When Will The Fraud Of The Century End?
Joel Bainerman
gold-eagle.com
The April 3rd issue of Newsweek magazine made history. It was the first time information appeared in a major international publication questioning the gross overvaluations of dot.com companies.
The cover story told the tale of how difficult it is for many dot.com companies to raise additional capital after their IPO price had fallen so much and since the IPO has produced no "future potential" one often hears so much about when the subject is the valuation of dot.com companies. It quoted a stock-tracking firm, IPO.com, as stating: "more than a quarter of the 71 Netcos that went public in the past year are now trading under their offering price."
In the very same issue, noted Newsweek columnist Robert J. Samuelson questioned the process by which dot.com companies (and all high tech companies for that matter) go public, he writes:
"…the business is hugely profitable for the underwriters- the brokerage houses that handle the sales". To the first of my knowledge this is the first time a mainstream publication even pointed a finger- any finger- at the Wall St. brokerage firms.
Samuelson reminds us of the research by Jay Ritter, a professor of finance at the University of Florida, who researched the industry of high tech IPOs and found that the large brokerage houses run a cartel and all charge 7% for IPOs.
Although rather coy in his presentation, Samuelson thinks worse than he is telling: "Well, it helps if the Wall Street underwriter has a popular stock analyst whose recommendation will push up the price."
Samuelson as saying quotes ritter, "The conflicts of interest are immense. Stock analysts are increasingly "cheerleaders" As their pay depends on the firms' underwriting business; the end result is enthusiastic research reports.
Samuelson says a mouthful with this statement: "Logic suggests that IPO underwriting standards have eroded- and they have.
Ritter adds: "Before Netscape's IPO in l996, companies going public generally were profitable. Now most run losses."
Samuelson: "Sooner or later, some investors will suffer huge loses. "Fleecing" is the word that springs to mind."
I would say fraud is a more accurate description of what Samuelson is talking about.
So Who Organizes This Fraud?
Initial Public Offerings (IPOs) of high tech companies is a fraud on the public. A small group of investment bankers on Wall Street have carried out what should be considered the biggest fraud mankind has ever witnessed.
One of the biggest secrets in the investment banking/IPO community is how exactly underwriters "value" high tech start ups in their IPO. Another secret that is kept hidden is the inherent conflicts of interest and unfair playing fields that are built into every IPO as one side controls the IPO process and the other side (the public) merely plays a reactive role. Under these conditions the public is at a disadvantage when high tech companies go public as they are pitted against underwriters and investment bankers which have far more information as to what the real status or potential of the company is. While most people think that underwriters only take companies they "believe in" public, the fact is there is no punishment given to these promoters of the stock if the stock does not do well after the IPO. In other words, with no accountability built into the system, it is no wonder so many IPOs lose their initial public offering value.
It wasn't always this way. Thirty years ago, say, for example, a company that makes industrial pipes for air conditioning units wanted to go public. There would be no way this could happen unless the company showed it had a strong sales record and profits. The size of the sales and profits would determine the value of the company. This was the way IPOs were handled for decades until NASDAQ came along. Then, all of a sudden, something known as "future potential" was born which enabled companies with no sales history and no profits to issue their shares to the public based on the premise that they would "do well in the future" due to their "great technological potential."
The problem is, most don't.
One only has to look at the recent crop of IPOs of Internet companies to ask the question: by what standard or by whose valuation gives a company like Amazon.com which lost $291 million in the last four quarters, a market cap of more than $21 billion? Priceline.com which had less than half the losses has a market cap of nearly $8 billion. Yahoo with $341 million in revenues and $22 million in profits has a market cap of more than $47 billion. Would any company pay the owners of Yahoo $47 billion in cash to acquire that company? Would, or could, any business entity or individual have the cash to purchase Microsoft whose market cap is more than $150 billion. If the market cap of a high tech company doesn't really reflect the amount of amount that entity could be sold for, then the market cap figure has no meaning in the real world of dollars and cents.
How did "dot.com' companies attain such monstrous valuations? Is it truly just a case of supply and demand- as the press and the underwriters tell us? How is that companies that didn't exist two and three years ago can be worth today tens of billions? (even if it is just on paper). They can't, and aren't.
