June 9, 1998

There are basically two ways for a company to raise capital to grow its business. One way is through debt financing which is borrowing the money from a bank or issuing bonds. Another way is through equity financing which is selling shares of the company's stock.

When a company sells stock, the company is actually selling parts of itself, giving up some of the ownership, however, with debt financing, the company gives up no ownership, but now has an obligation to pay back the bank and if they issued bonds then an obligation to pay interest on the bonds and eventually the face value of the bonds when the bonds mature.

When a company wants to use equity financing for the first time they will have an IPO or an "initial public offering." An IPO is a company's first offering of common stock to the public. To have an IPO the company will select an investment banker to handle the offering. From Barron's Dictionary of Finance and Investment Terms: an investment banker is "acting as underwriter or agent, that serves as intermediary between an issuer of securities and the investing public. In what is termed firm commitment underwriting, the investment banker, either as manager or participating member of an investment banker syndicate, makes outright purchases of new securities from the issuer and distributes them to dealers and investors, profiting on the spread between the purchase price and the selling (public offering) price. Under a conditional agreement called best effort, the investment banker markets a new issue without underwriting it, acting as agent rather than principal and taking a commission for whatever amount of securities the banker succeeds in marketing. Under another conditional arrangement, called standby commitment, the investment banker serves clients issuing new securities by agreeing to purchase for resale any securities not taken by existing holders of rights."

"Where a client relationship exists, the investment banker's role begins with preunderwriting counseling and continues after the distribution of securities is completed, in the form of ongoing expert advice and guidance, often including a seat on the board of directors. The direct underwtiting responsibilities include preparing the Securities and Exchange Commission registration statement; consulting on pricing of the securities; forming and managing the syndicate; establishing a selling group if desired; and pegging (stabilizing) the price of the issue during the offering and distribution period."

To elaborate of some terms used above, again, from Barron's Dictionary of Finance and Investment Terms:

Underwrite: "Investments: to assume the risk of buying a new issue of securities from the issuing corporation or government entity and reselling them to the public, either directly or through dealers. The underwriter makes a profit on the difference between the price paid to the issuer and the public offering price, called the underwriting spread."

"Underwriting is the business of investment bankers, who usually form an underwriting group (also called a purchase group or syndicate) to pool the risk and assure successful distribution of the issue. The syndicate operates under an agreement among underwriters, also termed a syndicate contract or purchase group contract."

"Strictly speaking, underwrite is properly used only in a firm commitment underwriting, also known as a bought deal, where the securities are purchased outright from the issuer."

"Other investment banking arrangements to which the term is sometimes loosely applied are best effort, all or none, and standby commitments; in each of these, the risk is shared between the issuer and the investment banker."

"The term is also sometimes used in connection with a registered secondary offfering, which involves essentially the same process as a new issue, except that the proceeds go to the selling investor, not to the issuer. For these arrangements, the term secondary offering or secondary distribution is preferable to underwriting, which is usually reserved for new, or primary, distributions.

Flotation Cost: "cost of issuing new stocks or bonds. It varies with the amount of underwriting risk and the job of physical distribution. It comprises two elements: (1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out- of-pocket expenses). Securities and Exchange Commission studies reveal that flotation costs are higher for stocks than for bonds, relecting the generally wider distribution and greater volatility of common stock as opposed to bonds, which are usually sold in large blocks to relatively few investors. The SEC also found that flotation costs as a percentage of gross proceeds are greater for smaller issues than for larger ones. This occurs because the issuer's legal and other expenses tend to be relatively large and fixed; also, smaller issues tend to originate with less established issuers, requiring more information development and marketing expense. An issue involving a rights offering can involve negligible underwriting risk and selling effort and therefore minimal flotation cost, especially if the underpricing is substantial."

"The underwriting spread is the key variable in flotation cost, historically ranging from 23.7% of the size of a small issue of common stock to as low as 1.25% of the par value of high-grade bonds. Spreads are determined by both negotiation and competitive bidding."

