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Fixing the ‘Brain Damage’ Caused by the I.P.O. Process (nytimes.com)
137 points by KKKKkkkk1 on Sept 20, 2017 | hide | past | favorite | 78 comments

Good analysis from Matt Levine on how Social Capital Hedosophia Holdings Corp (SPAC trying to eliminate the headache of IPOs) is actually more expensive than going public.

> A final thing about SPACs is that they are so expensive. Banks charge a rack rate of about 7 percent for initial public offerings, though big sexy tech IPOs tend to be done more cheaply. SPAC sponsors compensate themselves rather more lavishly. Hedosophia's sponsor -- a Cayman Islands company owned by Palihapitiya and his co-founder -- invested $25,000 to found the SPAC. In exchange for that nominal payment, and their work on finding a company to take public, they get 20 percent of the SPAC's stock. (They are also are putting in another $12 million or so to buy warrants in connection with its IPO.) A 20 percent fee for taking a company public is just ... more ... than a 7 percent fee. And that's not even counting the 5.5 percent fee that Credit Suisse charged for taking Hedosophia public! Something like a quarter of every dollar that investors are putting into Hedosophia is going to compensate financiers for doing the work of (ultimately) taking a unicorn public, which is a funny way to make that process more efficient.


I was confused by Hedosophia's value proposition after reading that earlier article as well, but NYTimes seems to do a better job of explaining it.

> "For all this, he takes a tidy fee: 20 percent of the $600 million. But if his company acquires a business five to 20 times its size through a reverse merger, he said, the fee is the same as or smaller than a banker’s fee — and it is all in stock, so unlike the banks, Mr. Palihapitiya’s interests are aligned with the company’s."

Ie, the banks charge 7% of the startup's IPO valuation, whereas Hedosophia's sponsors charge a flat 20% of the $600M, regardless of the valuation of the startup it buys. According to the above math, if Hedosophia reverse-merges with a $3B unicorn, the effective fee would only be 4%.

That's not correct. The bankers' fee is 7% of the money raised in the IPO, not of their total valuation.

Matt Levine addressed that one too: https://www.bloomberg.com/view/articles/2017-09-19/memory-mo... Can't see how to link into the article but if you ctrl-f Hedosophia you'll see his point.

Thanks for the link. I'll admit that I'm not an expert in IPO-finance, and I'm surprised that Andrew Ross Sorkin and Matt Levine are saying such diametrically opposing things. There's probably some nuance to their disagreement that I'm missing.

There is no one better than Matt Levine on things like this. No hype, no handwaving, no BS. Just build the deal in an Excel spreadsheet and understand how it works.

Well said.

Careful, it's not more expensive for the company, just the financiers. By investing in this SPAC, you're basically willing to 1) eat the fees to bring a unicorn public earlier, and 2) and actually participate in a potentially "hot" unicorn that you're trusting Chamath will find.

For the company, you get to go public at 1) just the reverse merger fees which is significantly lower than IPO fees, and 2) at less time than going public (basically 1-2 months for the merger to go through)

> it's not more expensive for the company, just the financiers

This is not how spreads work. (The problem is related to determining where the burden of a tax falls.)

If an investor is willing to pay $10 for a company, an IPO gives the company $9 and the banker $1. That same investor would pay $8 for 80% of what those $10 would have bought. The price to the company is, out the door, lower.

I’ll give the SPAC sponsors credit for beating the VCs and investment bankers at the fee game. They get a wider spread than the bankers. (IPO fees aren’t allowed, by law, to go to 20%.) And they get VC carry for what’s essentially a flip. Except it’s better than carry—there’s no hurdle! They could lose 80% of investors’ money and they’ll still get their 20%.

Disclaimer: I am not a lawyer. This is neither legal nor securities advice.

I feel like.... maybe some of these guys are feeling the hangover from other people's money, and trying to have it both ways.

It's far from easy to bootstrap, but you basically solve all the problems these guys are talking about if you can survive it. The problem, of course, is that your unit economics have to work, you have to have the personal patience and resources to get to profitability, and you have to survive a potential funded competitor using their financial leverage to sell at or near a loss and torch your position in the market.

So a lot of folks take the money, but you take the money, you gotta pay it back. An IPO is ultimately just kicking the can down the road, and taking on a new set of guys that are going to cash out your venture debt for public debt. Who also expect to be paid back. I don't see a way out of this devil's bargain short of, you know, delivering on the milestones you talked about in your pitch deck, or in your roadshow.

