Just for disclosure, before doing the "startup thing", I worked for several year...

hkmurakami · on March 2, 2013

As you know (having been in ibanking), the IPO sales process of shares goes something like this:

1. The company and ibanks determine the offer price and offer the shares to institutional investor customers (ranging from mutual funds, money managers to other banks).

2. The banks then turn around and sell these acquired shares as "IPO shares" at the offer price pre-market-open to their clients. Basically, "financial advisors" at places like BoA, ML, JPM, etc move these shares onto their retail customer base.

3. The next day, the market opens and the shares start trading in the open market. Any "mom and pop" investor can buy the shares on market.

Now, the institutional investors in (1) have done their homework and think it's worth buying the shares, whether they intend to keep the shares or push them onto someone else soon. So they don't need to be "protected" (as long as the S1 is accurate).

What about the people in (2)? Well, the sophistication of these retail investors ranges from sophisticated to clueless. Actually, there's really no material differnece between (2) and (3), other than (2) having a bit more money on average than their (3) counterpars.

But what can you really do when all the necessary financial information of a company is presented in the S1? Retail investors have developed this strange notion that investing in common stock is this "easy" way to make money, when in fact it has always been an area where "you better know wtf you're doing". Do you prevent "clueless" people from buying shares at all? Do you similarly prevent "clueless" billionaires from buying Picasso paintings?

I mean you'd think that if the IPO price is too high, then the investors simply wouldn't buy. After all, if we consumers think a product is too expensive (whether it be a house, a car, or a phone), we'll exercise discretion and shy away from the purchase. The underlying issue (provided that the S1 information is reasonable and accurate -- which is one valid concern you raise) I think is the ignorance and unfounded optimism of the average retail investor towards IPO shares. TBH I don't see how this "retail investors getting wronged" phenomenon gets rectified unless these investors themselves become educated about basic investment principles.

brianchu · on March 2, 2013

1) Yes, price does not necessarily mean value. But that is a really philosophical tangent (What is "value", bla bla bla etc.) that is pretty irrelevant. For all intents and purposes the two are interchangeable on the market. For all intents and purposes, the value of something economically is the highest price someone will pay for it.

2) >Groupon is Groupon. Groupon is not Silicon Valley, Groupon is not Amazon, Groupon does not represent any other company/industry other than itself. Do not go the Amazon, Webvan, etc. route, because mixing stories does not make the story any more right.

This argument is true in a tautological sense, but doesn't really provide a reason against comparing Groupon to other companies when valuing it. Yes, the fundamentals of Groupon matter, but growth in the abstract (not just YOY revenue growth) is difficult to evaluate. People will turn to other ways to evaluate companies, typically by comparing a company to other companies in the same sector. To give you an extreme example of this principle, VCs really don't care about an early startup's fundamentals. They'll look at the strength of the team and they'll evaluate (in a hand-wavy fashion, I acknowledge) the idea of the startup, and the reason they'll value, say, a YC startup with 3 co-founders at $6 million despite no revenue is because in their experience, they've seen companies with strong technical+operational teams return 100x. Yes, this example is not directly applicable to Groupon, since they did have revenue numbers to look at, but no doubt some people evaluated Groupon based on the idea of ecommerce growth.

I never thought Groupon was a good stock to buy. But I remember at the time that even though I saw that the fundamentals were weak, I personally could not be sure of myself because I saw my mother and many of her female friends (also mothers) buy tons and tons of Groupons. Hindsight is 20/20.

3) That is a terrible idea. How do you define "fairness?" Again, given that the inherent definition of "value" is essentially (in a market economy) the highest price someone is willing to pay, I don't see any situation in which a company's IPO would be canceled. In fact, this appears to be a de-facto price ceiling since you are essentially capping the valuation at whatever the SEC/auditor determines is the fair valuation, regardless of what people are willing to pay, something you will get virtually no economist to agree to. Last I heard, the SEC is not in the business of setting IPO prices (yes, you might argue that they're not technically setting the price, but the end result is that they are setting the price).

antr · on March 3, 2013

> the fundamentals of Groupon matter, but growth in the abstract (not just YOY revenue growth) is difficult to evaluate

Yes, forecasting growth is tough BUT if you have a price to start from, you can very easily back-solve the growth rate of a companies revenues, cash flow, etc. You don't have to be a genius to extrapolate that at a +$13bn equity valuation Groupon needed to achieve spectacular growth and cashflow generation over that next 5-7 years. Once you observe the implied growth rates, margins and cash-flow needed to be achieved one can genuinely analyse and criticise a valuation.

