IPOs and the Culture of Promotion

At this point, the mispricing of initial public offerings by the investment banks that underwrite them has become so routine as to be invisible. But last week gave us yet more evidence that even as the IPO process embodies one of the most valuable aspects of U.S. capitalism–its appetite for risk, and its willingness to fund new enterprise–it also embodies two of the least valuable, namely the cultures of promotion and of Wall Street insider-ism.

Take Healtheon, for instance, Netscape founder Jim Clark’s new online health-care firm. The company was scheduled to go public last November, but the weakness of the IPO market in the wake of the stock market’s summer cratering forced the company to withdraw its offering. As the tech and IPO markets rebounded over the past three months, Healtheon prepared a new IPO, and went public Thursday. The offering price was $8 a share, but the first sale was at $23 and the stock finished at $31 3/8.

Similarly, Prodigy Communications, one of the biggest dogs in Internet history, went public on Thursday at $15, had its first trade at $20, and finished the day at $28, before rising another $7 a share on Friday. And VerticalNet exploded from $16 a share to finish at $45 a share on its first day. None of these spikes could have been unexpected. rose 474 percent on its first day, while leaped 606 percent and was up 274 percent. and have risen more than 300 percent on the first day. In fact, if an Internet firm’s stock isn’t up at least 50 percent after its first day of trading, you know that something is dreadfully wrong. Which may mean simply that investors have become uncharacteristically sane.

The question, then, is why investment banks are content to underprice offerings so consistently. What you hear from people on the Street is that pricing is much more difficult than it seems to be. Companies want their stocks to get at least a little bump in the aftermarket, so that the people who made the initial investment don’t feel like they’ve been had. And obviously selling a full block of even 5 million shares is harder, and will require a lower price, than selling 100 shares to some day trader after the IPO.

Accepting all that, there’s no way that pricing is that difficult. If was offered at $8 a share, had its first trade at $27 a share, and then rose as high as $97 a share on its first day, then it could have been offered without any difficulty at $25 a share. And if it had been, the company would have been $17 a share richer than it now is.

The problem, of course, is that if had gone public at $25 a share, all of those customers and friends of the investment bank–and of the company–who got to buy into the IPO would have been $17 a share poorer. And since some of those customers include people who will be bringing that investment bank business in the future, keeping them happy is obviously important.

At the same time, companies themselves, particularly Internet companies, appear to be succumbing to the idea that IPO hype is somehow a way to build a business. The founders of, for instance, recently told the Wall Street Journal that they weren’t concerned about the low offering price for their IPO because they thought that the publicity generated by the stock’s precipitous rise on that first day was more valuable than the extra millions of dollars the company would have raised had the IPO been priced better. Since the publicity generated had nothing to do with’s actual business, it’s hard to see this as a worthwhile tradeoff. But maybe in the new universe of the Net, having a hot stock matters more than having a real business. I don’t believe it, but at this point, who knows?

The real irony here, of course, is that it seems increasingly likely that deep pockets are going to be essential on the Web. With everyone losing money hand over fist, just keeping enough capital to stay in the game is going to be both crucial (which is why just raised $1.2 billion in a convertible bond offering) and difficult. Yet it’s precisely Net companies that are throwing away millions because of the mispricing of their IPOs. Don’t look for market efficiency here. There’s none to be found.