IPOs Without the IPO

CONTRARY INDICATOR November 3, 2011 By Daniel Gross

Groupon is expected to price its initial public offering Thursday. The debut of the daily deals site has been one of the most anticipated events in the capital markets for 2011. But it may prove to be anti-climactic. For in some important regards, Groupon’s IPO has already happened.

IPOs serve a few important purposes for technology companies. They allow the firms to raise new cash that can spur growth. They let founders, early investors, and early employees cash in on all their hard work by creating a market for shares and options. And they create a currency companies can use to make transactions. The day of an official debut has frequently been a life-changing one for employees and early investors. Once the stock symbol hits the tape, they can start making plans about new houses and cars, philanthropy, and new ventures.

But that’s the 1990s way of thinking about it. These days, many of the hottest technology companies effectively go public months before their smiling bosses ring the symbolic bell at the NASDAQ or NYSE. Fevered interest by venture capitalists and institutional investors has allowed companies like Groupon or Zynga to sell big chunks of shares. And new platforms like SecondMarket, which create private markets for the stock of hot companies that aren’t yet publicly traded, provide a venue in which investors and shareholders can meet. SecondMarket runs programs for companies that let insiders with options or shares — be they low-level programmers or top executives — monetize their illiquid assets by selling them to accredited investors and institutions through regular auctions.

In the 1990s, the only way for a founder or early employee to make big money on the success of their company was to sell shares to the public, cede some control, and open themselves up to scrutiny, criticism, and oversight. That has changed. Mark Zuckerberg of Facebook has been able to maintain some of the (wait for it!) privacy that comes with avoiding a public offering while reaping some of the benefits of owning a huge chunk of stock that occasionally trades. Grand gestures, like Zuckerberg’s September 2010 commitment of $100 million to Newark’s public schools would have been impossible in an era when shares of private companies didn’t already sell in size.

So why do I say that Groupon’s public offering has already happened? As Jennifer Van Grove reportedon Mashable in June, Groupon had recently raised nearly $1.1 billion in two rounds in venture capital funding: $135 million in April 2010 and another $950 million in December 2010 and January 2011. But the overwhelming majority of that cash did not wind up in Groupon’s coffers. As Van Grove wrote, “altogether, $946.8 million, or roughly 86% of the funds raised across the three investments, was paid out to Groupon directors, officers and stockholders. Just $151.4 million was retained by the company to use as working capital and for general corporate purposes.”

IPOs frequently let founders sell in the offering, or simply create a market in which they can sell. These deals were a little different. The company sold shares in a private offering and then used the proceeds to buy shares from insiders who had a much lower cost basis. Andrew Mason, co-founder and CEO, received $28 million for parting with some of his shares. Entities controlled by co-founder Eric Lefkofsky “cashed in shares for a combined total of $381,904,359.” By this spring, fueled with the cash thus raised, Lefkofsky was already on to other ventures. In September, he joined other investors in purchasing Chicago’s iconic Wrigley Building.

Meanwhile, Groupon’s shares have continued to trade on platforms like SecondMarket, allowing other employees to cash out and effectively setting a “market price” on the company. Now, the strategy behind IPOs is that releasing a small amount of shares onto a huge public market on a single day will create a frenzy of demand that boosts the value of the company. But the successive rounds of venture capital and the periodic trading of shares on SecondMarket have allowed that buzz to build up — before the shares hit the market. SecondMarket and the venture funding market are different than public markets. There’s no shorting, and you can’t buy puts on the shares. Markets are places where people express opinions about stocks. But the only opinions expressed in these markets are positive ones.

In the months after a hot tech IPO, reality often sets in and the price comes down. But there are signs that this cycle has already happened with Groupon — before the official IPO. In the thinly traded secondary markets, the air can come out of stocks before they go public. In October, tech reporter Michael Arrington reported that a SecondMarket auction for Facebook shares failed for the first time. In the weeks and months approaching the IPO, analysts and critics began punching holes in Groupon’s expense and accounting structures, and questioning its long-term prospects. Some fret that the company’s most explosive growth may be behind it. And that caused some of the air to come out of its stock — before it even started to trade. As Alistair Barr reports in Reuters, the IPO is expected to value the company at somewhere between $10.1 billion and $11.3 billion. That’s less than the value private investors placed on it this summer. In fact, “it is unlikely to go anywhere near the value of close to $20 billion that the company fetched in the secondary market this summer.”

This is progress of sorts. In bubbly periods, individual investors desperate to get in on hot initial public offerings frequently paid very high entry prices — only to see the value of the shares drop. In Groupon’s case, the successive fundraising rounds and regular trading on secondary platforms has already established a market for the shares. Groupon’s IPO may be the rare case in which individuals buying small lots of shares wind up getting a better price than well-connected institutions and millionaires.

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