In 2010 I blogged about David Kirkpatrick's business history, The Facebook Effect. Earlier this week, the California Legislative Analyst's Office invoked Kirkpatrick's title to speculate about tax revenues from a Facebook IPO. From the Overview of the Governor's Budget:

The Facebook Effect. Facebook Inc., a privately held company headquartered in Palo Alto, may proceed with an initial public offering (IPO) of its stock in 2012. Facebook reportedly is considering issuing $10 billion of stock in an IPO that would value the company at over $100 billion. Other companies also are considering IPOs in the coming years. 

In the coming months, the state’s revenue forecasts will need to be adjusted somewhat to account for the possibility of hundreds of millions of dollars of additional revenues related to the Facebook IPO. These revenues could affect the budgetary outlook beginning in 2012-13. We caution that it will be impossible to forecast IPO-related state revenues with any precision, and it is likely that little information about the state revenue gain from the Facebook IPO will be available before investors file tax returns in April 2013. (Even then, due to the confidentiality of individual taxpayer information, we are unlikely to know precisely how much state revenues increased due to Facebook’s IPO.) 

In considering the size of the Facebook IPO effect in the coming months, revenue forecasters will have a difficult task. Our office’s income models are based on historical trends and, therefore, already assume that some level of IPO activity occurs for California companies each year. Moreover, in our recent forecasts, our office has deliberately built in “extra” capital gains (above those generated by our model) in 2010, 2011, and 2012 to try to account for a variety of factors, including the surprisingly strong PIT receipts in some recent months. Finally, Facebook-related capital gains likely will prove to be a relatively small percentage of California’s overall capital gains in 2012. If the stock market as a whole has an unusually strong or weak year, that fact could change forecasted capital gains up or down by much more than the positive Facebook effect.

In case you missed it, the projected size of the IPO is $10 billion, and the expected valuation of Facebook $100 billion! For a sense of perspective, Google sold $1.67 billion in its IPO in 2004, giving Google a valuation of more than $23 billion.

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Usha has already blogged about the possibility of Facebook foregoing the traditional bookbuilding IPO in favor of an online auction.  In 2004, I first wrote on the online auction as an alternative to a traditional IPO in Moral Hazard and the Initial Public Offering.  At the time, I argued that online auctions could yield a higher price for the issuer due to the underpricing phenomenon.  However, after that article was published, online IPOs slowed to a trickle, absent the one highly publicized Google IPO, which was not technically a dutch auction at all.  (Here is a listing of all online auctions to date.  There have been no new IPO auctions since 2008.)  I wrote about the Google IPO in this article, What Google Can't Tell Us About Online Auctions (and What it Can). 

I finally came to the conclusion that auctions were great at capturing the market price of an issuer's shares, without the underpricing discount; however, investment banks are able to increase the market price so the end result to the issuer may be the same or greater.  This led to the third article, Initial Public Offerings and the Failed Promise of Disintermediation.  I think the Google IPO is a great example of this.  Google, which was just as hot in 2004 as Facebook is in 2011, believed quite correctly that it did not need Wall Street to sell its shares.  The public did not need to be sold on buying Google.  So, if you have the most fabulous house in a hot market, you can do FSBO.  But, Google actually needed Wall Street to buy, which didn't happen.  The larger institutional investors sat out and the analysts were very negative, rightly or wrongly.  Now, Google's share price has never looked back, so I'm sure Sergey and Brin aren't shedding any tears.  But, Facebook might think twice about deciding to go it alone on sheer Palo Alto power alone.

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So, in case you haven't looked at your retirement savings the past week, stocks have taken a beating lately.  Because of this, stories are popping up suggesting that the tech IPO boom version 2.0 may slow down.  Groupon and Zynga filed registration statements this summer, but have not launched yet.  (Groupon's Amend. No. 1 here; Zynga's Amend. No. 1 here).

