No-Mind

The mind must always be in the state of "flowing," for when it stops anywhere that means the flow is interrupted and it is this interruption that is injurious to the well-being of the mind. In the case of the swordsman, it means death. When the swordsman stands against his opponent, he is not to think of the opponent, nor of himself, nor of his enemy's sword movements. He just stands there with his sword which, forgetful of all technique, is ready only to follow the dictates of the subconscious. The man has effaced himself as the wielder of the sword. When he strikes, it is not the man but the sword in the hand of the man's subconscious that strikes.

— Takuan Sōhō, The Unfettered Mind

There is a tradition within Bushidō, the ancient Japanese way of the samurai, which states that a warrior must always be prepared for death; in fact, that a true warrior should always act in combat as if he is already dead. Only in this way does he have a chance of attaining mushin no shin, mind without mind, without which he cannot hope for success.

On this Memorial Day, I would ask each of you to reflect on this thought—forged in a culture and society in which combat was usually conducted at close range, with edged weapons, between combatants who could normally see each other's eyes—in the context of modern, mechanized warfare. Where death or incapacitation is more likely to come

• without warning
• from a distance
• from an unseen opponent
• in the form of splintered, searing metal which shatters limbs and tears flesh.

Then ask yourself who is more courageous: a professional warrior, raised from birth in a tradition of service and self-abnegation, facing a known opponent at arms length, or an 18-year old Specialist, fresh off the boat from America, driving a Humvee through the IED-riddled streets of Ramadi.

Then, please, do me a favor: Say a prayer of thanks, and protection, for all our young men and women in harm's way. They deserve it.

Happy Memorial Day.


© 2011 The Epicurean Dealmaker. All rights reserved.

Pebbles in the Stream

I.

Above all else, the mentat must be a generalist, not a specialist. It is wise to have decisions of great moment monitored by generalists. Experts and specialists lead you quickly into chaos. They are a source of useless nit-picking, the ferocious quibble over a comma. The mentat-generalist, on the other hand, should bring to decision-making a healthy common sense. He must not cut himself off from the broad sweep of what is happening in his universe. He must remain capable of saying: "There's no real mystery about this at the moment. This is what we want now. It may prove wrong later, but we'll correct that when we come to it." The mentat-generalist must understand that anything which we can identify as our universe is merely a part of larger phenomena. But the expert looks backward; he looks into the narrow standards of his own specialty. The generalist looks outward; he looks for living principles, knowing full well that such principles change, that they develop. It is to the characteristics of change itself that the mentat-generalist must look. There can be no permanent catalogue of such change, no handbook or manual. You must look at it with as few preconceptions as possible, asking yourself: "Now what is this thing doing?" ¹

II.

We can still remember the golden days before Heisenberg, who showed humans the walls enclosing our predestined arguments. The lives within me find this amusing. Knowledge, you see, has no uses without purpose, but purpose is what builds enclosing walls. ²

III.

Think you of the fact that a deaf person cannot hear. Then, what deafness may we not all possess? What senses do we lack that we cannot see and cannot hear another world all around us? ³

IV.

I have said: "Blow out the lamp! Day is here!" And you keep saying: "Give me a lamp so I can find the day." ⁴

* * *

V.

You should never be in the company of anyone with whom you would not want to die. ⁵

¹ The Mentat Handbook, Children of Dune.
² Leto Atreides II, His Voice, Children of Dune.
³ The Orange Catholic Bible, Dune.
⁴ Bijaz to Hayt, Dune Messiah.
⁵ Ancient Fremen saying, God Emperor of Dune.

© 2011 The Epicurean Dealmaker. All rights reserved.

Hail Mary, Full of Grace

Life is like an analogy.

— Aaron Allston

I am a fan of the carefully chosen analogy, O Dearly Beloved. Perhaps you have noticed this. Analogies can be persuasive rhetorical devices, both illuminating and clarifying difficult topics by drawing attention to their similarity to situations and things with which we are more familiar. Using an analogy can reveal aspects of the subject in question which would otherwise be difficult to perceive. A well-chosen analogy can make the reader say, "Why, yes, of course. Why didn't I see that? How clever."

But analogies can be dangerous, too. In particular, analogies can encourage an over-facile equation of things which are fundamentally dissimilar based upon a few, selected characteristics they share in common. This can lead an author and reader to draw unsupported conclusions, or to extend the analogy to other aspects of the subject to which it does not truly apply. Carried too far, an unsupported or overextended analogy can conceal more than it reveals, or beg the more interesting questions at hand in favor of cheap and easy parallelism. Carried to an extreme, a faulty or weak analogy can even suggest an incorrect interpretation of events, or counterproductive behavior.