When Did The Fraud Begin?
This fraud on the public didn't begin with "dot.com" companies. It has been taking place since the late-l970s. If a company was in a high tech industry the public was told that that company didn't need to show any profits before going public, because, it had "future potential" something a non-high tech company could not claim. For instance, a company classified as high tech that sold $5 million worth of products but lost $2 million, could attain a market valuation of hundreds of millions of dollars- just because the company happened to operate in a high tech market. The same company, usually six months to a year before the IPO, would have raised capital from venture capitalists at a tenth of the amount the company was valued at for the IPO. These gigantic leaps in valuations simply don't occur in non-high tech companies. The current situation can be considered an unfair business practice and unfair to all the non-high tech companies whose valuation can never be estimated on "future potential" but rather on real sales and real earnings.
So how can it be that a company worth $30 million suddenly is worth $300 million six months later? Could a non-high tech company ever claim such a high valuation? This is where the high tech fraud begins. When the underwriter issues shares to the public all that is happening is that ink is being applied to paper. The company is worth no more the day after than IPO than the day before. It doesn't take much to uncover the deception.
When high tech companies go public at astronomical valuations, it is John Q. Public that pays the ultimate price. The underwriters, investment bankers, venture capitalists, and company founders, all make out like bandits. If four out of five companies are trading below their IPO value within two years, is it really possible that the investing public is making enough profits on the other 20% to carry these losses- and still show a profit? If 80% of all companies that go public are trading below their issue price, and the rest aren't showing any great sales record to justify the high public valuation they receive- then it can be assumed that investing in high tech companies when they go public is not an attractive investment.
The actual valuation of all the high tech companies traded on NASDAQ, is in reality (meaning if measured by the amount of profits they return to their shareholders) but a fraction of what their public value is. I intend to bring these figures to the public's attention by tabulating all of the IPOs that have taken place on NASDAQ since its inception, how much money was raised from the public (or more accurately put, de-frauded from the public), and how many of those companies survived and earned respectable profits for their shareholders. How much money went down the drain into the pockets of the underwriters, investment bankers, venture capitalists, and founders of the companies? I contend that while there are a few exceptions of companies doing extremely well, such as Dell Computers and Microsoft, few of the thousands of companies that have gone public have done well. In most cases, (according to the one study the figure is 80%), the public lost their money because of the inflated valuation of the company in its IPO.
That being the case, a massive fraud occurs with every new IPO. I intend to expose the theft of the public's money and believe with the existing amount of information available I could prove this basic contention. If I tabulated all of the companies that ever went public on NASDAQ and then listed their current value (of the ones that still exist that is) the extent of the deception would be astonishing.
We are told underwriters value the stock at an IPO based on "market demand" that they consider the market to accept. This is a lie. The market does not set the valuations of high tech companies at IPO; the underwriters do. If they value the company too low they risk leaving money on the table. If they value it too high, they risk not being able to sell all the shares.
It is important that the investing public knows that the chips are stacked against it when it steps into the IPO ring with the underwriters. I contend, and believe I can prove, that most, if not all high tech companies that go public, are overvalued. In the after market the public can and sometime do make money trading high tech stocks. The problem is the investors who go into the investment at the time of the IPO. They are the big losers.
Consider These Facts:
According to the investment banking firm, Broadview Associates, since l996, 80% of all high tech IPOs on NASDAQ trade below their IPO price after two years of trading (there is no reason to believe the rate is any lower previous to this date). It can be assumed that the underwriters, venture capitalists, investment bankers, and company founders don't suffer any losses in these transactions as the valuation of these companies, in most cases, is at least ten times what the last round of valuation was priced at when the company was still private. This means that these entities can only lose if the company valuation falls to one-tenth of the IPO price. This radical loss in stock value is rare. Usually, if a company's stock slips it drops by a half to three quarters of the IPO price. In this scenario, the underwriters, founders, and VCs still gain.
