The Initial Public Offering (IPO) can be a lucrative gravy train for the chosen few consisting of the company’s founder(s) and management team, the venture capital firms, the investment banks, and the best clients of the investments banks. The general public investors are last in line and may carry substantially more risk relative to the potential reward compared to the chosen few, or “insiders”. But, to be fair, the venture capitalists absorb all of the initial risk for a new company’s formation by fronting millions of dollars to fuel the early growth phase. Millions of dollars can be lost if the business idea flops, but millions or billions can be made if the business idea takes off.
In the case where a business concept performs well, the insiders are well positioned and insulated to make extraordinary amounts of money. For simplicity, lets use an example that includes one insider for each insider category and make simple assumptions as to how shares of the company are priced and allocated. In reality, there are many insiders serving each function. Lets say the venture capital firm invests $100 million in a company. At the time of the investment the firm agrees to issue 50 million private shares that represent that $100 million initial investment. This translates to just $2 per share. Now, lets say the company wants to give the founder of the company 15 million shares and the recently hired CEO 5 million shares. The venture capital firm now has only 30 million shares but is betting that when the company goes public the share price will be much higher that $2 dollars per share so that they can cover their initial investment in the company, the founder, and executive management team.
Before a company can go public it must hire an investment bank that will handle all the underwriting of the stock and create demand for the stock when it goes public. The investment bank rounds up a few of its premier clients and generates interest and commitments from the clients. The investment bank also estimates the projected value of the company’s stock price and market capital to set an offering price on the day the company goes public. Meanwhile, the media and press is leveraged (owned by powerful financial institutions and linked to the “inside” community) to hype up the company and build public (often the suckers) excitement around the initial public offering. The investment banks receive handsome compensation in the millions for underwriting the company’s stock and setting the initial public offering price.
Now, lets see how insiders get rich. Lets say the company decides to offer to the public 7 million shares. And lets say 5 million shares come from the venture capital firms share, one and a half million from the founder, and half a million from the CEO. That leaves the venture capital firm with 25 million private shares, the founder with 13.5 million private shares, and the CEO with 4.5 million private shares. Remember, these private shares only have an exercise price or cost of $2 dollars per share. Now, lets say the investment bank decides to set the initial offering price for the stock to be $20 per share to the public. Because the company is only floating (offering to the public) a small portion (7 million) of the total company’s shares (50 million) to the public, there is greater demand for these shares. As we all know, a smaller supply combined with media hype drives up the price. Now, lets say the price of the stock on the initial day of trading jumps up to $30 dollars or 50% of the initial stock price. Such jumps on the initial day of trading is not unusual if the company offers a small float and has enjoyed great media hype.
Based on the above scenario, the following describes how rich the insiders got. First, “the company” raised $140 million by selling 7 million shares to the public at $20 dollars per shares. But, the company pays $30 million to the investment bank for underwriting fees and other services. Therefore, the net proceeds to “the company” amount to just $110 million. The remaining private shares held by the venture capital firm, the founder, and the CEO of 43 million at $30 dollars per share are now worth almost $1.3 billion dollars. If the venture capital firm were to cash out all their 25 million private shares at $30 dollars per share they would haul in $750 million. Not bad considering they only invested $100 million in the company. If the founder were to sell all his shares he would pocket $378 million net after deducting the $2 dollar per private share cost. And the CEO would cash in $126 million net. Keep in mind the CEO also probably earns an annual salary and bonus of $500,000 or more. So, in this example, the company brought in $110 million to fuel the future growth of the company, but the insiders hauled in potential value of $1.3 billion for their own pocket books and the investment banks earned a measly $30 million.
There are many more complexities to discuss in the scheme above, but the overall point is still valid. Initial public offerings, in many cases, are not primarily undertaken to raise capital for the company, rather, they are undertaken to vastly increase the bank accounts of the insiders. It is the insiders that can reap the greatest rewards from an IPO, not the company. And the company is what all the outside investors pay for when they buy shares on the public stock exchange. And when that company ends up being simply a media hyped shell game and the stock price plummets to $7 dollars per share, it is the outsiders that directly paid the insiders for their outrageous wealth accumulation. But the insiders already have all the money once the public becomes aware that the company was nothing more than a hyped up Ponzi scheme or fraud. This is what happened during the Dot Com bomb. This is what happened with Enron. This is what happened during the housing derivative scam. And this is what I believe will happen with the Social Networking/Media sector. Don’t invest in Facebook, Twitter, or any of the other company’s in this hyped up hollow sector, unless you are on the inside IPO gravy train.