But spare me the crocodile tears, huh? You took the money, you gotta pay back the money. Plus interest. And a lot of these IPOs, they had to make big promises when they went public-- big multiples, big projections, to support big valuations. Now you are sitting on a big pile of teachers' pension money and you have to deliver.

Ask any of these CEOs if it would be cool to hear from there direct reports once a year or once a decade. This is just a whining plea for no accountability from managers. The right to execute a long term vision has to be earned by effective communication and superior execution. Just look at Amazon. No quarterly profits and it is the darling of a Wall Street. You don’t get to flounder around without a clear strategy or results and then complain people want to know every 90 days where things stand.

Amazon is exceptional. Emulating Amazon will get most companies delisted.

They're not "exceptional" they've just managed to find productive ways to reinvest their profits.

The reason their stock is valued so much is partly because if he wanted/needed to, Bezos could wake up one day and cut all programs focused on expansion and return the saved costs / new profits as dividends. The reason this doesn't happen is that the money is (thought to be) better spent on increasing the size of the business. There's no reason other companies couldn't do this, although I expect the main limit to this strategy is the extent to which you can productively reinvest capital. This is a function of foresight/luck (e.g. branching into AWS) but also of the market you're in: to what extent do you begin to experience diminishing returns as you spend more money on improving your product? I think that with logistics, as with Amazon and e.g. Walmart, the returns diminish very slowly, or even increase with money spent (economies of scale).

Can you describe more about what practices would cause delisting?

Running out of money by only spending on R&D and having your share price drop below listing thresholds, I think, is the implication.

Yeah, I don't think you'd even have to run out of money. There are plenty of companies generating a fair amount of cash flow that hover in the dangerous territory of < $3 a share. It only takes one bad quarter.

Here's an example of a company that generates cash but only recently is in the safe-ish territory:


(Not that I think they are emulating Amazon, mind you, just making the point that you can have a going concern, and still get delisted.)

More broadly, unless you have an amazing business, you probably shouldn't emulate Amazon (or Google, or FB, or any other business that is depending on free cash flow to fund R&D as opposed to generating profits).

> the dangerous territory of < $3 a share.

that's only dangerous until the stock does a reverse split.

Share price doesn't dictate how much money they have. Amazon makes buttloads of money; they just choose to use it rather than give it back as dividends.

No. That wasn't implied either. Conversely, net profits do tend to be a positive indicator of share price.

It's also incorrect to say that AMZN "makes buttloads of money", with sub-1 EPS[1] at a nearly $1,000 share price.

[1] https://finance.google.co.uk/finance?q=NASDAQ%3AAMZN&fstype=...

Just shy of $38 billion in one quarter revenue is "Buttloads of money". I wasn't necessarily relating it to the share price.

The piece doesn't really articulate a problem, if anything the reverse is true more often than not: management chases short term performance numbers to the detriment of the long term success of the company and long term shareholders.

It's more just like "woah we're hip smart tech bros we need to fix the stock market!" even though none of their claims really have any merit.

IPOs are still stupid for a lot of reasons, but stratifying shareholders (why is the answer to everything from the Valley always more stratification?) is neither here nor there.

Here's my problem with the Long Term Stock Exchange idea...

What makes the tech echosystem thrive is the flexible capital and labor model. Anyone can get a little money to chase their idea. The small ideas get starved for capital and labor until they get market validation. Then the capital and labor chases them. And that's how great companies grow so quickly in a land of startups.

Anything that restricts mobility of labor hinders this and should be fought. (Example: Non-competes, cost-prohibitive real estate, etc)

Anything that restricts mobility of capital should be fought too. To have capital available for great ideas, it should be easy to flee ideas that aren't working out. (This is also why share buybacks from mature companies are fine - the capital get recycled)

I have mixed feelings here, but I'm certainly not entirely negative.

Activist investors have done a great deal of real damage, mostly by demanding that sound companies sacrifice long-term planning in favor of dividends and short term wealth gain.

It's 'creative destruction', sure, but it's not about companies failing when they can't compete. It's about investors leveraging a regulatory environment to turn profit on something other than actual value creation. A system that directly rewards incumbents seems questionable, but a system where shareholders gain influence within a single company over time seems like a reasonable answer to short-termism.

I agree with you in principle. The problem is that status quo encourages very short term thinking that has caused a lot of damage. I think it's at least worth toying around with longer-term incentives to see what can come out of it. I'm not super excited about 5 or 10 year vests (especially 20 years into my tech career without an FU nest egg), but it's a far lesser evil than non-competes or astronomical real estate (the latter being the thing that will likely drive me away for the sake of my family).

