IPO Problems

Investment banks take small, private firms public in IPOs. These small firms want the capital to expand that the stock issue provides. However, every small-business owner would like to get tens or hundreds of millions of dollars to spend . Yet, very few small businesses would make good public companies. That is, the business model of many small firms would not work effectively as large, national firms. The small-business owners may not be capable of running a large business.

Typically, only a small fraction (less than 1 percent) of firms that want to conduct an IPO ever get to. Who decides which firms go public? Investment banks make this decision. After all, they are taking the risk as the underwriters. The banks thoroughly examine potential IPO firms. Traditionally, the policy of many banks has been to only bring a firm public if it has put together a good management team, developed a quality business plan, and perfected its business model enough so that it has earned profits in the past three quarters . The diligence of the banks had been successful. The companies brought public from 1986 to 1995 experienced only a 1 percent failure rate. ^[6] This rate is defined as a firm's stock price falling to less than $1 (or delisted from the exchanges) within the first three years after the IPO. Investment banks had done a good job of offering quality companies to investors.

Things began to change in the middle to late 1990s. The stock prices of technology firms dramatically increased, and this stock was enormously popular with investors. The demand from investors for more technology stocks seemed insatiable. Hundreds of millions of dollars were to be made by taking tech firms public. The investment banking industry would rake in more than $2 billion in banking fees. However, there were not enough new firms that met the traditionally high-quality standards of the banks. But investors did not seem to care. They seemed to want any new tech stock and at any price. Recall how high the average first-day returns of IPOs were in 1999 and 2000. The risk of underwriting these firms did not seem very high with such strong demand.

So investment banks lowered their standards to offer more firms. The standards seemed to get quite low indeed. Consider the IPO of Pets.com. In 1999, the firm had only $5.8 million in revenue and reported an operating loss of $61.8 million. Yet Merrill Lynch launched the Pets.com IPO in February 2000. The firm raised $66 million in capital and Merrill Lynch received more than $4 million in fees. ^[7] Ten months later, Pets.com folded. The firms that offered IPOs in the period 1998 to 2000 experienced a 12 percent failure rate. This is much higher than the 1 percent historical rate. The investment banks apparently lost their desire to be gatekeepers of quality firms and monitors for investors.

Investors probably measure success differently. They measure it by their investment return. Of the 367 Internet firms that went public since 1997, only 15 percent have made money compared to their offer prices. More than 200 firms have lost more than 75 percent of their value. What makes this even worse for average individual investors is that they rarely get the good IPOs at the offer price. They are usually forced to buy the stock when it starts trading on the stock exchange. By then, it has typically already increased in price. Therefore, the poor returns are even worse for individual investors.

In other words, investment banks consider an offering to be a success if they sell all the securities offered, raise the amount of capital needed for the firm, and receive their fees for the service. However, investors consider the offering a success if the security meets or exceeds the expected rate of return over the next month, year, and longer. The investment bank's focus ends when the securities are sold, but this is when the investor's focus begins. Therefore, banks and investors do not have the same interests at heart in this particular securities issue.