I write a lot about technologies, companies and industries, some about economics, but hardly ever about stocks or trading, so this column is an unusual one. But because of the hard work of a couple economist friends of mine I’m finally coming to understand a stock market phenomenon that has been hurting tech startups for over a decade — Exchange Traded Funds. Forget about bad banks, cooked books and even the recession: Exchange Traded Funds are forcing more and more good tech companies to abandon the idea of ever going public.
We saw this trend on this summer’s Startup Tour where not one of more than 30 companies we visited saw an Initial Public Offering (IPO) in its future. Every company saw itself eventually being acquired. But there’s a problem with being acquired, which is that it greatly limits the upside for entrepreneurs. Had Microsoft been acquired by IBM, for example, would Bill Gates today be the richest man in America? Heck no. Lotus Development was acquired by IBM and the fortunes of those Lotus people haven’t fared any better than those of their colleagues at Big Blue. Yes, they got $3.3 billion, but today that’s not worth much more, maybe less.
IPOs are better if they work. IPOs make entrepreneurs big rich. So why aren’t there more of them?
That’s a very good question — one that until this week was generally answered by experts rolling their eyes like they were trying to explain the great frog die-off. IPOs are too expensive, we’re told. A positive upside is no longer as certain as it was in the 1990s, they say. Acquisition is just plain easier and big companies have learned better how to grow by acquisition: look at Cisco.
Then along this week came Harold Bradley and Bob Litan of the Kauffman Foundation with a completely new and novel reason for the decline in IPOs. They say in their new study that Exchange Traded Funds have caused such volatility for newly-public tech companies — volatility that has nothing at all to do with the companies themselves — that founders are being scared away from IPOs and into being acquired for substantially less money than they might have made.
Exchange Traded Funds have been around since the early 1990s and can be thought of as index mutual funds on steroids. Both types of funds have underlying assets that reflect their target index. If the mutual fund or exchange traded fund is intended to represent the Dow 30 Industrials, then it should own all 30 stocks in equal amounts. Where the funds differ is in how they are traded and taxed. Index mutual funds are priced to represent the value of their underlying shares so the redemption price is set once per day based on the closing Net Asset Value of the stocks in the portfolio. Day traders aren’t interested in index mutual funds because there is no intra-day price volatility. There’s no shorting, either. You can’t normally borrow and short a traditional mutual fund, nor would you want to because the tax consequences could ruin the deal. But ETFs, in contrast, vary in price throughout the day based on supply and demand so day traders might be interested. If the ETF price varies significantly from the price of the underlying basket of stocks, then there is an arbitrage opportunity that some trader will notice and take advantage of — buying the ETF while selling the underlying stocks, for example — generally without the tax concerns of a traditional mutual fund because the retail ETF shares are traded through intermediary market makers that effectively decouple share gains from underlying capital gains. Got that? Me neither, but that’s the way it works. Oh, and ETF shares can be shorted, which of course increases volatility even further.
ETFs change value constantly based on supply, demand, manipulation and rumor. And here’s the weirdest part: at the end of the day index mutual fund prices are changed to match their Net Asset Value while with index Exchange Traded Funds at the end of the day the underlying securities are bought or sold to reflect the notional value of ETF shares. As a result ETFs are constantly buying and selling, leading to yet more volatility.
Now that we have some vague understanding of ETF structure, here is how they screw things up for little companies. This happens in two very different ways, first by reducing market interest in individual stocks in favor of funds that hold those stocks and second by amplifying the share volatility of small companies that are not widely traded.
In relative term,s retail investing in the USA has died. The huge trading volume increases of the last two decades have been driven almost entirely by institutional traders with their computers buying or selling billions of shares per day. Compared to these institutions, you and I and our trades have almost no impact on where the market is going. Since we have no sense of efficacy, we trade mutual funds or ETFs, which is to say we let the institutional investors do it for us.
“People have given up on picking stocks,” said Bob Litan. “Indexes are cheaper and ETFs have tax advantages. So much money is now in the index ETFs that many investors no longer care about the individual companies that underly the index.”
If an ETF is comprised of large cap stocks like Microsoft and Dell, that’s fine, but if the index is composed of smaller companies like the Russell 2000 index, those companies with very few shares outstanding are in for a wild ride. One ETF, IWM-Russell 2000, is the largest shareholder for more than 800 of the companies in that index. If the ETF goes up then the ETF has to buy more shares of the underlying securities or issue more shares of the ETF, itself. If the ETF goes down then it may have to sell shares. And none of this has anything to do with the fundamentals of those particular underlying stocks.