> That is a terrible idea. How do you define "fairness?" Again, given that the inherent definition of "value" is essentially (in a market economy)...

I don't think you understood my point. I'm not talking about something being fair (like you refer "fairness") or not, I'm talking about a Fairness Opinion or FO. An FO is an exercise that investment banks, auditors, consultants and other qualified parties, do on a daily basis. In the corporate world, specially with public companies, when a tender offer is received or presented an "independent" party provides a FO to inform investors and other stakeholders (primarily the board), that the offer is priced as expected or it is too high or too low. Issuing an FO is one of the most market friendly, pro free-market, instruments/exercises out there, instead of just dumping shares at a dubious valuation while deep-throating "unqualified" investors.

>But I remember at the time that even though I saw that the fundamentals were weak, I personally could not be sure of myself because I saw my mother and many of her female friends (also mothers) buy tons and tons of Groupons. Hindsight is 20/20.

I'm not saying that Groupon is not a viable business. I believe the contrary, I think there is a good business somewhere. But a good businesses can be under- and over-valued. The fact that people use Groupon doesn't make a ridiculous valuation justifiable.

> Again, given that the inherent definition of "value" is essentially (in a market economy) the highest price someone is willing to pay...

What you refer to here is the Price you are willing to pay; Value is a different thing. Any serious valuation exercise uses a discounted cash flow model driven by a solid operational model. Any other methodologies are simply hocus pocus. I suggest you read "The Intelligent Investor" by Benjamin Graham. It was published over 60 years ago, but it is as useful today as it was back then. This book distills value investing from speculation. Let me just finish by saying that the recent financial crisis, specially that of the US housing was due to the decoupling of prices and value; understanding both will be of value (no pun intended).

wpietri · on March 3, 2013

Thanks for the detailed reply.

Regarding 1, I know they're different. But value isn't knowable except in retrospect.

Regarding 2, my point with my Amazon story is that reasonable people can disagree about the value of something, and therefore be terribly wrong about price, and that it works both ways.

Regarding 3, it's interesting. I think your approach basically means that high-risk companies couldn't ever IPO, because there would be large legitimate differences in independent opinions. That seems like a high cost to pay. If I had my choice, we'd just outlaw sales and marketing. They'd put prospectuses up on web sites, announce the IPO date, and we'd see what happens. Equally unlikely that will ever happen, of course. Legislators and regulators don't work for the citizenry these days.

I think a market is essentially a giant learning machine. But because the knowledge is stored in humans, I think markets need to keep re-learning lessons. The dot-com bubble was a giant lesson in substance over dreams. More than a decade later, enough people had forgotten that they needed a lesson. Facebook and Groupon hopefully taught them that just because they think a product is swell and popular doesn't mean you should buy in at the IPO.

lifeisstillgood · on March 3, 2013

I don't think 3. Should be getting the ribbing it is as an idea. I think that SEC required "Amicus Briefs" would go a long way to tempering some irrational exuberance.

However the Prospectus document for the IPO at Groupon made sobering reading and covered pretty much all the points being raised here. Prospectuses are horrifying things to read carefully - everything that could go wrong is detailed.

So I would suggest turning 3. Into a requirement for a standard modelling simulation framework - which the SEC supports and mandates that the IPOing company provides whatever functions within that framework are representative of the various scenarios in the prospectus

Something similar is proposed for monitoring bank risk but I cannot remember the link - it's an SEC experiment from a few years back iirr.

antr · on March 3, 2013

I 100% agree that the Prospectus is "The Document" and that retail investors do not read it (and sadly may "professional" asset managers too).

Unfortunately the prospectus is a one-sided story, and it will never say if the valuation is stretched or not... even the price and issue number is inserted at the last minute! Yes, I know the company is book building, but if a company out there is going to go public, a public institution should be calling BS from a valuation stand point, and amend the "Risk Factors" of the company accordingly.

My point 3 was an in-extremis case. Nevertheless FO's are a very common and inexpensive instrument, and it is a shame that the public investor doesn't have access to this BS detector.