Assume a company is floated at a $100 million valuation and sells 25% of its stock for $25 million. The company is holding on to the $25 million. The stock then looses, say, half of its value and the market cap is now only $50 million. What has happened is that the investors who bought into the IPO lost $12.5 million in value. The company has $25 million in the bank but have only $12.5 million worth of stock that is on their balance sheet as a liability. The market cap of the 75% of unissued stock is $37.5 million- at least on paper. As the last valuation of the company was probably somewhere in the $30 million range, by taking the company public they have recouped all of the investment (at least from the perspective of the most recent investor who invested in the last round before the IPO; earlier investors have already registered a capital gain during the last round of private placement before the IPO) and the company still has $25 million in the bank it received from the IPO, of which theoretically, only 25% of is owed back to the public shareholders. In this scenario, the underwriters, investors and founders of companies win when high tech companies go public- even if the stock plummets and never recovers. The public, who invested in the company at an inflated price, are the big losers.
The problem with IPOs is that most never lived up to what was stated in their prospectus and what was endorsed in these prospectuses by their underwriters. A founder and his underwriter that takes his company public has no personal responsibility to the original investors in the stock and for the public valuation that was given it. Yet if the founders and the investment bankers make the claim, that, for example, Company X has no sales but insists its valuation is $100 million when it goes public, and two years later it's public valuation is only, say, $40 million, then someone is lying and perpetrating fraud on the public.
That is not to say every investor group would win such a case in court, but at least they would have some recourse against IPOs which were highly inflated so that the two vested interests, the founders and the underwriters, could earn substantial profits. These enormous windfalls should come along with a risk. If they can't prove to a judge how they arrived at their valuation of the company, perhaps they should be required to give some of the IPO proceeds back to the public investors. We aren't talking about criminal charges here, simply the right for investors who feel they have been cheated to recoup some of their losses.
There must be checks-and-balances built into the system so that companies and their underwriters know full well that a start-up's technological claims are dubious, think twice before they shove the next questionable IPO out the door. Shouldn't the public expect a company that registers with a stock market to issue shares in it to at least live up to its word? If you take a company public and it really bombs, yes, you can be held responsible. At the very least, the investors should have the right to sue the owners for false pretense and the resulting financial loss from their fraudulent claims. While this sometimes does happen today, have it is not very common. If more people understood how the organized fraud works, there would undoubtedly be more class action suits filed against company founders and their investment bankers and underwriters.
The close-knit club of investment bankers that dole out all the great deals to themselves, or hype the living daylights out of a company which eventually fizzles out and does nothing, should be taken to task for their business practices. The public underwrites (excuse the pun) these losses of stock value and this unjust transfer of wealth is a fraud that should be exposed. There is no way the SEC should allow companies to approach the public for financing without absolutely any sales record and no real assets behind the company. "Technology assets" should be treated on the balance sheet the way goodwill is. Would you invest in a company based solely on its "goodwill."
One could argue that the stock market is a risk and that people shouldn't risk buying shares of start-ups that go public if they aren't prepared to pay the price. That logic could apply to more mature companies, but when a company is allowed to issue public shares based on nothing more than some nebulous "future potential of its technology" then it should also be prepared to pay a price if it doesn't do what it said it was going to do.
When a company issues its stock on NASDAQ it only has to issue a very small amount of stock for it to gain a public valuation and a public worth for all the stock- meaning the unissued stock as well. If a company goes public for a $100M and sells 25% to the public for $25M, the other 75% that is still in the hands of the founders, underwriters, and investors, receives a public valuation even though that stock has never been issued in a public market. This is no other word to describe this other than fraud.
In reality, the stock held by the founders and investors has no value since it hasn't been issued on any public market. If the company took the 75% of the unissued stock and sold it on the market, the price of the stock would plummet. Put another way, the only reason why Bill Gates is supposedly worth $120 billion is because of the private stock he holds. The billions are "on paper" as is most of the so-called wealth created in the high tech industry. Yet that "paper wealth" is magically transformed into real wealth and this is where the fraud on the public begins.
Gates' billions are computed when the amount of his unissued, private stock, is multiplied by the current price of the stock that is traded at publicly. In reality, that privately held stock only has value if a private buyer is willing pay Mr. Gates for it. Otherwise, it has no value, as it hasn't been issued in any public market. The fact that the public allows holders of private stock to be given the same value for that stock as what the stock is trading for in a public market, is fraud. This is not some type of wacky theory that can never be proven, but rather, is the bread and bones of the highflying, high tech investment community.