So, how have this Spring's tech IPOs fared?  I looked at Zipcar, Linkedin, Pandora and Zillow.  Yes, they have all gone down recently, but all are down from their high trading first days.  Zipcar priced at $18 on April 14, opened at $30 and rose to $31.50.  Today it is $22.  Linkedin priced at $45 on May 19, opened at $83, and rose to $122.  It's at $84.  Pandora priced at $16 on June 15, opened at $20, rose to $26.  It's $13.21.  Zillow priced at $20 on July 20 and opened at $60, its all-time high.  It is now at $26.80.  In keeping with the IPO model, those who were allowed to buy stock at the IPO price are in the best position; investors who purchased the first day of trading, the worst.

And what about the Facebook elephant in the room? 

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As Christine has noted, IPOs are back, and that means fun for corporate law types.  Today's front-page WSJ reads "Groupon to Gauge Limits of IPO Mania."  Facebook, Zynga, and companies I'm not cool enough to have heard about are being floated as IPO candidates, and venture capitalists are salivating over the social network economy, both leading actors and bit-part players.  IPOs are back, baby!

Except that they never really left.  Rather, companies were accessing the public markets while skirting the regulations surrounding going public, by way of "reverse mergers."  With a reverse merger, an already-public shell corporation acquires a public company.  Presto, the once-private company trades publicly--generally over-the-counter, it's true, but publicly.  Chinese companies in particular have used this method to trade in the U.S.   Reverse mergers figure in today's WSJ because the SEC is examining whether audits of these Chinese firms were up to snuff.  According to the article, since February about 40 Chinese firms have acknowledged accounting problems or had trading of their stock suspended for accounting issues. 

Some readers might remember that I've been working on a special flavor of reverse merger, a SPAC. Among other things, it's given me a window into the world of OTC trading and the Pink Sheets--a world of tiny companies that don't usually make it to the paper or to the attention of law professors.  They're not generally mentioned in the financial press, but there have been a healthy number of IPOs in this space.  

I'd argue that we know relatively little about IPOs, but we know even less about this marginal world at the edges of securities law.  More on SPACs, and on what they can teach us, at the end of the summer.  I hope. 

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Last week, commentators were saying that LinkedIn was pricing its IPO shares low ($32-35/share, $3 billion valuation), possibly signaling a concern about a social media bubble.  Well, apparently not everyone is afraid of a little frothy bubble action. A few days ago, LinkedIn repriced at $45.  Way off.

Shares opened today at $83/share.  Yes, you aren't having flashbacks -- Google priced at $85 and went up 18% the first day.  Shares of LinkedIn were recently trading at over $120, and is right now at about $108.

So, time to brush off things we used to talk about when we talked about IPOs.  Why so much underpricing?  Mistake?  Strategic on the part of the issuer?  On the part of the underwriter?  Who drove the run-up?  Smart money?  Herd money?  What will the share price be in 12 months?  36 months?  I love IPOs.  

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LinkedIn is set to issue shares in an initial public offering on May 19, and the share price sets a valuation on the social network company at $3 billion (share price range $32-35).  Nice.  LinkedIn is the first in a pipeline of new generation social media companies that everyone expects to go public:  Facebook, Groupon, Zynga, Twitter, etc.  Pandora is on its third amendment to its registration statement after filing in February 2011, but no IPO date has been set.  Skype is also on its third amendment after filing in August 2010, and no IPO date has been set.

The question that analysts keep asking harkens back to the 1999-2000 tech bubble:  Do the companies make a profit?  Yes, they are cool.  But shareholders need something more than cool after a month or two.  LinkedIn generates revenue through a premium service for subscribers and advertising.  It announced profits for 2010, but generated losses in 2009.  Is LinkedIn's IPO a sign of a bubble or just a sign that the IPO market is returning from a cold, cold slump?

As an aside, how many academics use LinkedIn?  I think I set up a profile over five years ago, but I'm more of a daily Facebook user.  Academics have such a fine line between personal and professional existences that Facebook seems to have filled that niche.  If I were practicing, I could see having a social network presence that was all business, though.  And, Academia.edu tells me that 5 of my FB friends are on its site, which posits itself as both the "LinkedIn for academics" and the "Facebook for academics."  Any Academia.edu aficionados?

