Question: Is it foolish to buy into tech IPOs?

Bear's Response

According to Morningstar, first-day returns for tech IPOs in 2012 (up to May 16) average 30% compared to 16% for the entire IPO market. Furthermore, the return for tech IPOs after the first day's close are 11% compared to 3% for the entire group of IPOs going public in 2012. The statistics seem to suggest that buying tech IPOs on the first day of trading isn't a fool's bet. The statistics could be wrong. Here's why.

Pre-IPO Valuations

Former TechCrunch editor-in-chief Erik Schonfeld believes that much of the value of a tech company is captured by private investors prior to going public, leaving very little appreciation for the little guy. Years ago, companies like Amazon (Nasdaq:AMZN) and Cisco (Nasdaq:CSCO) allowed investors to participate in 99% of the terminal value of these companies. Today, most of the upside is already spoken for pre-IPO. For example, Zynga (Nasdaq:ZNGA) did a final round of private financing at $14 a share, $4 higher than its $10 IPO price from last December. Counter-intuitively, the final round of private financing bumped up the value of Zynga prior to the IPO, leaving little motivation for post-IPO investors to get on board. Zynga's lost around 40% since then, with no hope of a positive return on investment anytime soon. A second example would be Facebook (Nasdaq:FB), where its valuation prior to IPO was already as high as about $100 billion, suggesting it was fully valued at $38 with no room for appreciation. Tech IPOs are hitting the starting line exhausted and out of gas.

Investment Zoo

In his book The Investment Zoo, Canadian money manager Stephen Jarislowsky says: "New issues are typically well promoted .... My experience is that you can buy nine out of 10 new issues at a lower price a year or two later .... I generally avoid new issues." Groupon (Nasdaq:GRPN), LinkedIn (NYSE:LNKD) and Pandora Media (NYSE:P) have earned aftermarket returns of approximately -59%, 9% and -19% respectively. All three had positive first-day returns including nearly a sizzling 110% for LinkedIn. The only problem with this first-day return - the average person wouldn't be able to achieve it because even though its IPO price was $45 a share, it opened on May 19, 2011, at $83. Six months later, it was trading around 28% lower (slightly below $60). The smart buyer waits.

SEE: How An IPO Is Valued

Exit Strategy

Union Square Ventures invested approximately $54 million prior to the Zynga IPO. The initial public offering in December 2011 and a subsequent secondary offering in April 2012 netted Union Square $82 million on the sale of 7.4 million shares, while still holding 25.5 million shares and realized gains of $28 million. Union Square was already in the black on its investment. Not coincidentally, the number of shares traded on May 29, the day the lock-ups expired, the volume on the day was 48.2 million, about 221% higher than the day before. Volume's been extremely torrid ever since, including a 57.5 million share day on June 12. The odds are high Union Square has been busy selling the last couple of weeks. I pity the first-day investors who managed to buy at the $11 open and are sitting on a 50% loss while the boys over at Union Square are sitting pretty and toasting their successes. Why pave the way for their lucrative exit?

Use of Proceeds

Zynga's IPO didn't raise a nickel for the company; 100% of the proceeds went to the selling stockholders. That's the wrong way to do an IPO. The right way is best illustrated by Guidewire Software's (NYSE:GWRE) IPO in January. Guidewire provides enterprise software to property and casualty insurers. Its stock is up over 117% from its IPO price of $13, making it the third-best-performing IPO year to date. Interestingly, Guidewire received 100% of the $119 million in net proceeds, which it will use for working capital. None of the existing shareholders sold any shares. Battery Ventures even expressed an interest in purchasing an additional 400,000. Even if you bought on the first day of trading at the high, you'd be sitting on around a 65% gain. I'm not suggesting you should buy on the first day, but if you must; at least make sure the conditions are in your favor because most of the time, they're not.

Dividend Recapitalization

Jeff Macke, co-host of Breakout, Yahoo Finance's popular show about the markets, characterizes the $400 million dividend paid to pre-IPO shareholders as "scummy" because it enriches one group of shareholders at the expense of the company's financial health. Worse, it then expects institutions to step up and invest in the IPO so they can repay the funds borrowed to give themselves an $8.27 per share parting gift. Let me make one thing perfectly clear; if you are dumb enough to invest in this IPO on any day you deserve to lose some or all of your investment. In the words of Mortimer Duke from the movie Trading Places: "This is an outrage! I demand a full investigation!"

The Bottom Line
Tech IPOs are paving golden exits for company managers and trying to sell overhyped operations to investors. Rarely are the conditions set up to favor investors looking to snap up stock in tech companies that go public.

At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

Don't forget to read the Bull Side of this debate and weigh in with your opinion below.

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