How the IPO Market Works 13 SECRET 1 How the IPO Market Works It should come as no surprise that New York City was home to the first hot U.S. initial public offering (IPO). In the spring of 1791, the first Bank of the United States (BUS), which was the young American government’s new central bank, began plans for a stock subscription to raise $10 million. When the stock subscription—what Wall Street bro- kers called IPOs back then—was launched in July, it sold out in an hour. The lucky purchasers of BUS stock were the U.S. government itself, buying $2 million worth of shares, and the powerful, London-based Barings Bank, which scooped up the rest. The shares, priced at $100 each, quickly shot up to $185 before dropping back to $130 that Sep- tember. Until BUS was forced to go out of business by the federal gov- ernment in 1811, its shares were a popular speculative stock for New York’s stock market participants, who traded shares at the Merchants Coffee House at the corner of Wall and Water streets. The great success of the BUS offering spurred other entrepreneurs to organize banks and raise money. Following a pattern that would be repeated many times over the next three centuries, the first companies to go public in a particular business sector are usually the strongest, and they are quickly followed by weaker and weaker fry. The Bank of New York, today a staid New York institution, became the first company to trade on the new New York Stock Exchange (NYSE) in 1792. It be- came a favorite of the sharp-elbowed speculators who made up the 13 01 killian 13 12/14/00, 2:04 PM Black 14 IPOS FOR EVERYONE majority of NYSE participants. The ease of raising money drew in hus- tlers, who launched issues of the Million Bank of the State of New York, Tammany Bank, and others. The frenzy to buy bank shares was so high that some of the banks were able to attract shareholders even though they had no customers, branches, or deposits. The Internet phenom- enon of profitless and revenueless companies isn’t so new after all! Alexander Hamilton, who was serving then as the first Secretary of the Treasury and who had been instrumental in the creation of the Bank of the United States and of the Bank of New York, worried about “un- principled Gamblers,” much as Alan Greenspan would later fret about “irrational exuberance.” Prices of the bank stocks soared. During the 1790s, over 290 com- panies were formed, mostly banks and insurance companies. Inundated by the flood of issues, suddenly people realized that many of these banks were complete frauds. Investors panicked and tried to dump their shares. When the dust settled, only the Bank of the United States and the Bank of New York survived. This scenario of greed followed by fear would be repeated time after time on Wall Street. In 1817 it was canal companies. The Erie Canal Company was the first to offer shares to the public. At the time, canals were a major revolution in travel and commerce, dramatically reducing the time it took to get goods to markets and allowing more products to be transported. The Erie Canal, which was completed in 1825, connected New York harbor, at the mouth of the Hudson River, to what would later become Buffalo on the shores of Lake Erie. The canal vastly re- duced the cost of shipping goods from the west to the east, made New York the major East Coast port, and spurred westward migration. These developments captured the imaginations of investors, and they scooped up shares. Just like the Internet revolution almost two hundred years later, the success of the Erie Canal created a frenzy for other canal stocks. Offer- ings for the Blackstone Canal in Rhode Island and the Morris Canal in New Jersey were vastly oversubscribed, with many more investors than there were securities to give out. Investors didn’t bother to look closely at the business, its management, or its finances. Investors gave the Chesapeake and Ohio Canal Company $22 million to build a canal that 01 killian 14 12/14/00, 2:04 PM Black How the IPO Market Works 15 was never completed. Within 10 years, the stocks of most of these com- panies were worthless. It is worth examining this bit of history because IPOs have always been at the cutting edge of the economy. The Internet infrastructure companies of today are the railroads of the 1840s, the mining compa- nies that came out of the craze that marked the 1848 California Gold Rush, the telegraph companies of the 1850s, and the electric compa- nies of the 1870s. Every public company started life as an IPO. Companies that would later become stock market behemoths were launched