The shares go up and down, well, because they go up and down, which makes a CEO feel helpless — sometimes so helpless that they my choose to opt out of the system by foregoing an IPO altogether.
“The index is the tail that wags the dog, ” Litan continued when I talked with him yesterday. “It’s like riding a bull. Why IPO into that?”
And so, more often than not, tech startups these days walk away from the public markets.
Next: What’s to be done about this problem and how can it make us all rich?
Interesting post Bob, I’l have to read more about ETFs to understand the situation better. Looking forward to your next post for sure! It would be great if there is (or could be) a better alternative to acquisition for entrepreneurs.
While I understand the lure of “going public”, free money and all that…
I entered adulthood (working for a financial institution, no less) just prior to the dot-com bust of 2000, and watched the terrible things happen to all things “publicly owned” since that time.
The only take-away I have from watching the spectacle of the stock market over the last decade is that stockholders do not necessarily have any interest in the health of the company they are “investing” in, and since they are “the boss” they can push companies to make ruinous choices in pursuit of very short term goals.
That seems to be the story of the American Economy since the 80s.
There seems to be a false dichotomy that you must choose between debt and investors.
Whats wrong with the idea of organic growth?
And whats wrong with the idea of staying private?
the markets are a game for the really, really big boys. they want a minimum of X dollars per unit of investment, or they are going to step on your air line until you give them the money.
they don’t care about tomorrow, 5 years out, hell, they don’t even care about what is in their portfolio. it’s all numbers, and if stocks don’t do it today, then they will loan out their money to a Mexican cartel for 30 days to run drugs with.
that’s what’s wrong with building a company, generating a future, doing things for the community, business continuity. you have to have that investor call whenever a 10K filing is made, and if you are a penny short on your earnings projection (oh, right, not yours, but the ones Wall Street analysts are making “for” you,) you get whaled on the stock price.
the table is badly tilted at this point, and my investments are going to bail out the banks, even now. monthly. and they should be darn glad I’m doing it 😉
That is exactly reason why Porsche never wanted to go on big market exchange. Big bosses in Porsche always stated public company on big market exchange has only short term goal and can’t execute long term strategy.
At the end banks forced them to sell the company to Volkswagen because they have too much debt and have problem to refinance it.
That might be right. Just compare it with GM. When gas was cheap they were building low quality SUVs like crazy for short term gain – there is always pressure from stockholders (who are mostly today mutual funds and investment companies) to make biggest profit right now – who cares what will be tommorow.
I am willing to believe that ETFs increase the volatility of (at least some of) the underlying companies, but your explanation about buying/selling shares if the ETF goes up or down is not correct. Shares in the underlying companies get bought or sold if the premium or discount on the ETF gets too big. That isn’t the same thing. The “or issue more shares of the ETF” is completely wrong–it is an “and”; the two go in tandem–more shares of the ETF means more underlying shares purchased, fewer means more shares sold.
The real question is why increased short-term volatility (which is all that the ETF behavior you are describing should be able to generate) should keep companies from wanting to go public. Even if you assume longer-term volatility, that would be good for option holders, who are usually the ones running tech companies.
Company founders don’t typically go to all that bother if their intention is to trade options, that’s why. They want to build companies and finance growth, but the ETFs push around small cap companies too much.
“.. intermediary market makers that effectively decouple share gains from underlying capital gains.”
This is what seem nuts to me, that special people in the system get to trade all day without tax consequences. Everyone should be taxed on all transactions, which would slow everything down, not to mention equalizing the playing field. Finance desperately needs slowing down, for its own good, as well as ours.
Yes! So many silly games on the stock market. It’s easy to see why so many people think the current financial system is broken and no longer represents a realistic contribution to the regulation of our society. Greed is a weapon of mass destruction as has been adequately demonstrated by the current financial crisis. However, unconstrained growth in a finite environment is an even surer poison.
I am not an expert, but from what I understand a Market Maker is quite crucial to the way the market works. If you want to buy or sell, he is obliged to deal with you at the market price. If he does not have shares to sell, he has to go and buy them himself at whatever price it costs him. If you want to sell, he has to take your lame shares.
