The capital markets, otherwise known as the stock exchange, has traditionally been described as the place where companies go to obtain the capital they need to grow.  For many companies, however, the IPO market has simply become the exit plan for founders and venture capitalists. Here are three examples. 

The Initial Public Offering vs. Venture Capital 

The public market has traditionally been the resource for growing companies to obtain capital needed for growth. 

The venture capital market, however, has grown to such an extent that it has become the resource for companies to grow. 

In addition, many technology companies have not had the same types of capital needs that manufacturing companies of the past have needed.

What this has combination of events has done is distort the purpose of the capital markets, particularly for technology companies. 

It would be  pointless to make a list of all of the technology companies in the great internet bubble of the late 1990s that made tremendous profits for investors in companies prior to the IPO, but failed to make profits for persons who invested in the market. 

There are simply far too many examples, particularly of companies that have since experienced bankruptcy. 

However, there are three good examples of this problem today, which we list below. 

Groupon 

Groupon is probably the best example of a company whose business plan seems designed to create a great IPO rather than a lasting company. 

Since its beginning, we have detailed the company as “baffling,” since it has shown a history since its beginning of a trend of increasing needs for working capital as revenue grows. 

This is the exact opposite of a growth company, whose needs for working capital are supposed to be obtained from revenue growth. Operating margins are supposed to be large enough that working capital needs are satisfied by increasing revenue. 

Groupon, however, has shown a history of working capital needs increasing as revenue grows. 

We pointed this out in our first review of Groupon, shortly after it IPO’d, in November of 2011. 

Groupon has been viewed as “free money” by its customers, while the issuers of the coupons have viewed the “discount” cost as marketing. 

But the problem has always been that Groupon’s working capital has largely been supplied by capital investment. 

Groupon’s quarter with its largest working capital amount was the quarter before the company IPO’d, where the current liabilities were supplied by venture capitalists investing just prior to the IPO. 

Working capital in Q3 2011 was $348 million; the most current working capital figure is $331 million. This is despite revenue increasing from $430 million to $601 million. 

Groupon’s lowest working capital was in Q2 of 2012, at just $300 million. 

This is simply an anomaly in the capital markets.  Profitable companies with rising revenues and increasing profits usually see their working capital needs decrease, as short term assets (cash) rise faster than short term liabilities. 

The reason for this is that the G&A costs at Groupon are an incredible 60% of revenues, largely due to commissions paid to salespersons selling coupon deals to merchants. 

Even today, Groupon’s working capital is less than the total working capital it had before its IPO. 

If you’ve ever wondered where Groupon’s “free money” comes from, it comes from investors. 

Those investors have had little return on their money, however, as the stock has fallen from its initial trading level of $28, after an IPO at $20, and now trades around $6. 

Vonage

Vonage is another stock that has never risen above its IPO price, despite increasing revenues and even profits increasing. 

Vonage IPO’d in May 2006 at a price of $17 and has never risen above that price, even on the first day of trading. The price today is less than $3. 

Vonage also has a working capital problem, which has been negative until this past year. 

In addition, Vonage showed a profit of nearly $400 million in the quarter ending in December 2011, but $325 million of this was a tax credit entirely due to a non-cash accounting maneuver.  

How many investors in Vonage were aware of this?  

We cannot be sure, of course, but it is a good guess that in the individual investor marketplace, few Vonage investors understood the nature of the “income” in that quarter. 

Facebook

Facebook is the most famous example of a stock that has not risen above its IPO level, despite the company increasing in revenue and profits since its IPO time. 

The company IPO’d almost one year ago, in May of 2012, at a price of $38.00. Trading opened at $42. 

Today, FB stock trades at about $26, or roughly 2/3 of its IPO price. 

The addicted users of Facebook who bought the stock because they loved the company and its service as part of their daily life have yet to see a profit from that investment. 

Conclusions

Vonage, Facebook, and Groupon all have one thing in common: a tremendous customer base of individuals. 

These are companies whose ultimate end users are the mass market consumer. In addition, all of them appear to offer to the end user a “good deal.” 

Vonage appeals to the customer who wants to save money on traditional phone service, although the bundling of phone, internet, and TV has now rendered traditional “phone” service virtually free. 

Facebook is free, although the user is assaulted by ads. 

Groupon, to most users, appears to be better than “free,” as the coupon represents “free money” at most of the issuing merchants. 

How many of the ultimate holders of these companies are individuals who “loved” the company so much that they bought the stock at the IPO? 

All of these companies received massive investments just prior to their IPO from venture capitalists and private individuals, many of whom held their shares for less than one year prior to the IPO. 

The purpose of those private investments was not to provide capital “at-risk” in order to develop a company. Instead, it was largely to “dress-up” the company in preparation for the IPO. 

The buyers of the IPO for these stocks was largely private individuals and mutual funds that are “required” to own the stocks, either as an index fund, or as a sector fund in which the giant stock is a major player. 

What types of real risks were taken by the venture capitalists in these cases? 

The poor performance of all of these stocks after the IPO is prima-facie proof, in our opinion, that the real reason for the IPO was not to raise capital for the company’s growth needs, but instead to provide an exit plan for the early (and the last-minute) private investors. 

The stocks were then dumped on the public, who have now taken losses of various sizes, depending on how long they have held the stock. 

The real moral of this story? 

Don’t buy a stock simply because you like the company or its products. 

It may be that the company stock itself has been marketed and created for sale, just like a product. 

Comments may be e-mailed to the author, Robert V. Green, at aheadofthecurve@briefing.com 

The capital markets, otherwise known as the stock exchange, has traditionally been described as the place where companies go to obtain the capital