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We have been talking about "frozen" capital markets for so long, it may be hard to remember a time when money flowed freely, but that time may not be far way. After hearing news this morning of Hulu's plans for an IPO, I was thinking about the prospects for the IPO market during the coming year. We all expect GM to file for an IPO this week, and I am of the school of thought that figures a successful GM IPO will open the market for other firms. Listening to a local business executive whose firm is testing the waters, I think we will see a large number of firms take the plunge within the next year if GM is successful.

Marketplace had a story on IPOs this afternoon, but it also had an even more encouraging story about commercial paper. The market for commercial paper is humming, driven by low, low interest rates. Scott Grannis explains the (potential) significance:

Here's an obscure but important measure of credit availability and financial market health that shows dramatic improvement year to date: nonfinancial commercial paper issuance (i.e., short-term obligations of large, generally highly-rated companies, typically used to fund short-term credit needs such as accounts receivable and inventories). That this measure has jumped over 50% in less than eight months is a very positive sign in my book. For one, it means that credit markets are vibrant: not only are large corporations willing to take on extra debt, but investors are willing to buy it. And since commercial paper rates are extraordinarily low (about 0.25% for 60-day paper), the availability of very cheap financing appears to be encouraging companies to expand their operations.

The commercial paper market is only half what it was at its peak in 2007, but seeing the words "confident" and "vibrant" in place of "frozen" or "stagnant" is a nice change.

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So, three years after KKR began planning an IPO, shares ("common units" or limited partnership interests) of KKR & Co. L.P. are trading on the NYSE.  If we can even make our memories go back to a time before the 2008 financial crisis, we will remember when Fortress and Blackstone, two other private equity firms, went public, generating hundreds of millions of dollars in tax-advantaged gains to their founders.  But KKR came a little late to the party, and ended up postponing its IPO, only to list its shares on the Euronext Amsterdam exchange through a foreign subsidiary, KKR & Co. (Guernsey) L.P. nine months ago.  Today, all of the holders of KKR Guernsey units received units of U.S.-based KKR, and could immediately trade them on the NYSE.  These units opened this morning at $10.50 per unit, and has gone up to over $11, but is now at $10.48 on what turned out to be a weak trading day.

Blogger Emeritus Vic Fleischer has been the go-to person on the tax implications of these private equity limited partnership IPOs for quite awhile.  On his own website, he has written about this new KKR deal and the pending legislation that is putting pressure on the founders to sell their founding stock quicker rather than later. 

No new shares were sold today, although the media is referring to the listing transfer as an IPO.  However, the Prospectus for the registration of the new shares and the in-kind distribution note that the firm anticipates a "Public Offering" of $500,000,000 worth of shares:

Subject to market conditions, we are planning to sell common units in a public offering following the U.S. Listing, which we refer to as the "Public Offering". Assuming an aggregate offering amount of $500,000,000 at an offering price of $9.44 per common unit, which is the last reported sale price of KKR Guernsey units on Euronext Amsterdam on July 6, 2010, we would issue 52,966,102 common units in the Public Offering resulting in an aggregate of 735,973,522 common units outstanding on a fully diluted basis, with new common unitholders holding 7.2% of our fully diluted common units, former KKR Guernsey unitholders holding 27.8% of our fully diluted common units and our principals holding the remaining 65.0% through KKR Holdings. . . . . .None of our principals is selling any common units or will otherwise receive any of the net proceeds from the Public Offering, and any common units issued by us in the Public Offering would reduce the interests in our business held by KKR Guernsey unitholders and our principals on a pro rata basis. We have filed a separate registration statement with the Securities and Exchange Commission to register the Public Offering. There is no assurance that the Public Offering will be consummated as set forth herein or at all. The U.S. Listing is not contingent on the occurrence of the Public Offering.

Vic explains that if Henry Kravis were to sell $500 MM of KKR units under today's tax regime, the tax bill would be $75 MM. If pending legislation were to pass and Kravis' gains were not taxed at capital gains rates, then the bill could be twice that or more.  Though the Prospectus repeats several times that no principals will be selling common units in the Public Offering, the principals may intend to sell at other times.  Did I mention how much I missed Vic?