during these heady times. American Express and Wells Fargo, later to become giant finan- cial institutions, came into existence as couriers delivering stock certifi- cates and cash to and from the increasingly busy brokerage houses. The business evolutions of both those companies help put the public’s fas- cination with Amazon.com and eBay in perspective. Companies that are long-term winners evolve over time, changing as technology changes. As a unique sector of the equity market, IPOs are situated in terms of risk and potential return between the high-risk venture capital compa- nies and older, established companies. Exhibit 1.1, “IPOs—A Unique Asset Class,” shows this risk/return profile. It is also worth pointing out that the first to try to exploit a new opportunity are not always the first to claim success. The now defunct Internet retailers, who were the first to try to commercialize the World Wide Web, have predecessors in history. Most of the men who sieved muddy water in the streams of Northern California never really ben- efited from the California Gold Rush. Rather, it was the Bavarian immi- grant who began selling them work clothes made of blue denim in 1853 who created wealth that has endured. Levi Strauss, in fact, did its IPO in 1971, over a century after its founding. The greed-and-fear cycle of the stock market, with its booms and busts, is played out with much more intensity with IPOs. The feeding frenzy over Internet stocks in 1999 was just another chapter in the normal cycle of the IPO market. Hysteria develops over IPOs because of the known investment rewards of getting in early on new technologies. Demand is strong because the supply of shares is limited. At the begin- ning, the investment potential seems limitless. Investors see IPOs as a 01 killian 15 12/14/00, 2:04 PM Black 16 IPOS FOR EVERYONE Exhibit 1.1 IPOs—A Unique Asset Class High Venture Capital Return IPOs Established Companies Low High Risk Low No liquidity Volatile High liquidity Inside knowledge Little research Much research Source: Renaissance Capital, Greenwich, CT (IPOhome.com). way to buy a ticket to the future. Weak, copycat IPOs force investors to look closely for flaws. And when they do, reality sets in. Then, just as bad money drives out good money, investors see flaws in every IPO and frantically dump them all. This cycle happened with Internet retailing in 1998 and 1999. At first, companies that sold goods over the Internet were driven up to impossibly high valuations, as was the case with Amazon.com and eBay. And then Christmas of 1999 happened. Investors who owned the “e-tailing” stocks bought things from the companies and quickly real- ized that prices were high and fulfillment was dreadful. Investors watch- ing television or listening to radio were barraged by commercials on no-name dot.coms. They realized they couldn’t remember which ads were for what IPOs. The twin problems of poor execution and over- spending with too little results caused investors to rethink their infatu- ation with e-tailers. And down, down, down, the stocks came. The pat- tern was exactly the same as it was for the bank stocks of the 1790s— when the dust settles, only the sound companies are viable. This doesn’t happen only to Internet retailers. In the early 1990s, the federal and state governments allowed Indian tribes to open casi- nos. Grand Casinos, which operated two Las Vegas-style casinos for the Ojibwe Indian tribe, was one of the first to take advantage of this new 01 killian 16 12/14/00, 2:04 PM Black How the IPO Market Works 17 ruling in 1991. Then state governments up and down the Mississippi River relaxed gaming laws, spawning a new industry—riverboat gam- ing. In 1992, Casino Magic, which ran one Gulf Coast casino, went public with great fanfare. It was followed by President Riverboat Casino, which claimed to have the largest riverboat casino in the United States, oper- ating out of Davenport, Ohio. Even tennis great Jimmy Connors was an investor. The floodgates really opened in 1993, when it seemed like anyone with a seaworthy barge, a few packs of cards, and a gambling license could go public. Faced with an oversupply of small gaming operations, investors took a close look at what they had bought and didn’t like what they saw. Mounting an IPO on the business model of having a single, small gam- bling barge was pretty risky. What about hurricanes? Ooops! Bad weather along the Mississippi and disaffected investors practically drove the smaller players out of business. Since 1993, the IPO market has not seen another gaming IPO from a legitimate underwriter.