July 23, 2021
News broke this week that popular stock trading app Robinhood is going public… to the tune of a cool $35 billion valuation.
Robinhood has been in the spotlight (and under the microscope) the past few years, most recently for its role in the GameStop meme-stock frenzy.
So should you buy in? Or run for the hills?
It’s complicated… And there are no short answers to these questions, so – for the sake of everyone’s attention span – we’re going to cut this essay into two emails. We’ll publish the concluding story tomorrow morning.
Let’s dive in…
Don’t Be Tempted by Robinhood’s Massive IPO
When a company sells its shares to list on a stock exchange, known as an IPO, it’s the closest thing that the investment world gets to sex appeal…
It’s like a fashion show with money involved… The best catwalks get the most cash.
But just like that Chanel dress isn’t something you can buy off the rack at Target, few IPOs are available at the issue price for regular investors like you and me.
And similar to how Groucho Marx didn’t want to be a member of any club that would take him as a member, you might not want to buy into any IPO that you can actually access. Hedge funds, mutual funds, pension funds and their moneyed ilk get first dibs, and enjoy the occasional first-day share price run-up… If you’re offered IPO leftovers, they’re probably spoiled – and headed for the discount rack at the open.
Now… enter Robinhood. It’s the stock trading platform/meme-stock hothouse/kamikaze capital crossroads that business briefing company Morning Brew says will be “the hottest IPO of the summer” when its shares start trading on July 29. (Or at any rate… sexier than, say, Bowlero, the operator of 321 bowling alleys that’s going public via a SPAC this summer too.)
In defiance of IPO conventions, Robinhood says it will designate as much as 35% of its anticipated $2 billion offering for the company’s customers, who are individual investors. (Whether or not that’s a good thing… well, see below.)
Should you buy shares of Robinhood (or any other IPO)? Below are nine questions to ponder before you do.
1. Who gets the cash?
(A quick primer… in an initial public offering, or IPO, a company goes from being privately owned, to being publicly traded on an exchange. The whole point of the exercise is to raise capital. Any other – non-IPO – time that you buy the shares of a company, you’re paying another secondary-market investor… and the company itself doesn’t get any of your cash.)
Sometimes the founding shareholders (who are usually also senior management) of a company receive some, or even all, of the proceeds of a share offering. If so, ask yourself: Why are they selling? After all, these insiders know – better than anyone – the real prospects of the company. And though it’s not a crime for them to want to take a bit of money off the table, it’s not a good sign if they’re selling a lot of their stake. As a shareholder, you want the head guys to have plenty of skin in the game too.
In its offering, Robinhood is aiming to sell around 55 million shares – of which 2.6 million will be sold by the company’s two co-founders, CEO Vladimir Tenev and chief creative officer Baiju Bhatt, and chief financial officer Jason Warnick. That means that the vast bulk of the proceeds of the offering will go to the company. Importantly, despite selling some shares, management will still own most of the company.
2. Why is the company selling shares now?
A company may decide to sell shares to raise capital because it needs funding to grow… or is looking at making a big investment, like acquiring a plant or a competitor… or it just needs more cash to fuel the locomotive. (A bad reason to raise money: It’s in desperate need and can’t tap any other sources.)
Less optimistically, management may have a queasy sense that the company has peaked – and that the time to sell is now or never. The company naturally hopes that it’s “selling high” – while the buyers of the IPO of course are aiming to “buy low.” It’s difficult for both to be right.
So why is Robinhood selling now? First, the company is hitting all cylinders. Revenues rose by 245% in 2020… And the total number of registered users has more than doubled in 2021, so far, to 31 million. It’s difficult to imagine that things could get much better.
That’s partly because such strong growth gets more difficult to achieve as the base rises (it’s much easier to double users from a base of 15 million by adding another 15 million… than double from a base of 31 million by adding another 31 million users). Arguably it’s easier to sell shares, at a higher valuation, when the company is showing otherworldly growth (that is, now) – rather than once growth (inevitably) slows down.
The good thing is, Robinhood isn’t like a sex addict at a monastery when it comes to cash… As of the end of March, according to the company’s prospectus, Robinhood had $4.8 billion in cash on its balance sheet.
Now that sounds like a lot. Just earlier this year, at the peak of the GameStop trading frenzy, the company had to impose trading curbs on customer accounts when it didn’t have sufficient capital to back customer trades. At that time, the company raised $3.5 billion within four days in convertible debt (that is, which can be exchanged into shares) in order to keep its doors open.
So another few billion in the coffers from an IPO would be useful in case something similar – or, more likely, something different but also with repercussions involving as many zeros as you have fingers – happens again.
3. Is the company profitable?
Usually, if a company going public isn’t profitable, you’re not investing – you’re speculating. That doesn’t mean you shouldn’t buy the IPO, but it does suggest that the risk associated with the offering is higher. And you should account for that higher level of risk accordingly.
Robinhood was profitable – just – in 2020 (though it posted a large loss in the first three months of 2021, partly due to an accounting adjustment). The highly scalable nature of the company’s business – it can add lots more customers without needing to increase expenses as quickly or as much – suggests that Robinhood would have to do a lot of things very wrong to not become profitable fairly soon.
(This question makes more sense for smaller, earlier-stage companies that are still struggling to find a path to profitability. And it’s less relevant for pie-in-the-sky companies – like, say, highly speculative biotechs – that are funneling cash into a single project in the hopes of a massive payoff at the end, and which aren’t focusing on profits in the meantime.)
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4. How much trouble is the company in?
Many companies going public face legal challenges of one sort or another. Lawsuits for companies are like parking violations or speeding tickets for people… Everyone has some of them, and – unless it’s doing 85 MPH in a school zone, or one a week – they’re mostly harmless.
Robinhood, though, is in trouble… and plenty of it. The company has (at least) seven ongoing regulatory investigations, involving anti-money laundering, cyber security, platform outages, customer communication, and more.
Just before its IPO paperwork hit the wires, the Financial Industry Regulatory Authority announced it was slapping Robinhood with its biggest-ever fine – $70 million – for causing “widespread and significant harm” to customers over a period of more than five years.
Meanwhile… the basis of the company’s entire business model is to be paid to send its trade flow to other brokers that make markets (that is, which actively quotes prices for both sides of a trade) for the shares that Robinhood’s customers are buying and selling.
This payment for order flow (“PFOF”) model generated nearly two-thirds of Robinhood’s revenues in the first quarter. (Robinhood was the first online broker to not charge its customers for trades… However, the company gets its pound of flesh from customers in other ways – like this.)
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And PFOF is what the Financial Times calls a “tempting target” for regulators… [the company’s prospectus] highlights just how vulnerable Robinhood’s business model is to regulatory scrutiny. For would-be investors, the biggest risk is the legal hits would keep on coming,” it warned.
The problem is that PFOF sets up a potential conflict of interest whereby companies like Robinhood that use market makers might be tempted to send orders to those who offer the highest fees – rather than brokers that offer the best execution for customers.
And history shows that brokers and market makers are like flies and honey – they always find a way to get mixed up with each other. In many markets over time, they have a habit of teaming up to buy and sell for themselves, to profit ahead of price moves stemming from client orders (that’s a nasty little move called “front running” that can get you into a ton of trouble).
Would the Securities Exchange Commission really kick the legs out from under Robinhood by smashing PFOF with a set of regulatory brass knuckles? Probably not… But the risk still looms large.
The second half of Kim’s story on Robinhood will be online tomorrow morning.
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July 23, 2021