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In Business Associations, I try to drive home the message that shares in a closely-held corporation are theoretically freely transferable, but in practice not so much.  The market is illiquid, and finding others to purchase your shares, particularly if they reflect a minority interest, will not be easy.  As an outsider, it's hard to value the shares.  In addition, the most assured route to receiving an return on investment of minority common shares is either through discretionary dividends or possibly through employment at the corporation, leaving the outside investor uneasy.  But what if you could overcome these obstacles -- a market that connects buyers and sellers, provides market-based valuation, and signals the potential of an eventual liquidation event?

Sharespost.com is apparently a website that attempts to connect sellers and buyers of unregistered shares in private corporations.  These are shares that would be owned by founders, employees, perhaps angel investors?  Note, however, that these are share in venture-backed corporations, not in your family business.  So, the venture-backed nature sends a signal to the market not only of value, but also of potential exit.  This website, in fact, is mentioned in a Recorder article on Facebook shares.

Sound perfect, but what are the concerns?  My first thought was securities law.  The article says "Companies such as Sharespost.com and Secondmarket.com have sprouted up in the past two years, following an SEC rule change that relaxed restrictions on selling shares of private companies."  OK, but the SEC hasn't promulgated any safe harbor that says any person can sell any shares to any other person at any time.  Looking on the SharesPost.com website's "Legal" page:

Though each participant in a SharesPost facilitated contract is solely responsible for making their own legal determination about the availability of an exemption from the securities laws, we believe we have constructed the SharesPost process such that Buyer and Seller can generally make use of a Section 4(1) exemption, and in some cases, Rule 144. Supporting such an exemption is the fact that only SharesPost members with a password protected account are able to participate in postings, only accredited investors can be SharesPost Buyers, and only sellers holding their shares for at least a year can be SharesPost Sellers.

First, I think SharesPost means that most will qualify for the safe harbor in Rule 144, and in some cases the more restrictive original 4(1) exemption.  The three requirements listed seem focused both on meeting holding periods in Rule 144 and ensuring that this is not a public distribution but a resale to specific buyers who can fend for themselves under 4(1) (or 4(1 1/2), in securities professor jargon). 

So who is really concerned?  Issuers.  First, resales can threaten to bring the number of shareholders to over 500, triggering full-fledged registration requirements under 12(g) of the Securities Exchange Act.  Second, issuers seem to be worried about insider trading problems, prompting Facebook to ban their employees from selling shares on SharesPost.com except during certain windows.  Facebook may be trying to control a different problem than insider trading, however.  (In fact, having the company set windows for trading seems to raise more insider questions than not.)  Issuers may be worried about 12(g).  They may be worried that whatever exemption they used to issue the shares will be busted by an untimely resale.  They may also be worried about feeding a secondary market that may be too incomplete to give good information or even a little too complete.  Private issuers don't have to tell the market as a whole how well they are doing day-to-day.  An incomplete market can mess up going public plans (like Facebook's rumored plans) by inadequately reflecting that private information so as to send a lower, incorrect pricing signal.  Or, premature negative inside information may make the market a little too complete when an issuer would prefer opacity.

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So the headline of a WSJ article today is "SEC Didn't Expand Upon Stock-Abuse Settlement," and the first sentence reads:  "The Securities and Exchange Commission has failed to turn key parts of a landmark stock-research settlement into industrywide rules, a move that threatens to gut pieces of the pact."

So, what's going on?  The 2003 "Global Settlement" among the ten biggest Wall Street firms (at the time), the NY AG's office (remember Spitzer?), the DOJ and the SEC required the banking parties to implement certain reforms with regard to conflicts between analysts employed by the banks, who were issuing research reports on current or prospective investment banking clients.  At the same time, Sarbanes-Oxley had been passed, requiring the SEC to promulgate rules addressing analyst conflicts of interests.  In response, the SEC passed Regulation AC and the NASD (now FINRA) passed several rules, including Rule 2711, to address the same issues.  As you might imagine, the SEC regulation addressed a tiny slice of the problem, requiring "clear and prominent certifications" by resarch analysts providing reports about any conflicts of interest.  Rule 2711 went further, addressing disclosure of conflicts, but also compensation, supervision, and communication between analysts and investment bankers at the same firm.  The Global Settlement admittedly went even further, requiring disclosures on the first page of research reports, physical separation of analyst and investment banking activities, and the presence of a compliance officer during communications between analysts and bankers.  So, seven years later, what's wrong?