Analogies are like spices: a judicious application can enhance and bring out the flavor of a dish; too much can overwhelm it and even change its character entirely. Sriracha, anyone?

* * *

So, for example, I am innately suspicious of the most common analogies which businessmen (almost always men, natch) use to characterize business: war and sport. While certain characteristics of these phenomena have obvious parallels in the world of business—high-stakes competition against determined opponents, a focus on developing and maintaining strategic and tactical advantage, and the importance of disciplined and coordinated teamwork, for example—there is a great deal of business which is not at all like either sport or war. In particular, no-one usually dies in business, and standard business methods do not normally include the destruction by attrition of an opponent's personnel and matériel through the overwhelming application of violent force. This is a—if not the—key definitional characteristic of the aims and methods of war. Without this core quality, business is nothing like war, except in the most superficial aspects listed above.¹

By the same token, businesses compete in a far more fluid and undefined competitive space than do sports teams. There are no regularly scheduled games, championships, or league rankings in the world of business. Competition among businesses is not governed by a rigid, highly codified system of rules, overseen and enforced in real time by independent officials who can intervene with absolute authority. Business competitions rarely result in easy to understand outcomes: Coke, 23; Pepsi, 21. Finally, unlike sport, business is not at its core an entertainment, or play. It is deadly serious, and it involves almost all of us as direct participants and competitors. Employees are not fans. While sports fans can have a lot of emotional capital at stake (and money, too, if they wager), they do not lose their jobs, get laid off, or suffer pay cuts if their favorite team loses the playoffs. In its form and essence, sport is simple, clean, and relatively static. Business is nothing of the kind.²

* * *

Hence, you may understand why I am less than enthusiastic about a recent article written by Roger Martin, the Dean of the Rotman School of Management, which appeared in the Harvard Business Review. In it, Professor Martin draws an extended—if not exhaustive—analogy between the behavior of business executives and American football quarterbacks. His basic complaint, if I read him aright, is that, unlike quarterbacks who play to accomplish real results (i.e., winning), public company CEOs run their businesses to satisfy market expectations. That is, they manage to their company's stock price, not to its real financial and operating results.

Here is what Mr. Martin has to say:

CEOs routinely go to the microphones to apologize or make excuses for missing the analysts' consensus earnings estimates — even if their real results are substantially up. And executives routinely take extreme and risky actions at the end of fiscal periods in order to juice results to hit those consensus earnings estimates.

Why is it that what is inconceivable in football is standard in business? The answer is that compensation is largely based in the expectations market in business and is strictly based in the real market in football. CEOs have a large portion of their compensation based on the performance of their company in the stock market, so CEOs spend their time shaping and responding to expectations. Quarterbacks have no part of their compensation based on the performance of their team against the point spread, so they focus completely on winning games.

Football has figured this out a lot better than has business. Football focuses its key players on the real game; business focuses its key players on the expectations game. Football gets 100% useful activity from its key players; business has them engaging plenty of their time in non-value-adding activities, like talking to analysts. It is time business learned a few things from football.

Perhaps Mr. Martin has been addled by enthusiasm for his analogy, but I think this is pretty silly advice. For one thing, quarterbacks and football players get paid for "real" results (winning football games and championships, for example) because those results are so well-defined and easy to measure. Did the Steelers beat the Bengals last night or not? That's a simple yes or no answer. Did the Steelers win the Super Bowl or not? Ditto. On the other hand, how do you measure success in business? Is it that net income increased by 15% year over year, or revenue by 10%? Is it that your company gained three points of market share, or reduced its outstanding debt by 10% with free cash flow?

Sports teams and fans track lots of statistics over the course of a season, but let's face it: the only thing that matters at the end of the day is whether they win or lose. Football teams and quarterbacks can put up better statistics than anyone else in the league, but if they don't win games, it just doesn't matter. Football is simple: over the course of a season each team in the league competes against all the others, and the playoffs and championship determine—by definition—the "best" football team of the season. There is no equivalent in the world of business. The metrics of success in business are far more multiform, variable, and relative: revenue growth, income growth, operating margins, free cash flow, market share, etc. You cannot point to a company's results at the end of a fiscal year and definitively declare that it "won" or "lost." Even if it outperformed its entire history in terms of growth, margins, and profitability, that does not mean it outperformed its competitors. There is no commonly accepted measure of absolute success in business.

