.6 billion, so the company market cap is 36 billion." Right? Well, depends. 10% of Google may be a so little chunk for investors that there probably will be a large demand -- so the price will go up and up, and in the end the 10% will be valued very high even if that doesn't represent the other 90% of the company.

We have been seeing this on the 1990s and util 2001 on so many dotcoms. Some of them had only 5% free float or less. Some of them were trading a volume of 30 or 40% of the total free float... Ħevery day!

So, basically, you can't compare a 10% free-float like Google with companies like Amazon, Yahoo, Microsoft or Apple who have a 70%, 80% or 95% free float.

I think this is an important issue to be considered in this IPO.

Posted by: Alvy at July 27, 2004 06:11 AM