Hard to discern from the article.  In August, the SEC went to U.S. District Judge Pauley, who approved the Global Settlement, to loosen some of the accords in that settlement.  Now, apparently the settlement was to be reviewed after five years, and the settlement was always intended to be stricter than industry-wide rules put in place at the same time.  However, the media has latched on to the fact that (1) the SEC wants to loosen its regulatory grip on some former wrong-doers and (2) the SEC never put in place regulation that would make these settlement terms permanent and industry-wide.

So what parts of the settlement were amended, and how does it change analyst practice now, with Regulation AC and Rule 2711 still in place?  Pauley may have kept in place the strictest reforms.  In fact, the WSJ Blog describes the incident as Pauley rejecting the SEC's request.  But, the article tells us "[t]hough it keeps a firewall that forbids stock analysts and investment bankers from talking without a rules-compliance officer present, the decision essentially eased other restrictions involving the dealings between investment bankers and analysts, including a clear separation between analysts and the firms' investment-banking operations."  However, it doesn't tell us what that restriction was or how it was eased.  So, let's take a look at Pauley's Monday, March 15, 2010 order, which amends "Addendum A" of the Global Settlement, here.  To find out what parts of the Global Settlement stay in place, we need to compare it to the original Addendum A, here.  The changes are actually substantial.  Here are the changes the banks agreed to in 2003 that now go away: 

2. Legal Compliance. Research will have its own dedicated legal and compliance staff, who may be a part of the firm's overall compliance/legal infrastructure

5. Compensation. Compensation of professional Research personnel will be determined exclusively by Research management and the firm's senior management (but not including Investment Banking personnel) using the following principles:

a. Investment Banking will have no input into compensation decisions.

b. Compensation may not be based directly or indirectly on Investment Banking revenues or results; provided, however, that compensation may relate to the revenues or results of the firm as a whole.

c. A significant portion of the compensation of anyone principally engaged in the preparation of research reports (as defined in this Addendum) that he or she is required to certify pursuant to Regulation AC (such person hereinafter a "lead analyst") must be based on quantifiable measures of the quality and accuracy of the lead analyst's research and analysis, including his or her ratings and price targets, if any. In assessing quality, the firm may rely on, among other things, evaluations by the firm's investing customers, evaluations by the firm's sales personnel and rankings in independent surveys. In assessing accuracy, the firm may use the actual performance of a company or its equity securities to rank its own lead analysts' ratings and price targets, if any, and forecasts, if any, against those of other firms, as well as against benchmarks such as market or sector indices.

d. Other factors that may be taken into consideration in determining lead analyst compensation include: (i) market capitalization of, and the potential interest of the firm's investing clients in research with respect to, the industry covered by the analyst; (ii) Research management's assessment of the analyst's overall performance of job duties, abilities and leadership; (iii) the analyst's seniority and experience; (iv) the analyst's productivity; and (v) the market for the hiring and retention of analysts.

e. The criteria to be used for compensation decisions will be determined by Research management and the firm's senior management (not including Investment Banking) and set forth in writing in advance. Research management will document the basis for each compensation decision made with respect to (i) anyone who, in the last 12 months, has been required to certify a research report (as defined in this Addendum) pursuant to Regulation AC; and (ii) anyone who is a member of Research management (except in the case of senior-most Research management, in which case the basis for each compensation decision will be documented by the firm's senior management).

On an annual basis, the Compensation Committee of the firm's holdinglparent company (or comparable independent personslgroup without management responsibilities) will review the compensation process for Research personnel. Such review will be reasonably designed to ensure that compensation decisions have been made in a manner that is consistent with these requirements.

6. Evaluations. Evaluations of Research personnel will not be done by, nor will there be input fiom, Investment Banking personnel.

