GOD DAMN IT. I thought Joe Nocera was smart. Then I read horseshit like this:
[I]n reality, LinkedIn was scammed by its bankers.
The fact that the stock more than doubled on its first day of trading — something the investment bankers, with their fingers on the pulse of the market, absolutely must have known would happen — means that hundreds of millions of additional dollars that should have gone to LinkedIn wound up in the hands of investors that Morgan Stanley and Merrill Lynch wanted to do favors for. Most of those investors, I guarantee, sold the stock during the morning run-up. It’s the easiest money you can make on Wall Street.
As Eric Tilenius, the general manager of Zynga, wrote on Facebook: "A huge opening-day pop is not a sign of a successful I.P.O., but rather a massively mispriced one. Bankers are rewarding their friends and themselves instead of doing their fiduciary duty to their clients."
With this appalling emission, Nocera joins the ranks of the table-pounding, idiotic commentators—including Henry Blodget, Jim Cramer, and, apparently, the financial markets expert in charge of underwriting tomatoes and cabbages over at Farmville, Eric Tilenius—who have tripped all over themselves to draw the exactly wrong conclusions about this week's 110% pricing day gain in LinkedIn's IPO.
In fact, Nocera cites Henry Blodget approvingly for one of the stupidest analogies about initial public offerings ever conceived:
But over at the Business Insider blog, Henry Blodget — who knows a thing or two about bad behavior on Wall Street — had the perfect analogy for what the banks had done to LinkedIn.
Suppose, he wrote, your trusted real estate agent persuaded you to sell your house for $1 million. Then, the next day, the same agent sold the same house for the new owner for $2 million. "How would you feel if your agent did that?" he asked. That, he concluded, is what Merrill and Morgan did to LinkedIn.
Jesus. The mind just fucking boggles.
Where to begin? Such a target-rich environment.
I know, let's start with The Stupidest Analogy About IPOs Ever Conceived. Blodget asks how you would feel if your real estate broker sold your house one day for $1 million to someone (a friend of his, presumably) who turned around and sold it the next day for $2 million. You'd be pissed, right, and feel betrayed? Of course you would. That would be a big problem.
But let me posit another scenario. Let's say that you didn't want to sell your entire house and move out. Instead, you want to raise some money for kitchen remodeling. Being a clever, innovative sort, you decide to do so by selling a small portion of the equity in your house (you own it debt free) to a bunch of strangers for $50,000. Your broker tells you he thinks he can sell that based on an estimated valuation of your house at $1 million, which means you need to sell 5% of your equity. You say great, he sells it for you, and the next day a whole other bunch of strangers are trading the shares you sold for $100,000.
Is this a big problem? Well, if you and your broker knew that demand for a tiny sliver of your home equity would be so strong, you could have raised $50,000 by selling a smaller portion, say 2.5 or 3%. After all, you don't need more than fifty grand to remodel your kitchen (it's a nice kitchen), and, what with interest rates so low, you sure didn't want to put any extra in the bank. But your broker was adamant that you needed to sell at least that much because, if you sold less, those shares wouldn't trade easily enough, and it would have been hard to drum up enough interest to sell them in the first place, perhaps even for any price.
More to the point, do you really care? You got your money, you still own 95% of the equity in your house, and you feel pretty happy that the home you built over many years with your bare hands seems to be worth $2 million. Especially since you paid less than $30,000 for it in the first place. You know that if you want to sell your house tomorrow, or any additional portion of it, you have a pretty good chance of getting close to $2 million for it. Your broker shrugs apologetically, you pat him reassuringly, and you both walk off to the kitchen remodeling store arm-in-arm whistling. Fifty grand foregone seems like a pretty small price to pay to find out the true value of your home, no?
So, using Henry's house sale analogy, and correcting it to reflect the facts of the LinkedIn IPO, the underwriters' behavior doesn't seem quite so damning after all, does it?
Like I said: The Stupidest Analogy About IPOs Ever Conceived.
Next, let's turn to Mr. Cramer, another supposedly intelligent man, who ranted on air that LinkedIn's IPO was "outrageous" and "preposterous" and, apparently, should have been prevented by regulators. His major criticism seems to be that the deal was too small. By selling only 8.3% of the company's shares in the offering (pre-shoe), Cramer claims that the company and its underwriters created a buying frenzy for LinkedIn shares through sheer scarcity.
