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Don’t Be Shark Bait

The popular TV show Shark Tank pits budding entrepreneurs against a group of successful entrepreneurs (the sharks) such as Mark Cuban, Kevin “Mr. Wonderful” O’Leary and others.  The goal of the budding entrepreneurs is to convince one or more of the sharks to buy a part of their business in order to raise capital for their business.  

The sharks’ questioning follows two main paths.  The first is to see if the business idea makes sense.  Some of the ideas are so ridiculous that they don’t withstand the sharks’ withering questioning, and these budding entrepreneurs are quickly laughed off stage.  

If a business passes the first test, feasibility, the sharks hone in on the financial value of the firm to see if the budding entrepreneurs asking price is realistic.  This is where the sharks’ knowledge of balance sheets, market share, pricing, etc. often expose the excessive financial value that budding entrepreneurs assign to their businesses.  If one or more of the sharks is interested in the business (at a much lower price), the shark(s) will counter-offer.  How do things work out for the budding entrepreneurs?  Often not well for those who won’t come down enough on their asking price.  This is where the sharks chew them up.

Is there a real world equivalent of Shark Tank?  One could say that the world of initial public offerings (IPO) is similar.  A person starts a new small company.  It grows and becomes a larger company.  Sometimes others (venture capitalists) provide money in exchange for partial ownership of the company.  At this point it is still privately held, its stock is not traded on the public stock exchanges.  A popular way for the private owners to get their money out of the company is by getting the investing public to buy it.  They do this by issuing publicly traded stocks via the IPO process.  This is commonly called “going public.”  The Facebook IPO is an example of this.

How does a company go public?  They will solicit bids from investment banks to value the company, (which sets the number of shares and the initial price per share) and to prepare and submit the required regulatory documents, and promote the IPO.  The process is regulated by the Financial Industry Regulatory Authority (FINRA) and the SEC.  

On December 11, 2014 FINRA issued a public statement describing the fines it levied on 10 investment banks for violating a rule that prohibits an investment bank’s analysts from offering favorable research on an IPO in exchange for winning the business of the company going public. 

The case involved the 2010 Toys “R” Us offering.  The ten banks included some well-known names such as Goldman Sachs, Citigroup, JP Morgan, Wells Fargo, and Merrill Lynch.  A complete list of the infamous 10, along with their respective fines, is in the press release linked below.  FINRA’s press release stated that “Specifically Toys “R” Us asked equity research analysts from each of he 10 firms to make separate presentations to Toys “R” Us management and sponsors for the purpose of ensuring that the analysts’ views on key issues, including valuation factors, were aligned with the views expressed by the firms’ investment bankers.”  In other words, if the books “were cooked” to support a high IPO price, the analysts were supposed to verify that valuation.  

This is a clear violation of FINRA’s research analyst conflict of interest rules.  As Brad Bennett, FINRA Executive VP and Chief of Enforcement noted, “The firms’ rush to assure the issuer and its sponsors that research was in synch with the pitch being made by their investment bankers caused them to overstep the prohibitions against analyst solicitation and the promise of favorable research.”   What is interesting is the violating firms were fined even though Toys “R” Us didn’t proceed with the IPO.  

Also, the press release noted that “In settling this matter the ten firms neither admitted nor denied the charges but consented to the entry of FINRA’s findings.”  Were the Wall Street sharks guilty?  What do you think?  Is it possible that violations related to other IPOs have gone undetected by FINRA?  Do the police nab every speeder?  

One lesson learned by wise investors is to avoid buying IPOs.  One should never own individual stocks anyway since you miss out on the free lunch of diversification.  In fact, the mutual fund company that we use to invest in stocks, Dimensional Fund Advisors (DFA), will not purchase recent IPOs.  They maintain this policy because they believe that there can be overinflated pricing of the IPO at the initial offering price.  Given FINRA’s recent finding who could argue with DFA?

We don’t have the sharks from Shark Tank on our side to help us debunk an IPO’s price.  Therefore, the best course of action is to not become shark bait for the Wall Street sharks and avoid buying IPOs!

Click here for the FINRA press release

 

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