8. Termination of Coverage. When a decision is made to terminate coverage of a particular company in the firm's research reports (whether as a result of a company-specific or category-by-category decision), the firm will make available a final research report on the company using the means of dissemination equivalent to those it ordinarily uses; provided, however, that no final report is required for any company as to which the firm's prior coverage has been limited to quantitative or technical research reports. Such report will be comparable to prior reports, unless it is impracticable for the firm to produce a comparable report (e.g., if the analyst covering the company andor sector has left the firm). In any event, the final research report must disclose: the firm's termination of coverage; and the rationale for the decision to terminate coverage.

9. Prohibition on Soliciting Investment Banking -Business. Research is prohibited from participating in efforts to solicit investment banking business. Accordingly, Research may not, among other things, participate in any "pitches7' for investment banking business to prospective investment banking clients, or have other communications with companies for the purpose of soliciting investment banking business. a. Research personnel are prohibited from participating in company- or Investment Banking-sponsored road shows related to a public offering or other investment banking transaction. b. Investment Banking personnel are prohibited from directing Research personnel to engage in marketing or selling efforts to investors with respect to an investment banking transaction.

11 (c)(3)-(5): [discussing when analysts may speak to prospective investors prior to an IPO]

3) All such oral communications to a group of ten or more investors must be made in the presence of internal legal or compliance personnel;

4) A written log of all oral communications described in (2) above must be maintained; and

5) All written logs must be retained for the period required by Rule 17a-4(b)(4). 2.

II.2 Transparency of Analysts' Performance. The firm will make publicly available (via its website, in a downloadable format), no later than 90 days after the conclusion of each quarter (beginning with the first full calendar quarter that commences at least 120 days following the entry of the Final Judgment), the following information, if such information is included in any research report (other than any quantitative or technical research report) prepared and furnished by the firm during the prior quarter: subject company, name(s) of analyst(s) responsible for certification of the report pursuant to Regulation AC, date of report, rating, price target, period within which the price target is to be achieved, earnings per share forecast(s) for the current quarter, the next quarter and the current full year, indicating the period(s) for which such forecast(s) are applicable (e.g., 3Q03, FY04, etc.), and definitiodexplanation of ratings used by the firm.

There's a lot there that is deleted. It may be that Rule 2711 covers these things now, so they are superfluous.  It may be that some of the accords turned out not to matter.  Or a combination.  (Do not have time to check word for word, but there are a lot of headings that seem to address the same topics -- compensation, communication, etc.)  Or it may be that the SEC is bowing to industry pressure to loosen its grip on analyst research. Either way, either the WSJ article is right and the SEC is being successful in going against public sentiment in loosening regulation right now or the WSJ Law Blog is right and the court rejected the SEC's attempt to loosen regulation right now.

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My research has focused on how sophisticated entrepreneurial parties – including angel investors, venture capitalists, venture lenders, and entrepreneurs – structure their relations, and how the corporate, securities, and commercial laws respond to their unique needs. In my venture debt paper, I discuss how lender liability and equitable subordination rules shape venture lender practices. In this post, I’ll focus on the securities laws.

First, there’s the exit structure of venture capital (with credit to Gordon for an excellent paper of the same name). In the past, hot IPOs allowed VCs to return big gains to their fund investors. In this recent public policy proposal (click on the Apr. 29, ’09 doc), the National Venture Capital Association laments that there were only six IPOs total in the U.S. in 2008. The securities laws aren’t helping the situation. As Larry Ribstein and others have observed, the costs of going public thanks to Sarbanes-Oxley have dampened the IPO market, and there’s a legal minefield we teach in the securities course known as the gun-jumping rules that makes the IPO process far more cumbersome and error-prone than the process for seasoned public offerings. Sure, a start-up needs to provide more disclosure than Microsoft, but it’s not like no one has vetted these companies. They have been subject to rigorous and repeat scrutiny from (venture) capital markets from their inception. Why are the gun-jumping rules so complex?