But this is ludicrous. First of all, it's not at all clear that the company needed the money it did raise in the first place. Pre-IPO, LinkedIn was debt-free, had over $100 million in cash on its balance sheet, and hadn't invested much more than $50 million in cash in its business in any one year since inception, most of which it funded from operations. The declared use of proceeds is typical content-free legalese [emphasis added]:
The principal purposes of this offering are to increase our capitalization and financial flexibility, increase our visibility in the marketplace and create a public market for our Class A common stock. As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to us of this offering. However, we currently intend to use the net proceeds to us from this offering primarily for general corporate purposes, including working capital, sales and marketing activities, general and administrative matters and capital expenditures. We may also use a portion of the net proceeds for the acquisition of, or investment in, technologies, solutions or businesses that complement our business, although we have no present commitments or agreements to enter into any acquisitions or investments. Based on our current cash and cash equivalents balance together with cash generated from operations, we do not expect that we will have to utilize any of the net proceeds to us of this offering to fund our operations during the next 12 months. We will have broad discretion over the uses of the net proceeds in this offering. Pending these uses, we intend to invest the net proceeds from this offering in short-term, investment-grade interest-bearing securities such as money market funds, certificates of deposit, commercial paper and guaranteed obligations of the U.S. government.
Like many maturing internet companies, LinkedIn is basically self-funding. Unless its executives go hog wild and start buying other companies with cash—Zynga, anyone?—I expect we'll see close to $300 million still on its balance sheet a year from now. Earning 30 basis points in short-term Treasuries. What would Cramer have the company do with more cash, buy back its own shares? Oops.
The only other source of shares would be current shareholders, but it's patently obvious almost no-one wanted to sell a substantial portion of their holdings on the IPO. Only relatively small holders Goldman Sachs, McGraw Hill, and SVB Financial sold their entire positions, for reasons best known to themselves. The fact that insiders were unwilling sellers can be deduced from the structure of the overallotment option (or "green shoe"), which is the 15% extra shares the underwriters have a right to sell in the face of strong demand. If sold, those shares will come from the company.
No, unless Messrs. Wiener and Hoffman have something surprising up their sleeves, I think we can assume that they did this IPO for the very reason they disclose in plain English:
The principal purposes of this offering are to ... increase our visibility in the marketplace and create a public market for our Class A common stock.
They did it to go public, which means, in this case, that current shareholders will be able to sell their shares in future offerings. They are priming the pump for bigger paydays in the future. Believe you me, I can guarantee the underwriters were begging company executives and big shareholders to increase the size of the offering, especially after they began to see the strength of demand. After all, the investment banks get paid 7% of the offering proceeds; the bigger the offering, the more money they make.
Viewed this way, the approximately 50% haircut the company and its current shareholders took on the offering was the price they paid to establish a public trading market for their shares. It was indeed a steep price—several hundred million dollars—but I doubt many of the newly minted billionaires and multimillionaires are too bent out of shape about it.
Finally, I would like to turn to the issue of valuation. People like Henry Blodget, Eric Tilenius, and uncountable others have been raving on and on about how the LinkedIn IPO was seriously "mispriced." To a person, they blame the investment banks which underwrote the deal, accusing them, at best, of near-criminal idiocy and, at worst, of criminally fleecing their issuing client and its shareholders. But this is just stupid.
Before they ever approach the market, investment banks do a lot of work evaluating new issuers to come up with a price which they think the company will be worth once it is trading normally in the marketplace. They do this based not only on the company's own historical and projected financial results but also on the trading multiples and profiles of comparable companies already public. Once they determine an estimated normalized value, they apply a standard 15% discount to the shares offered in the IPO. The purpose of this is to try to ensure that new investors have a positive investment experience with the IPO, and there is enough intrinsic value left for shares to trade up going forward. This is especially important if the company and/or its existing shareholders intend to sell shares in the future. Giving new investors in an IPO some value for free is the price of being able to do successful follow-on offers in the future.
Now, you can see that this exercise is an art, not a science. Investment bank IPO pricing is the epitome of (very) highly educated guessing. We often get it wrong, but, on average, IPO pricing is normally pretty accurate. After all, it's our job, and we do it well. The picture gets complicated, however, when the company in question, like LinkedIn, does not have any comparable peers among listed public companies. Our guesses become much less educated and much more finger-in-the-air type things. There is no cure for this but to go to market and see what investors themselves tell you they are willing to pay.