Pegging: "stabilizing the price of a security, commodity, or currency by intervening in a market. For example, until 1971 governments pegged the price of gold at certain levels to stabilize their currencies and would therefore buy it when the price dropped and sell when the price rose. Since 1971, a floating exchange rate system has prevailed, in which countries use pegging-the buying or selling of their own currencies-simply to offset fluctuations in the exchange rate. The U.S. government uses pegging in another way to support the prices of agricultual commodities."

"In floating new stock issues, the managing underwriter is authorized to try to peg the market price and stabilize the market in the issuer's stock by buying shares in the open market. With this one exception, securities price pegging is illegal and is regulated by the Securities and Exchange Commission."

Secondary Distribution: "public sale of previously issued securities held by large investors, usually corporations, institutions, or other affiliated persons, as distinguished from a new issue or primary distribution, where the seller is the issuing corporation. As with a primary offering, secondaries are usually handled by investment bankers, acting alone or as a syndicate, who purchase the shares from the seller at an agreed price, then resale them, sometimes with the help of a selling group, at a higher public offering price, making their profit on the difference, called the spread. Since the offering is registered with the Securities and Exchange Commission, the syndicate manager can legally stabilize- or peg-the market price by bidding for shares in the open market."

Primary Market: "market for new issues of securities, as distinguished from the secondary market, where previously issued securities are bought and sold. A market is primary if the proceeds of sales go to the issuer of the securities sold."

Now that you know a little about IPOs, I'll get to my main question, are IPOs a good investment? From what I've seen they are not. "You should be wary of purchasing IPOs because at the outset, they're usually more for traders than long-term investors. 'The price of any IPO stock always comes down on the next trading day,' says Calvin Lui, a West Bloomfield (Mich.) investor who bought Ziff-Davis and modem maker Broadcom, another recent issue, when they came out. He has since sold both. 'The prices of IPOs are so inflated that it is not worth keeping them overnight,' Lui contends." (Business Week, May 25, 1998, pg. 133)

"Shah's statistics on 3,100 IPOs over the past four years tend to back this up [Manish Shah is the president of Otiva, an IPO research house and sponsor of the IPO Maven web site, if you want to check it out IPO Maven ]." "The problem with IPOs is that the earnings of 60% of them disappoints investors by their third quarter as public companies, Shah says. When that happens, fast-money, 'momentum' investors dump the stock, and analysts turn their gaze elsewhere. Absent attention from the pros and liquidity, a new issue can often sink below the value of its underlying business. Solomon [an investor] learned just that lesson with EarthShell, a maker of biodegradable packaging that he purchased at the Mar. 24 offering for $21 a share. He still owns it-but it's $12 now. EarthShell declined amid disappointment over its prospects from profiting anytime soon on sandwich containers for McDonald's. Still, Solomon isn't giving up hope. He intends to sell the stock to record a loss for tax purchases, but plans to repurchase it 31 days later." (Business Week, May 25, 1998, pg. 133)

It is interesting to note that with most IPOs disappointing investors by the third quarter why are IPOs in such high demand? Most brokerage houses only offer IPOs to certain investors, for example, Charles Schwab, "Big customers get IPOs from Salomon Smith Barney." (Business Week, May 25, 1998, pg. 131) And DLJ Direct, "A $100,000 account gives you access to DLJ research and IPOs." (Business Week, May 25, 1998, pg. 133) It seems to me that since according to Wall Street, long-term investing is the only way to go (that's what they keep telling us anyway), IPOs would not be in high demand.

Even in the same issue of BW there is a story, "Stock Trading Can be a Nasty Habit." "It's a staple of personal finance advice: Buy and Hold, because trading the stock market is a sucker's bet. But does anybody know just how badly those quick-draw traders are shooting themselves in the feet?"