Therefore, while it is relatively easy to track and incentivize football players based on whether they won or lost, and how often, it is quite tricky to pick one or two easily measured metrics to determine compensation for business executives. It makes no sense to pay a CEO solely based on operating or financial results, because that ignores industry conditions and relative performance, among other things. Why pay a CEO an incentive bonus if net income increased by 15% on his or her watch, but net income at the company's closest competitors increased by 20% or more? Why pay him or her for increasing sales if sales across the entire industry rose due to exogenous factors outside any executive's control?

There is, however, one universal metric in business—at least for publicly traded companies—which can be easily tracked and measured: a firm's stock price. Since this stock price presumably embodies the real-time, summary judgment of investors about both industry conditions and a company's individual prospects, it can act as a reasonably reliable proxy for the performance of the company and, hence (again presumably), its executives. That is why you see so many companies tie a significant portion of their executives' compensation to their stock price. Now, because a company's stock price incorporates factors external to its own performance—most notably investors' perceptions of the company's absolute and relative success—you will see corporate executives devote a great deal of time and attention to persuading investors of their case, to satisfying investor expectations, and to generally managing to the share price in addition to delivering actual results.

* * *

But—and this is crucial—this makes all the sense in the world. Why? Because management's incentives are aligned with those of their company's investors. They want to see the share price to go up, just like investors do. In fact, for both investors and management, a rising stock price is "winning." Just like quarterbacks and their teammates get paid to win games, win playoffs, and win championships, corporate executives get paid to boost their company's stock price, because that's what their owners (employers) want them to do. Football players are incentivized to win because it makes the franchise earn more money, it gratifies the team owners' egos, and because to the best of my knowledge the NFL takes a very dim view of owners and players betting against their own teams. Corporate managers are paid at least partially in stock and options because investors want them incentivized to raise the stock price, so the investors who own the company can make money.

Now, can excessive focus on raising the stock price distract management's attention from running the business and delivering the operating and financial results over which they have real control? Sure. Does an effort to drive the share price occasionally encourage managers to engage in counterproductive and dangerous games like managing earnings and creative accounting? Of course. But no incentive system is foolproof, and no incentive system is immune from being gamed for someone's advantage.

Perhaps in his obvious enthusiasm for the apparent purity and nobility of American football, Mr. Martin has forgotten that sport is vulnerable to the very same distortions and bad behavior that he chastises in business. There is a very old set of bad, distorting, and counterproductive behaviors which afflict and undermine any sport which is focused on winning. It is called cheating.

* * *

So, in contrast to Mr. Martin's recommendation, I would posit another. There is something important which business can teach the followers and encomiasts of sport: never underestimate the incentive, opportunity, and temptation for human beings playing high-stakes games to cut corners.

That is called human nature.


¹ If you remain unconvinced, indulge me with a little thought experiment: what do you think the competition between implacable soda pop rivals Coke and Pepsi would look like if they could bomb each other's plants, machine gun each other's employees, and assassinate each other's leaders? Yeah. See the difference?
² Before the sports mad take up pen and cudgel, let me explain. Sport operates with far fewer degrees of freedom than does business. The rules, structure, and forms of acceptable behavior are limited and highly codified, by definition. That's what makes it sport. I say this not to take anything away from the skill, beauty, and excitement which well-played sport entails. It's just that sports participants channel their energy, skill, and determination into extremely limited and well-defined channels. In contrast, business is much more like a barroom brawl.

© 2011 The Epicurean Dealmaker. All rights reserved.

Dan, You Pompous Ass

Frequent visitors to this site know to discount my more fearsome moods and expostulations as simple proof of passionate engagement with my various subjects. Nevertheless, I am always pleased to receive constructive criticism when and where appropriate. Therefore, it is with gratitude that I acknowledge a pair of interlocutors who observed helpfully yesterday that I failed to directly address one of the principal charges which Joe Nocera leveled in his ill-considered jeremiad on the LinkedIn IPO. I can only excuse myself by noting that I must have gotten caught up in demolishing the silly accusations of Mr. Nocera's partners in disinformation.

For your convenience, I will repeat the core of his argument here:

[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."

Now, I think I rather conclusively eviscerated the notion that LinkedIn's underwriters "absolutely" knew the stock would more than double on the day of pricing in my previous post. They had no idea, other than LNKD was a hot IPO; therefore, all bets were off. Furthermore, even if they strongly suspected something like that would happen, there was very little they could do to forestall it, if LinkedIn's executives and current shareholders did not want to offer substantially more shares.

