Imagine you’re an early stage investor…
You look for companies that are just starting out and you provide seed capital to help expand the business. You look at hundreds of companies every year in search of that one idea that can really be turned into something amazing.
Not only are you looking for the best idea that will be developed into a company, but you’re also looking for the best team. You want a combination of experience, uniqueness, and a special can-do attitude from the founding members of the company.
So, after you find that magic mix, you provide the company with seed capital.
But, it’s not like buying stocks in the public market. You’ve got to make a significant investment, usually a minimum of $25,000, but most often well over $100,000.
It’s a big chunk of change for any investor, regardless of how big their bank account is. And it’s risky because you’re investing in a company that isn’t proven in any way.
You’re essentially betting that the company has the perfect mix of talented team, great idea, and ability to execute.
So you place your bet.
But, you’ve got to wait a while to see a return. We’re talking years. Most businesses take at least 5 years to really get off the ground. Many take well over 10 years to get real momentum.
And your initial investment in the company? It’s still there, but it’s locked up not giving you anything in return as there is zero liquidity.
But then one day, the ultimate exit happens. The company that you invested in finally goes public.
You get to cash out. All of the public investors will buy shares of the company allowing you, the original seed investor, an opportunity to finally get a massive return on your initial investment.
And because you took that early risk, you hope that the IPO (Initial Public Offering) is as high as possible. The higher that initial stock price is, the bigger your payout becomes.
In theory, an IPO should be the pinnacle of the company’s value… at least from the seed investor’s standpoint.
A Bloomberg article said it best today:
But the basic business of finance is buying low and selling high, and it is sometimes hard to resist the secondary cynical explanation for going public, which is that you do an IPO to top-tick the market for your stock and sell at the very high point of hype. If for instance you are a social media startup, and Facebook Inc. is angling to kill you, and you are in that sweet spot after “so important that Facebook is obsessed with you” and before “Facebook has killed you,” then that is maybe a good time to go public. And if you miss Wall Street expectations by a mile, in your very first quarterly earnings announcement after going public, then in a cynical sense you have done things exactly right: It’s better to disappoint investors after you’ve taken their money than before.
If you didn’t guess what company we’re talking about here, it’s Snapchat, which IPO’ed in early March with the ticker symbol $SNAP.
Earlier today, Q1 earnings were released, which has sent shares plummeting over 20%. And with an operating margin of negative 1,479% it’s no surprise.
But here is what I found the most interesting from the same Bloomberg article:
“Conventional business strategists would tell you that it’s probably not a great idea to spend almost $2.4 billion to make just $150 million in revenue. But Snap didn’t actually do that, not exactly. Of that $2.4 billion, almost $2 billion was attributable to stock-based compensation expense, “primarily due to the recognition of expense related to RSUs with a performance condition satisfied on the effectiveness of the registration statement for our initial public offering.” A ton of employee stock vested on the IPO, and Snap’s massive loss was due mainly to accounting for that stock.”
Translation = early investors cashed out! (Most notably the executives of the company who were awarded $750 million in stock for getting the IPO achieved.)
If you take a step back to think about this, you might come up with a similar conclusion:
Initial Public Offloading is a much better definition of an IPO.
Of course, this isn’t true in every case. As there have been many great IPO buys over the years.
However, it begs the question:
Are companies OFFERING shares, or are they OFFLOADING shares?
That’s why I generally avoid IPO’s and any trendy stock. Is there a chance of significant upside returns? Sure. There definitely is.
But, consider this:
If you combine massive downside risks with a historically expensive market, putting your hard-earned money into an investment that is simply cashing out the original investors is not exactly the investment I’d look for.