|
Spinning, laddering and shorting - they sound
like exercise routines,
but they're not. They're schemes used by investment banks during an IPO
to take advantage of new companies. "IPO" stands for initial public
offering and represents the first time a company sells shares in their
company to the "public." (You'll find out later why that word is in
quotes.) The best way to tell the story about IPO scandals is to hear
the story about my own experience with MP3.com - one of the most high
profile Internet IPOs of all time. Even though the IPO was more than 4
1/2 years ago, revelations are still coming to light which demonstrate
just how
corrupt the whole process is.
In July of 1999, I headed out on a roadshow to kick-off MP3.com's
IPO. The
roadshow was a three week whirlwind tour across two continents with
more
than 75 meetings. I was talking with money managers about digital music
and more specifically about MP3.com's
business. After my
presentations,
I hoped that the investors would place a pre-order for shares. In the
months prior to the roadshow we had hired an investment bank who had
setup the meetings and travelled with us. A tremendous amount of work
happens before a company can go public and it's the investment
bank's job to oversee and assist in the process. In return for their
help, they receive 7% of all money raised by the company. If this were
the only monetary reward bankers received, I probably wouldn't be
writing this essay. (Although some people rightly point that when every
bank charges the exact same amount and has for decades, then
there is obvious collusion.)
During the roadshow I met with about 100 potential investors trying to
learn as much about them as they did about me and MP3.com.
I dutifully
kept a list of which meetings went well (placed into my "they get it"
column) and which went poorly
(into the "don't get it" column). If someone did not understand our
business or did not
like our business, then it would not make sense to have them as an
investor since they would quickly sell the shares. Conversely, if
someone appreciated our business then it would make sense to provide
them with more shares since they would likely hold onto them. In
addition, I had researched the previous holdings of many companies from
public filings. I was surprised to see that many of the companies I was
meeting didn't have any investments in Internet companies.
Others had large holdings in companies like Yahoo!
and Real Networks
which indicated they had interest in building a portfolio of net
companies for the long run.
At the conclusion of the roadshow, we had an amazing 20 times more
orders than available shares and had to decide who got how many
shares,
which is called the allocation. The bankers are in charge of
determining allocation, so I shared my research with them about which
investors I thought it made sense to give shares to. I was assured that
they would take my information into account when distributing shares.
When the final allocation was provided to me I was stunned to find out
that companies that had NO Internet investments were given a
large number of shares. Others who openly were negative towards our
business were given shares as well. Meanwhile, the companies I had
rated
highly, received only a tiny number of shares. Clearly something was
wrong, but at that time I had no proof that there was unscrupulous
hidden financial dealings.
More than two years later, an SEC
lawsuit
ripped
the cloak of secrecy off IPO allocations scams. Instead of distributing
shares to the best potential shareholder, bankers struck secret deals
with the institutions that agreed to pay the most money by buying more
shares (laddering), paying higher commissions, or agreeing to other
financial transactions (spinning).
Besides allocation, banks also control the pricing of the stock which
means they determine what the opening price of a share of stock will be
sold for. Unfortunately the interests of the bank and the company going
public are not aligned. Let's use an example to illustrate this: Say
you
were a car salesman and Toyota came to you and asked you to sell 100
cars for the best price you could, and they allowed you to sell the
cars to anyone you wanted and to set the price. Undoubtedly
most people would be inclined to set a slightly lower price for the
cars making them a very good deal and then sell them quickly and easily
to their best repeat customers, friends, business partners, etc. While
that might be good for the car salesman, it is not good for
Toyota since they're not going to be getting the best price they can
for their cars. The same thing happens with bankers. They want to sell
shares at a good price because they want to continue to do business
with their best customers, but that doesn't help raise money for the
young company. With MP3.com,
the shares more than
doubled on the first
day, demonstrating that bankers severely underpriced the shares when
they set the opening price.
Earlier this month, even more corrupt
dealings
were uncovered
related to the MP3.com
IPO. The bankers
artificially forced the price
up, then dumped more shares on the market to take advantage of this
high price by shorting the stock ahead of other orders. There are even
more examples of how MP3.com
was abused during the IPO
process, but by
now I'm sick to my stomach recalling all of them and you're likely
tiring of reading about them.
MP3.com
is not an isolated case, but a sign of a fundamentally flawed
IPO process that exploits new companies. This is not to suggest that
there are not honest bankers in the world or that all companies will be
exploited like MP3.com.
But the current IPO
transaction is so riddled
with vulnerabilities and conflicts of interest that there is a strong
likelihood of exploitation.
 There's a real opportunity to use technology
to greatly improve the IPO
process. Bill Hambrecht started his own investment bank with this goal
in mind. He's built an
innovative system called the OpenIPO
which uses a
dutch auction process designed by the Nobel prize winning economist
William
Vickrey. It permits any individual or company to bid on shares, not
just a bank's best or largest customer. (Remember, the second letter in
an IPO stands for "public" and that's who should be able to
participate.) The initial price is determined by a predefined formula
designed to ensure an optimum price. I'm convinced that the OpenIPO is
a far superior way of doing IPOs that benefits companies and future
shareholders. The sooner the investment community fully embraces it,
the
better.
If you'd like to know more about how an OpenIPO works, there's a great Flash
demo online.
-- Michael
P.S.: Microsoft just sued Lindows.com in
Canada. We'll have more information on this later, but in the
meantime, we want to defend choice for the residents of our neighbor to
the North. You can help at ChoicePC.
The Michael's Minute Meter
View the Michael's Minute Meter Report
|