I'm not sure I follow you on real estate. Does the OP's proposal for long term capital fix that? Best I can tell, the one thing that will fix expensive real estate is autonomous cars. (Parking can be converted to housing, and longer commutes become tolerable)

Actually I was just reflecting your examples, not citing things which the proposal would fix.

ah - got it. Unfortunately expensive real estate is a 2nd order effect of flexible labor and capital.

As far as I can tell, the company doesn't get anything as the shares are traded back and forth. Yet they're still beholden to a lot of short term chasing, because that's what shareholders demand.

Right - the IPO is about trading future claims on income. But if the owners do bad things, in theory it hurts the equity price in the future.

The system isn't perfect by any means, but discouraging people from exchanging equity when they have differences of opinion doesn't help.

Well, bad is a relative term, and that's part of the problem. A number of "activist investors" consider it bad if they're not getting huge dividends and growth from every company, pressing short term gains instead of long term sustainability. And what's worse, sometimes these investors buy the stock specifically so they can do that.

It's not investors who pursue short term gains at the expense of long term gains, it's management. CEOS/Boards/Top management practice share price manipulation to maximize the value of their own stock options. If you are CEO of a company and you have a big block of options vesting at years end, it's time to announce a buy back program to get the stock to pop, even if it's determinedly to building the long term value of the business.

If you want shareholders to act more like owners, allow them to be treated like owners. Currently the SEC's anti-raider rules prevent any shareholders from proposing board slates. Boards are picked by boards, insiders pick insiders. That's the real disconnect here.

Every company needs to balance this. If there is no investment now, there is no future.

The key is the amount each company should invest depends on it's situation. Some companies don't do a good job investing in their future, and are better off returning money to shareholders. (Look at companies that "invest" in corporate jets for example) Other companies are better at making good investments, and should invest all their profits and then some.

And there, again, the myth is repeated that the market is an efficient way to encourage good ideas.

It isn't. It's a good way to encourage safe ideas.

Are you saying that limiting people's ability to exit bad investments encourages good ideas?

I think that the stock market model encourages short-term thinking. I think everyone agrees with that.

Thankfully there's another option: just don't sell out. Stay private. You might not become a billionaire, but who really wants to be a billionaire anyway?

Just because "everyone" agrees with something doesn't make it true.

Amazon, Berkshire Hathaway, Apple, etc, etc, are public businesses run for the long term best interests of their shareholders.

"Currently, an investor who owns one share for a month, or even a day, has the same voting power as someone who has owned a share for years. Mr. Ries wants what he calls “tourists” — short-term shareholders — to have less voting power than long-term shareholders, whom he calls “citizens of the republic.” Over time, shareholders of companies on the LTSE would gain more votes based on their length of ownership."

This is really a poorly thought out idea that's hugely counter-productive. You own your shares for 10 years and have mucho voting rights, but need to sell them. Now you have to sell them to someone who will get virtually no voting rights at the time of purchase. So all this does is make your shares way less valuable. It will end up creating "phantom sale" markets where you continue to serve as the shareholder of record, but agree to vote your mucho votes the way the purchaser wants you to.

The real problem isn't short term holders. The real problem is that shareholders aren't owners. The SEC won't let shareholders pick the boards of their own companies. Companies are owned by their managers now, and they are the short term thinkers using their incentive stock options to drive their decisions.

My prediction is that Chamath will use this SPAC to purchase Social Capital's VC investments. The conflict of interests are simply too great and I've seen this stuff before - it's almost always by design.

Makes sense. A payout on a payout.

Or perhaps we can drop the insane valuations of service companies whose value is in their staff not their assets, just pay people properly in the first place and have companies go back to earning profit and paying dividends to investors.

Or is that too rad for Silicon Valley?

I know that we're all supposed to live off pension funds, but the idea is that is after retirement not before through selling over inflated stock to them.

> we can drop the insane valuations of service companies

Awesome! But... how?

Strongly agree with you.

Color me skeptical and maybe one of the attorneys on HN could jump in, but solving the brain damage of an IPO reason seems like a red herring to me. SPAC could have value in a down market, when the IPO market is closed and a company is forced to raise a down round. Ratchets would kick in and founders would lose equity. If the SPAC, after fees, is able to offer a higher valuation to the company then its best alternative, it might actually work to benefit the company.

I haven't seen anyone comment about this down market scenario this past week and wondering if someone smarter than me had any thoughts?