So Nocera's remaining allegation—echoed by Zynga's GM—is that the underwriters took advantage of the expected pop in the company's shares to hand risk-free trading profits to their friends and best customers. There are two answers to this accusation, one based on the facts of how investment banks allocate shares in IPOs and another based in common business practice. I will address them both in turn.

* * *

First, lets examine the facts, as they are known in the reality-based community.

Once a company launches the investor marketing phase of an initial public offering—consisting of management trotting around to dozens of one-on-one management presentations and rubber chicken lunches in front of hundreds of institutional investors—its underwriters commence a direct outreach program to these very same investors. As the actual offering date approaches, a more intense program commences known as bookbuilding, in which the investment banks survey the buy-side investors as to their appetite for the stock, including preferred number of shares and price limits, if any. The twofold objective is to build a book of indicative orders that exceeds the anticipated size of the offering—to create conditions for a sustained level of demand support after the stock opens for trading—and to build this book with investors who do not have hard limits on the price they are willing to pay.

Now, every underwriter worth its fees will do its damnedest to build what we call a high quality book of orders. In other words, we want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket. These are the type of investors virtually all of our issuer clients want: investors, not traders; buy-and-hold accounts, not fast money hedge funds. Of course, the stronger the demand for the deal, the more selective underwriters can be in our allocations. The stronger the overall demand, the more likely it is that we can exclude buy side accounts who traditionally flip on the offering from the deal entirely. And believe you me, we know exactly who the fast money accounts and IPO flippers are. We track every deal, and we keep records.

The other material point to relate is that virtually every investment bank makes this process as transparent as possible to its issuer clients. As we approach the pricing date, underwriters hold calls with company management and selling shareholder representatives every day—and often several times a day—to relay investor feedback and update the status of the order book, including requested allocation sizes, limit orders, etc. While it is saying too much to assert every company has a detailed grasp of its IPO order book prior to pricing, it is almost never the case that the sellers are surprised in any material way by its final makeup.

Unfortunately, hot IPOs can disrupt underwriters' and issuers' carefully laid plans to build stable, supportive, long-term investor bases. Even buy-and-hold investors with the best intentions can yield to the temptation to flip their shares when an IPO doubles in price on the first day. We underwriters can look sternly at them, and ostentatiously put a black mark next to their names in our offering records, but it's hard for us not to understand the compulsion they feel. It also makes it harder for committed investors to add to their positions, as many of them prefer to let the stock settle down to a dull roar before they commit more funds to the investment.

But that, as they say, is a champagne problem to have. Most companies are so delighted with a strong IPO performance that they don't mind having a few more hedge funds and fast money accounts in their shareholder base for a while. After all, those guys' money is just as green as Warren Buffett's.

* * *

Second, I find it absolutely ludicrous that kibbitzers feel compelled to criticize investment banks for passing around favors in our gift and treating friends of the firm well. For one thing, investment banks by their very nature straddle both the buy- and the sell-side of markets. We have corporate clients and their inside shareholders who sell stock and institutional investor clients who buy it. Yes, we serve two client bases with potentially competing interests, but that is the very reason we are able to underwrite securities in the first place. We are middlemen, and it is the essence of what we do all day to balance the competing interests of our clients for the benefit of all. All our clients are fully aware of this.

For another, what business of any kind does not treat some clients better than others on occasion? Do you really think a midsize manufacturer gets the same attention and economic terms from Microsoft that General Electric does? Do you really think it is not in the very nature of business to trade favors for increased business, for better terms, for new business? Of course investment banks horse trade with certain buy-side investors; of course we give certain accounts bigger than normal allocations in IPOs; of course we give a hedge fund we owe a favor to access to a hot IPO. By the same token, we earn a lot of favor ourselves for giving accounts access to such hot IPOs. The horse trading goes both ways. And because we owe an obligation to underwrite a successful offering for our issuing clients, all the competing pressures from the institutional securities side of our house are generally and pretty successfully kept in check.

This—for those among you who might be unfamiliar with it—is commonly known as business.

* * *

Frankly, I have always suspected that the stentorious outrage about special favors and secret deals investment banks allegedly dispense on IPOs really boils down to simple envy. Nine times out of ten, I suspect the person whinging is just pissed off he did not get shares in a hot IPO himself. There is a name for such people in my business: retail flippers. And we never allocate shares in hot offerings to them if we can possibly help it.


© 2011 The Epicurean Dealmaker. All rights reserved.

Jane, You Ignorant Slut

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?

BECAUSE LINKEDIN ONLY SOLD FIVE POINT ONE PERCENT OF ITS FUCKING STOCK, NOT THE ENTIRE COMPANY ¹

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.