"Thanks to a just released study by Brad Barber and Terrance Odean of the Univesity of California at Davis, we now know. And the answer is that it's an ugly, bloody mess. The researchers looked at a large, unnamed discount brokerage firm's trading records for 78,000 households from February, 1991, through December, 1996. They found that after commissions and other transaction costs, the average household saw an annual average total return of 15.3%. But the 20% of households clasified as frequent traders-more than 48 trades per year-fared miserable, with an annual average net of just 10%." (Business Week, May 25, 1998, pg. 8)

Let's go over the facts again here briefly:

• Most IPOs disappoint investors by the third quarter.

• Since most IPOs disappoint by the third quarter they are not good long-term investment which is what Wall Street tells us is the only way to go.

• If the only way to go is long-term except for a few that call themselves traders, and IPOs are clearly not good long-term investments, why are IPOs in such high demand, the demand is so high that brokers only offer them to their "best" customers?

It is my personal belief that the reason is because it's a scam. Executives of the issuing companies are getting rich, the investment bankers are getting rich, the venture capitalists are getting rich, and the "best" customers of the brokerage houses are getting rich (this "getting rich" is so true that in Barron's Dictionary of Finance and Investment Terms they include a reference to it in their definition of an IPO, "IPOs are almost invariably an opportunity for the existing investors and participating venture capitalists to make big profits, since for the first time their shares will be given a market value reflecting expectations for the company's future growth"). With all these individuals getting rich someone has to be loosing and most likely it's the little guy.

They say that the investment banker assumes some risk, however, with the marketing power of the investment banker and their finely tuned network of brokers and dealers, they probably assume very little risk, the primary risk is on the investors that take part in the ownership of the stock after the initial public offering. If you honestly believe that the risk is most likely assumed by the issuing company's executives, the venture capitalists, and the investment bankers, then in actuality there must be very little risk because these individuals are clearly the most affluent individuals in America when it comes to new money.

From the movie "Wall Street," there was a big-time investor who was involved in insider trading, when a novice broker came to him to offer him a suggestion on what he thought was a good investment, the big-time investor told him that he only invests in sure things, those sure things being stocks that he had inside information on. The big-time investor had plenty of money so when a sure thing came a long he was ready to make a big profit. I think that IPOs are sure things as long as you, the issuing company's executives, the investment bankers, the venture capitalists, and the "best" customers of the brokerage houses, take most of their profits on the first day the IPO is traded (Some of these individuals are required to hold their stock for a period of time, this time varies and can be as short as 180 days, also, some of these individuals will continue to hold a small position to help convince everyone that they "still believe in the company," again their risk is nill because they have already cashed in enough stock to make a ton of money even if the stock tanks).

I am not trying to talk anybody out of playing the IPO market. What I am trying to do is to make sure if you do play the IPO market that you know the risks involved. Also, some mutual fund companies are not taking their own advice which is to be long-term investors and are playing the IPO market with your money. If you don't want to play the IPO market, make sure you are not playing it indirectly through stock mutual funds by carefully reading the prospectus of the stock mutual funds that you own. If after reading the prospectus you still can't tell how much they invest in IPOs, call the mutual fund company and ask them.

ADDENDUM (November 18, 1998)

Here's a real life example of what I'm talking about. On November 13, 1998 theglobe.com (TGLO) went public. On the first day, investors who had to wait for the opening would pay between $59 and $97 for the stock. Less than a week later, November 18, 1998, the stock would be selling for $32.

The investors who got in before the opening and sold the first day could reap 600% returns in one day. The investors who got in before the opening and who held to November 18, 1998 would still double their money. However, for the investors who had to wait for the opening and payed between $59 and $97, would lose anywhere from 2/3 to a little less than 1/2 of their investment.

To see the table that shows the prices of theglobe.com during this period just click here: Historical Quotes.

Please understand that anything can happen in the future. Theglobe.com may be the next Microsoft and everybody will be happy. However, the point of this story is not that no IPO is ever a good investment, but that for the investors who can get in before the opening it's almost always a win, win situation. For the investors who get in later, it's a different story, and their story is mostly based on luck and not investment accumen.