Why are reverse mergers not more popular? Seems like there is quite an opening for somebody to spin up assetless shell companies, take them public and then sell them off the private companies that want to go public, and denying market makers and underwriters their huge rake, and sidestep most of the other issues surrounding an IPO.

Want long term investors in your company - why not offer extra voting rights after specified periods of holding registered shares - one year one vote, 10 years 5 votes.

There are many things companies can do to encourage long term, stockholder engagement - starting a random new stock exchange seems to be a long way down the list

Other solutions are currently in place to solve the IPO and liquidity problem. EquityZen is a platform that lets employees sell shares before IPO:


The ICO funding model seems much better: complete transparency, a truly free market, it's very difficult to manipulate the currency (i.e., magically issuing new coins aka share dilution), and it's easy to get around the stupidity of the US gov by incorporating somewhere with more liberal laws like, say, Switzerland.

Why would you want to business by the rules in the US when the rules only exist to prop up rent seekers and the ruling elite?

The SEC introduced "accredited investors" in the USA because scammers were taking money from people who didn't/couldn't research scams and lost fortunes in get-rich-quick stock schemes.

Its a good question to ask if the regulation is more expensive than the scamming.

For the victims, it certainly wasn't.

And what follows to that assertion?

What I mean is that while it may be worse for optimizing the global output of the system than simply letting the scamming happen (which is what you seem to be asking about), it's important to remember that it's not all about optimizing the global number, but also preventing individuals from experiencing financial ruin.

I dont think prevention of financial ruin is the goal. Any proper investment has that risk as well. I think its just very ill-perceived by the population to have a pit of snakes and scammers and people flailing accusations. But is the bank really any better?

It's the stated goal, there are solid historical reasons for it, and it's a reasonable way to tackle it. It's very disingenuous to equate other investments with ICOs or startups in terms of risk, especially the risk of going to 0. If you invest in 3 random S&P 500 companies, it's very unlikely that you'll end up with $0 from that after 10 years. If you invest in 3 random startups, there's a pretty good chance that you'll have $0 from that after 10 years. If you invest in 3 random ICOs, you're almost certain to have no value from that in 3 years.

If the SEC made it incredibly easy for the general public to invest in startups, scammers would come out of the woodwork to fleece the public, as they have in the ICO world, and as they have in the past for more traditional stock investments. Making a fake company or bullshit ICO and hyping it to the public would be one of the easiest ways to make $10M, and the prospect of that is going to draw a lot of scammers.

That's the story they (the SEC and friends) provide, but to me it seems more like they wanted to make it hard for people with limited means participate in the legalized get-rich-quick schemes.

How about just let the market decide? Why do we have stupid rules that exclude poor people from investing?

Because when those poor people make one bad choice they lose everything, and the state has to take care of them.

Yeah, just like the government bailouts during the 2008 financial crisis[1]. Except the US gov doesn't bail out poor people.

[1]: https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80...

If the government hadn't done that, there was a very real chance of the economy grinding to a halt, with mass layoffs resulting, which would have had a very, very large impact on poor people. So yes, in a way, it was a bailout of poor people.

I think they should have done much more to break up the banks into smaller chunks in the aftermath, but I'm tired of this sort of lazy condemnation of what they did as some conspiracy to help rich people and not poor. They were trying to get the country through some very dire times.

Ok.... how does that relate to the topic we're talking about? I know it's fashionable to point to bankers and complain about how bad they are, and while most of it isn't incorrect, it doesn't answer the question of what happens to those who get taken in by scam investments.

"How about just let the market decide?"

That's what was the problem; the market was deciding it was a great idea to rip people off.

The cost of a bad high-risk investment is an annoyance to a qualified investor. It is catastrophic to a poor person. This is also why we require car/home insurance, but wealthy folks can opt out and self-insure since a total loss won't bankrupt them.

Unfortunately, letting "the market" decide will just make a bunch of poor people into broke people. Do you want to take a risk with a very low chance of success? The state has a Lotto ticket they'd like to sell you.

There could be some kind of test as an alternative way to become an "accredited investor". If you make $250,000 for two years, or have $1 million in liquid assets, or pass the test. Why not?

Because Risk is risky. Even brilliant professional investors have deals which go bad. Passing a test does not remove the bankrupcy problem.

Having a lot of money does not remove the bankruptcy problem. Having a family and/or friend support system does. Maybe if you can get four people who will vouch to let you sleep at their place while you recover from bankruptcy would be a better test?