If I’m right on this, I don’t think you can really expect to tax the market maker in the same way as the retail customer. It would be like charging both the car dealer and his customer for retail new car tax. The customer would just end up paying it twice.
Um, this isn’t right. ETFs aren’t throttling IPOs.
Yes, ETFs (and mutual funds) hurt small companies.
However, entrepreneurs and venture capitalist and investment banks get rich on the IPO itself. What happens to the small company’s stock after that is irrelevant, once the blackout period ends.
So does the company. It’s up to the company to make the stock more valuable to additional investors by using the VC/investor capital to generate profits. If they fail to do that no one gains, except the brokers that don’t invest but charge a fee for their services.
“once the blackout period ends”
Key phrase here. You have to ride the market for long enough to divest your shares. With the IPO black out period, insider trading black out periods, contractual limitations, and not wanting to kill the price by flooding the market, the exit can take a lot longer than one may like. Easier to sell the company off for some blue chip stock and sell the massive quantity off once any insider trading black out period related to the acquisition has ended.
well i most certanly agree with the “IPOs are too expensive” issue 😐
It’s been a while since I did any finance units but I believe the main problem is that IPO’s become divorced from the historical reason for offering shares to the public, that is to raise capital for the business to expand. It seems to me that the main concern these days is to generate immediate returns for company founders, angel investors and venture capitalists.
I remember the .com bust which was caused by companies going early to IPO’s that had not fully developed ways to monitise thier products and had unrealistic business models, lots of entrepreneurs did get very rich, sold up and left the remaining investors holding the bag. Which I assume promoted the development of traded funds which present less risk for fund managers.
I agree with this point. Notice that the entrepreneurs who got REALLY rich, like Bill Gates, did not use the IPO as an “exit” strategy, they used it as a growth strategy. Gates is still the largest shareholder at MS, and Ballmer is right behind him. If you have a tear off calendar counting down the days of your blackout period when you do the IPO, you probably should consider aquisition instead. But if you want to be the next Bill Gates, you better plan on hanging around.
Gates did not use the Microsoft IPO as a strategy of any kind, because he was opposed to the whole thing. Microsoft had plenty of cash flow to finance any level of growth it wanted. The Microsoft IPO came because there was so much secondary trading by early employees that the SEC would eventually have forced Microsoft to go public. Microsoft CFO Frank Gaudette just saw that train coming and jumped on.
In the trading I’ve done (non-professional) I:
– avoid stocks that have less average volume than 1 mil shares a day
– use technical analysis to determine buy/sell/short/cover/stops
– only look at the news/earning/what is going on in the market to decide if I want to play that stock or get out
– have avoided ETFs except if I am looking at a foreign country like Brazil or Turkey.
So, yes, in general I don’t really care about the company. Many small companies that have had an IPO in recent years would never come into my scope – not enough volume.
What I am looking for/at is the psychology of the market and charting trends and patterns.
It does make sense that ETFs would increase the volume and volatility of an individual stock.
“Next: What’s to be done about this problem and how can it make us all rich?”
We need an alternative to the existing stock market – a brand new market which is completely separate.
It should be based on common sense principles. It should have rules which actively discourage day trading, short selling, and complex financial instruments. It should encourage investors focus on the real value of companies.
I think a lot of companies and investors would be interested.
It might start off small, but it would grow rapidly. If the stock market as it exists is not working well for small companies and individual investors, then create an alternative market which works better.
OK. So you have 2 markets. The existing one and one based on “common sense principles”. Where do you think the money is going to go? Good chance it will not be where there are all sorts of rules and (most likely) limited returns. I dont like everything that goes on in the market (high frequency trading for one), but at some point, it does make sense.
Putting it another way, the people with the money (BIG MONEY) like the system the way it is because it benefits them and without big money you dont have a market.
If you’re the CEO of the company, there’s no reason for you to care about the daily girations of the stock price unless you’re planning on dumping your stocks. Also, the purpose of an IPO is not to make the CEO rich, it’s to raise investment capital for the company by selling the company itself. It sounds to me like the CEOs you’re talking to are either in it for the wrong reason, which is to get rich off an acquisition and them make the company somebody else’s problem, or they’re in it for the best reasons, and they want to keep the company private and grow investment capital the old fasioned way: by earning it.