But once we go to market, the issuer and the investment banks essentially hand the steering wheel over to investors. We pitch, and wheedle, and cajole, and praise the company to the skies, but it is investors who set the price, initially in individual conversations with the underwriters' salespeople—where they indicate the number of shares, if any, they want to get in the offering and any price sensitivities or limits they may have—next when the banks set the final price for the offering, and finally—and, by definition, definitively—when they bid up the price in the aftermarket after the shares are released for trading.
Let me make this perfectly clear: Investment banks do not set the ultimate price for IPOs; the market does.
And sometimes, as in the case at hand, you get what we call in the trade a "hot IPO." Investors work themselves into a buying frenzy, the offering becomes massively oversubscribed (e.g., orders for 10 or more shares for every one being offered), and the valuation gets out of control. Underwriters have a limited ability to respond to these conditions, which typically emerge during the pre-IPO marketing or "bookbuilding" process, including revising estimated pricing up, like LinkedIn's banks did (+30%), and increasing the number of shares offered. But eventually you just have to release the issue into the marketplace and let the market decide what the company is really worth.
That is when you see grizzled investment bankers, veterans of thousands of IPOs, sit back at their trading terminals and laugh in disbelief. I'll let you in on a little secret: Morgan Stanley and Bank of America Merrill Lynch think people who bought LinkedIn shares at $90 or more are nuts. Three days ago, they never would have imagined it could go so high so fast. (Give them a few days, of course, and a few pitches to other currently private social networking companies contemplating IPOs, and they will change their tune. They will say a $10 billion valuation for LinkedIn makes all the sense in the world and, yes, we can get you the same or better valuation for your gem of a company. We have short memories when it comes to money-making opportunities.) LinkedIn's price performance guarantees that future social networking IPOs will come at stratospheric initial valuations, too. Why? Because it is our newest and best comparable, of course. Duh.
So say what you will about hot IPOs causing bubbles, no-one directly involved in the LinkedIn offering—the company, the selling shareholders, the underwriters, or the initial investors—is remotely unhappy with what happened. I guarantee you the clients were guiding the process and making decisions every step of the way. The underwriters simply told them what was possible, took the company to market, and got out of the way.
As far as people who bought LinkedIn shares above the offering price, well, all I can say is good luck. No-one held a gun to your head and, for all I know, you may have made a stellar investment. Nobody can be sure that LinkedIn shares won't continue to rise from here. (Of course the converse is true, too.) I seem to recall a certain former Wall Street research analyst making a name for himself with what seemed like an outrageous prediction that Amazon.com would reach $400 per share during the prior internet bubble. If I remember correctly, I think he was proved right. One thing investment bankers learn early is never to underestimate the ability of the market to confound you.
But let's hear no more ignorant twaddle about "scamming," or dereliction of fiduciary duty, or bankers just being in it for themselves. It's just wrong, and it's based on an appalling misunderstanding of how and why IPOs get done by people who should definitely know better. It's just not that hard to understand.
And if the backchat doesn't stop, I may just have to get nasty. I won't like it, but that's something else I'm really good at, too.
DISCLAIMER: I was not involved in the LinkedIn IPO, and I have no position, direct or otherwise, in LNKD shares. My analysis is speculative, based upon my own knowledge of the industry, extensive experience underwriting IPOs, and general common sense. I make no representations that my description of what happened really did happen that way, but it's pretty damn likely to be true. Never, ever take anything I say here as investing advice. If you do, I will hunt you down and kill you.
1 My analogy is approximately correct, based on the information disclosed in LinkedIn's IPO prospectus: the company sold a 5.1% stake consisting of 4.8 million newly-issued shares to investors (selling shareholders, like Goldman Sachs, sold the rest). The original shareholders' basis in the company was $120 million, or 2.8% of the original IPO valuation at $45 per share (p. 38). I ignore for these purposes whether the underwriters will exercise their overallotment option (the "green shoe"), which they most certainly will. Those additional 1.2 million shares will come from the company, too.
© 2011 The Epicurean Dealmaker. All rights reserved.