Also, as said elsewhere, society now seems to let people risk big money gambling at casinos when the expected return is always negative.

It's more like the rules exclude honest poor people from investing. I have several acquaintances of modest means who invested in privately traded stocks through the simple expedient of lying about their income and assets. To be clear, I'm not claiming that this is smart or ethical but it happens all the time. People can write down any numbers they want on the accredited investor forms and usually no one checks.

Can't let those dirty commoners have access to the juiciest investment opportunities. Those should be reserved exclusively for the already-wealthy. And if they complain, say we know better and it's for their own good. Of course, everyone knows the already-wealthy are smarter than the rest of us, and only they are capable of doing the unfathomably complex math needed to evaluate an investment.

So what do we do when someone who doesn't actually have extra money loses it all in a scam investment?

The same thing "we" do when they spend it all on lottery tickets or blackjack? There are already many existing ways for people to lose all their money, with much lower EV than investing in a small growth company. Why is it that this particular type of investment is carved out as something common people should be protected from?

A case in point USA retail investors where banned from the Royal mail privatisation which was a no brainer investment

And a scam on the British people.

> complete transparency

What are the reporting requirements for a company undergoing ICO?

Do holders of ICO tokens have any say in the governance of an ICO company? Can they fire the founders if they are mismanaging the company?

What can they do to stop the founders from taking the money, and going to the Bahamas (Or spending it on their Uncle Tim's consulting business)? What recourse do you, as an owner of an ICO token have against that?

I've never had a serious answer to the last two points. The kind of transparency you tout is not the kind of transparency that securities markets currently lack.

Pretty much every ICO is a securities offerings. (Don't let the talk about "utility tokens" fool you.) If you offer a security, there are applicable SEC rules. If you want to raise money from unaccredited investors, you have to follow "Reg CF" [1], which involves regulatory filings. Most startups raise money according to Reg D of the 1933 act [2]. Depending on how you advertise your offering, there are more or less strict rules and regulations. For example, if you ever publicly mention the offering, you'll have to verify your investor's accreditation (rule 506(b) vs. 506(c)).

All of this applies to any securities offering, including ICOs.

[1]: https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051... [2]: https://www.sec.gov/fast-answers/answers-regdhtm.html

IANAL… this is not legal advice, etc. etc.

It varies from coin to coin. For example, I prefer to steer clear of coins like XRP which are governed and managed by a central authority (in this case Ripple, Inc.). Something like Decred, on the other hand, has a very interesting governance model[1] which will be proved out by the market.

Many of these projects are open source, so you can audit, compile, and run the source yourself. There's nothing to stop an owner of cryptocurrencies from going to the Bahamas anymore than there is to stop the CEO of Google.

Here's[2] a good introduction to decentralized currencies for you to learn about them.

[1]: https://docs.decred.org/getting-started/constitution/

[2]: https://www.youtube.com/watch?v=fOMVZXLjKYo

In most (all?) recent ICOS you exchange some ETH with an internal token (aka "coins") that is tracked in the ethereum blockchain.

After the ICO the developers have all the ETH and almost no oversight, they can sell the ETH and go to Bahamas. They can claim that the project is dead, and so the internal tokens are effectively worthless, but they already sold the ETH and are already in Bahamas and you can try to extradite them for fraud if lucky. Or they add some more and more features before launching, an decide to work remotely from Bahamas for a few years ...

When Larry Page goes to the Bahamas, they don't take the company's treasury with them.

Who exactly are the developers going to do with the ICO money? From the looks of it, the answer is 'pay themselves'.

Which is 'fine', if the value they created is the crypto-currency itself - wham, bam, they are done - at the time of the sale. This is not the case for the vast majority of ICOs - there are just a bunch of promises about how eventually the coin will be super-useful, with no oversight for how to get from now to then.

Larry Page (who isn't the CEO of Google btw) still owns all his stock, regardless of whether he's in the USA or the Bahamas.

Larry Page also uses his stock to pay himself.

These cryptocurrencies only have value as long as the market considers them valuable. If Alphabet's stock price dropped, Larry's net worth would decline proportionally.

And yes, they certainly took in money during the initial funding, but Larry and friends did the exact same thing when they pitched Google to early investors.

Larry Page not being the CEO of Google is somewhat pedantic… he's the CEO of Alphabet, formerly known as Google. Sundar Pichai is the CEO of formerly Google's Google division, now known as the only Google, reporting to Larry Page.

"complete transparency"

How so? What reporting requirements are there for these? What requirements are there on transparency after the ICO?

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