Second, long before exit, private placement rules and broker-dealer laws might be impeding optimal levels of funding from angel investors, the precursor to venture capital. In my last paper, Financing the Next Silicon Valley, I explored both the ban on general solicitations in private placements and the reach of the broker-dealer laws to see whether angels had reason to fear the application of these laws to their activities. I concluded that there is a plausible case that the letter of these laws, if not the spirit, are indeed violated by routine angel group practices. First, when entrepreneurs approach angels (and VCs) without a “preexisting relationship,” as they do whenever they send a business plan cold, there appears to be a general solicitation. This leads to a host of potentially bad outcomes including recission rights, dissuading follow-on VC financing, and delaying an IPO. Second, when individual angels take the lead on a start-up’s due diligence for their group and receive extra stock in the start-up as compensation, they arguably fit within the definition of a broker-dealer. I can’t imagine that the broker-dealer laws were meant to apply to this situation, and granted the SEC hasn't enforced either of the laws I mention (to my knowledge), but the cloud of uncertainty they hang over angel group practice certainly isn’t enticing more angel investments, at least according to my sources.

Bottom line: with our traditional economic engines like Wall Street finance and the auto industry in crisis, we need start-ups more than ever, and there won't be start-ups without angels and VCs. Market forces have already hit these investors hard; the securities laws shouldn’t exacerbate the problem. The SEC and Congress should re-examine these laws and ease up a bit to help keep our entrepreneurial culture going strong.

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In what may be the most successful IPO in twelve months, Rosetta Stone Inc. is certainly having a nice morning, trading at times over 40% its opening price of 18%.  Now, I always bristle at the categorization of "successful" IPOs as the ones where the early purchasers make more capital by reselling to the second purchasers than the actual founders did from the sale of the original IPO shares, but why quibble in today's economy?  Let us put aside our underpricing debates and be happy that today there are buyers, and they are investing in that Michael Phelps thing, I mean, Rosetta Stone.

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eBay has announced that it will spin off Skype, the voice-over-IP service, in the first half of 2010 because of "limited synergies."  O.K., I'll put that in my 2010 Outlook calendar.  Today, this article in the Guardian speculates that the early announcement is part of a standoff between eBay and the founders of Skype, who license technology to eBay that is necessary for Skype to function.  Apparently, the founders are threatening not to renew the license, but are offering to buy back Skype at fire sale prices, assuming that no one else will buy Skype from eBay because it is worthless without the Joltid technology.  I'm not sure how the IPO of Skype solves eBay's problem.  Supposedly if one acquirer realizes that Skype isn't worth anything, then numerous public acquirers would think the same thing.  If this is true, then the owners of Jiltid won't be cowered into raising their asking price or renewing the license.  We'll see how this game of chicken progresses, but it's an interesting study in long-term licensing.

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NetSuite Inc., a business software company owned primarily by Oracle's Larry Ellison, went public on December 20, 2007 using the W.R. Hambrecht OpenIpo platform.  Besides being merely another datapoint in a very small group of completed U.S. IPO auctions, the NetSuite offering raises some interesting questions.

The offering was initially publicized with an expected price frange of $13 to $16.  On December 19, after having the registration statement declared effective and accepting bids for over a week, the offering was priced at $26.  On the first day of trading, NetSuite shares closed at $35.50.  What do these numbers tell us, if anything, about IPO auctions?  One could tell a story that market demand for the offering was $26 and that the auction format allowed the company to capture the full market demand.  However, the offering price then rose to $35.50, suggesting that $26 was not the full market demand after all.  Perhaps from the bids received on December 19, $26 did represent the full market demand, but demand rose on December 20 as the market responded positively to the higher-than-expected offering price.  The share price rose due to this herd effect and will eventually fall due to arbitrage.  (The current price is $29.62)  Let's call this story Alternative #1.

If one is cynical about auction IPOs, then one could construct a different story.  Perhaps the market demand was always higher than $26 -- somewhere between $26 and $35.50.  The folks running the auction IPO underpriced this offering just like underwriters in bookbuilding offerings.  This story has some support in the fact that the offering was overallotted and that NetSuite allowed its underwriters to purchase more shares to sell after the IPO closed.  Let's call this story Alternative #2.  However, the next question would be whether the auction underpriced the issue more or less than a bookbuilding offering would have.  Would a bookbuilding offering have resulted in an offering price closer to the $13 - $16 range, pocketing more of the underpricing for those receiving IPO shares and not the company?  Or would the bookbuilding offering price have been between $26 and $35.50?