How such absurd and apparent fraud and deception continue (let alone get worse with "dot.com" IPOs), unabated?
The answer lies in how the business press treats the IPO industry and why investment bankers and underwriters are presented to the public in such glowing terms. In contrast, I will reveal the inherent conflict of interests that are self-evident in the investment-banking world. For instance, an investment bank can invest in a company, take it public, do research on the company's stock and recommend buying the stock to the public, as well as buy and sell the stock. I believe it is time these conflicts of interests are exposed as the investment bankers have an advantage over any other trader of the stock, as the companies are their investment banking clients. It is absurd to contend that under these conditions there is no insider trading. The fact is the playing field for those who buy and sell stocks is not level as the investment banks have an unfair advantage over the stock buying public.
The game is also rigged in that the underwriters sell the stock of a real good company, one with real sales and actual profits, pretty much only to their most favored clients and not the general investing public at large. This small group of favored high net- worth investors who are clients of the investment bank receive the best deal as they don't get saddled with the crappy companies (if they did they would take their business elsewhere) but only the good ones. Guess who is given the privilege of buying shares in the not-so-desirable IPOs?
It is better for the general public to have high tech companies sold to other high tech companies rather than having this start up companies go public. In this way a company is sold, a capital gain is registered, and taxes are paid. When high tech companies go public, even if they earn profits, they rarely pay taxes other than income tax on their employee's salaries. A buyout/acquisition, even if at inflated prices, is between a buyer and a seller. The public is not involved in these transactions and thus they can't be defrauded. My contention is that if the public wants to benefit from high tech it should do it by receiving tax revenues when companies are- not as investors in IPOs. The only IPOs that should take place should be for companies that have a respectable track record and significant sales history. For instance, if a company is selling $20 million and wants to public at a valuation of $50 million, this could be considered a fair valuation and those buying into the IPO could consider it a good investment. When that same company is valued at $200 it is not. The public needs to realize that the stock market needs to return to what it used to be before NASDAQ came along: a source of relatively inexpensive capital to fuel future expansion and growth.
The real problem is that after a few years, after four out of five IPOs just fade away into nothing and irrelevance, nobody remembers them. Nobody remembers all the "dogs" that people invested in and went nowhere. This form of fraud has been going on for 20 years. Before, you had to have a decent sales record before you could go public. Three guesses as to who changed the rules?
Why It Is Important That The Fraud Ends
The hyped-up valuations of high tech companies can only exist because they are perceptions that are accepted by the public due to the promotional efforts of the investment banks. If I claim Amazon.com is worth not $28 billion, but $50 million, and you say "according to its market cap it is worth $28 billion" then I say the public valuation is wrong and is fraudulent. If there are people willing to pay that high price for the stock, at a market cap of $28 billion, they need to know they are making a bad investment. Wall Street investment bankers have convinced the public that the "market cap value" of a company is its true value. It is hoped that after reading my book people will begin to question these assertions and begin to look more seriously and realistically at how IPOs of high tech companies are valued.
The whole subject of how to place a degree of morality into the world of high tech investment banking and IPOs of high tech start up, has never been written about. Nor has the negative influence of the current "high tech boom" been analyzed correctly. If my contention is correct that a nation's technological assets get dulled (by technological assets I mean that country's strength to develop all types of technologies, not just information technologies, or Internet-related technologies) by having so much investment made in Internet/Information Technologies as opposed to other technological sectors, then this book will be an important study of probably one of the most important issues facing modern society: how best to exploit and foster the future development of a nation's technological skills, resources and capabilities. When the Internet is given billion dollar valuations so people can "be connected" but at the same time start ups developing new forms of renewable energy or waste management have a near impossible time competing for these available investment capital, society as a whole will suffer.
More people need to understand that the fate of a country's technological resources are more important than the interests of a small group of venture capitalists and investment bankers that are the only big winners in the high tech rip-off that currently takes place. The public is getting no great return by investing in a high tech IPO as the price of the stock is always, always, over inflated. The VCs and investment bankers know how the game is played. It is time the public learned the rules as well.
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Joel Bainerman
isratech@mail.netvision.net.il
8 August 2002
Joel Bainerman writes on Israeli and Middle Eastern business and economic affairs. |