ADDENDUM (October 8, 1999)

Today, Jupiter Communications (JPTR) had an IPO. If you got in at the offering price of $21 you made 69.1% in one day. Remember, getting in at the offering price for a small investor is almost impossible, and even if you can get in, most likely, it would be a very small number of shares, just enough so the big boys can say they are giving some small investors the offering price.

If however, you could not get in at the offering price and had to wait for the opening. The price you would have gotten was $36, a half point more than what the stock closed at. In fact, you could have paid up to $47 3/8 for the stock around 10:30 EST and with a close of $35 1/2, you would have already be in the red by almost 12 points at the closing. Even if you had gotten the best price for the day, which occurred for about a second, you would only have a gain of $2 1/2 points at closing.

The big winners for Jupiter on its opening day: insiders, the investment bankers, venture capitialists, and the broker clients that got in at the offering price.

ADDENDUM (October 22, 1999)

Here's a note I sent a friend today:

Once you asked about IPOs. I said unless you got in before the opening most IPOs are the pits.

Here's an example and it's a good example because the financial news is stating that this is the best IPO ever, 386% in one-day. Makes novice investors excited as hell.

However, a quick look at the opening day trading data and you will see the real picture.

The stock is Sycamore Analytics (SCMR). The news reports that it was offered at $35 and closed at $184 for a one-day return of 386%. But the key here is offered to who? The insiders own 100%, but now want to offer some equity in the company to others. Those others who will get the $35 price will be the favorite customers of the investment bank that is doing the IPO (more than one investment bank may be involved).

Even if your broker has some stock available at $35 and is willing to let some of it go, to show their clients they are willing to help even the little guy, it would only be a very small number of shares and could be as low as 1 or 2 shares.

If you did not get in at the offering price and had to wait until the stock was available in the seconday market, that's the one we all trade on, the best price you could have gotten was $182 or at best, about a 1/2% return for the day. If on the other hand you had placed an order before you went to bed, the next day you would have found out that you got the opening price of $271 which would give you a 30% loss the first day.

With a trading range for the day of $182 to $271, small investors mostly paid much more for the stock than the stock closed at. On the other hand, insiders and those who got in at the offering price made almost 400% on the first day.

So when you here the financial news state that investors made out like crazy today with Sycmore's IPO, remember that what the financial news media really should have told everyone was, "Insiders and those who got the offering price made out, whereas most small investors got took."

...But if Sycamore does this and the market does that, and the yen does this, and the Fed chairman does that, Sycamore stock may be $500 at the close next Friday.

ADDENDUM (November 1, 1999)

From Reuters:

"Monday November 1, 7:41 pm Eastern Time

Schwab to offer rich clients access to pre-IPOs

SAN FRANCISCO, Nov 1 (Reuters) - Charles Schwab Corp. (NYSE:SCH - news), the world's No. 1 discount brokerage, said Monday it would offer wealthy clients the chance to invest into private companies that are planning to go public.

Schwab said it would offer clients the ability to make such private-equity investments through a partnership it had struck with OffRoad Capital, a San Francisco-based financial services firm.

Investors who want to invest in these pre-IPOs, however, must have $1 million or more in assets in accounts held with the discount brokerage, said Greg Gable, a Schwab spokesman.

The Securities and Exchange Commission limits such types of investments to so-called accredited investors, people whose net worth equals or exceeds $1 million. But Schwab raised that bar further by limiting the investment option to clients who hold $1 million or more in assets in Schwab accounts alone.

``These are investments designed for affluent customers,'' Gable said. ``They are high-risk investments, so there needs to be that break-off in terms of applicability.''

The idea is that investors could buy into private companies with plans to go public within a certain time frame. That way, they would have some way to take part in the eventual IPOs of many of the companies and sell their shares, giving them some liquidity down the road, Gable said.

OffRoad Capital is able to gain access to such investments through an agreement it has with Robertson Stephens, a prominent U.S. securities firm based in San Francisco."

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