An ancillary question, and one that I raise in my article Initial Public Offerings and the Failed Promise of Disintermediation is whether a bookbuilding offering would have raised market demand to higher than either $26 (under Alternate #1) or $26 + X (under Alternate #2) through the underwriter's marketing and reputational value.  In the NetSuite offering, the lead underwriter was CreditSuisse, so it may be that this offering had both the pros of a Hambrecht IPO and an offering led by a Wall Street underwriter.

In addition, this offering raises questions I haven't considered, but on which I would love more data.  First, Ellison sold about 10% of his own holding, but retained a majority of the shares.  Remember that in the Google offering, founders Sergey Brin and Larry Page also sold a small percentage of their shares.  Does the presence of a shareholder with a large stake who is selling shares in the offering create an incentive to go the Dutch Auction route?  Or would the retention of a large stake create an incentive to go the bookbuilding route and hope for a price "pop" that lasts long enough to sell inside shares?  Does the shareholder's stated intentions for programmed sales change this incentive.  (Also remember that both Brin and Page sold off large amounts of Google stock beginning shortly after the IPO.)  Does the savviness (is that a word?) of the founders affect the offering decision?  Ellison is obviously a seasoned player in the technology world.  Ellison, Brin and Page are currently the #4 and #5 (tie) wealthiest Americans.  Is it a coincidence that each chose an auction IPO?

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Last March, I had the privilege of speaking at the second annual symposium of the Ohio State Entrepreneurial Business Law Journal entitled "IPOs and the Internet Age:  A Case for Updated Regulations."  My esteemed co-blogger Vic Fleischer was also there, as well as other esteemed law colleagues.  I have recently fulfilled my promise to provide a paper for the journal (almost on time, too!), and I have posted this paper to SSRN.  The title is Initial Public Offerings and the Failed Promise of Disintermediation; the abstract is here:

At the beginning of this millennium, the future of initial public offerings conducted using an Internet-based auction method in the United States seemed very bright. The Internet, and web-based technologies, promised disintermediation in the IPO markets just as it had in other markets where producers could be linked with consumers without costly intermediaries. In a world in which a buyer would choose to pay a certain price (X) for a product, the producer of that product would prefer to capture as close to 100% of X as possible and not share unnecessarily with intermediaries. The market for initial public offerings is no different from other markets; a small number of investment banks and the underwriters and brokers they employ act as intermediaries that distribute and market offerings for a substantial fee, including a customary discount on the offering price that benefits the intermediaries. However, web-based auction IPOs have the potential of allowing issuers to avoid these investment banks and sell directly to the public at closer to the market price (100% of X), not the bookbuilding underprice (approximately 80% of X), minus the substantial underwriting fee.

However, the number of online auction IPOs each year is miniscule compared with the number of IPOs conducted in the U.S. using the traditional bookbuilding method. Although the market saw an increased number of auction IPOs in 2005, following Google's 2004 auction IPO, the market for online IPO auctions against stalled beginning in 2006. Proponents of these IPOs must explain why the auction IPO model has not challenged, much less replaced, bookbuilding as the dominant offering method in the U.S. This Article argues that although the Internet works well to eliminate intermediaries formerly necessary for distribution, the Internet cannot reliably eliminate intermediaries used by the public for creating demand networks and establishing third-party certification. Because of the power of investment banks and their demand networks, the base market price (X) of any product will be increased (X + Y). Therefore, an issuer must determine whether more profit is to be made by sharing revenues with Wall Street intermediaries and receiving 80% of (X + Y) than by capturing 100% of merely X. In addition, to attempt to ignore these powerful Wall Street intermediaries comes with great risk. In certain cases, those who attempt to sidestep these intermediaries may find themselves capturing not 100%(X) but 100% of a depressed market price (X-Z). Given this choice, rational issuers will choose the bookbuilding method, which promises .80(X + Y).

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