“If you’re the CEO of the company, there’s no reason for you to care about the daily girations of the stock price unless you’re planning on dumping your stocks.”
There is, if you want to keep your job. Directors are major shareholders or answerable to major shareholders. They lose too much money, you lose your job.
as above – precisely.
consider https://www.nytimes.com/2010/11/09/business/09flash.html?_r=2&pagewanted=1&ref=business
companies are losing EVERYTHING in their stock value in a single day in spite of having absolutely no reason to do so, all because (in one case) one day trader screwed up, dumping too many shares at once, and all the software went on “automatic” after that.
When the average length a stock is held during a trading day is 11 seconds (no, I’m not kidding), how the hell can it be said that the market is really a good indicator of the economy or the state of the companies being traded?
Here’s the rest of the story…or the other side of the coin, as it were:
https://www.investors.com/NewsAndAnalysis/Article/553406/201011101909/Report-Villainizing-ETFs-Is-Lambasted.aspx
boberto are you doing your predictions again this year? i hope so.
I dunno, Bob. I suspect that few IPOs are immediately incorporated in significant amounts into ETFs or Index Mutual Funds. Is there any data on this?
Also, I think that the attractivness of an IPO is strongly affected by the personal preferences of the entrepeneurs. One with a strong technical interest may really have little interest in managing a fast growing organization but have other clever ideas up his sleeve, where another has visions of world domination in something like the unobtainium mining industry and needs massive capital to achieve those goals. An acquisition would likely be preferred by the first and an IPO by the second.
Is it possible that the nomination and selection process for your set of startups somehow resulted in a group where IPOs are just not the best or favored option?
Another recent trend in the tech sector is waiting for a long long time before an IPO. Google is an example where they waited long enough to go IPO thereby increasing their value many-fold. Looks like facebook is following suit. The most popular social-networking web site is taking more time to decide on an initial public offering after Russia’s Digital Sky Technologies bought a stake.
”
But there’s a problem with being acquired, which is that it greatly limits the upside for entrepreneurs.
”
So you claim there is a significant population of people who would “risk” their careers and time starting up a company for a billion dollars, but would not do so for a “mere” so ten million dollars?
I call BULLSHIT. Until you can provide genuine evidence of this claim, I state loudly and clearly that it doesn’t pass the common sense test. You’re making a claim about the world based 100% on ideology, and 0% on rationality, common sense, intelligence, history, human psychology, etc etc etc.
We’re talking apples and oranges here. I’m not saying that people won’t found companies without the prospect of big IPOs. People will always start companies. What I AM saying is that by accepting alternate exists like acquisition those founders are often leaving money on the table — money the could have put in their pockets through an IPO.
I can see how ETFs increase traded volume in a small company stock, and therefore how often it’s prices varies. I suppose that counts as ‘volatility’ in a technical sense, but only because it causes the stock price to track the prevailing market trend. But surely that can’t be a bad thing for a stock? If the overall market rises or falls,and if all other things (i.e. company fundamentals) being equal your stock will generally follow that trend, then how is that bad?
On the flip side it means there is more of a market for the company’s stock, i.e. more liquidity. That’s going to give direct investors in the stock more confidence in their ability to trade in and out of the stock when they want to. Surely that’s a good thing?
While I do not have a dog in this fight, viewing the field from afar (Canada), one can see the rampant disregard for anything that isn’t “more-now” in the upper regions of the US economy – dare I say society itself. While investing was always about earning, there used to be an underlying process that saw value and wanted to back that to enable the growth that additional resources could offer. Well, no more.
I can’t help but wonder how long this can go on before the whole thing comes crashing down. Pretty sad when the parasites turn on their own species. Isn’t that pretty much the definition of cancer?
Bob, it’s interesting that you didn’t mention SOX compliance. I’ve seen that cited frequently as a major disincentive to tech companies going public. That never made sense to me- SOX compliance for a small company just starting out shouldn’t be that big a deal.
Exactly. As John Dvorak says: “This stupid law has to go. Completely.” https://www.marketwatch.com/story/its-time-to-repeal-sarbanes-oxley
And he also says: “The last drop of blood already has been squeezed from the turnip. Now what?” https://www.marketwatch.com/story/business-climate-is-dead-in-america-2010-11-12
IPO’s give out a lot of stock at the startup of a company. And this same stock is dumped into the market 2 or 3 months later which decreases the total assets per share of stock and the price goes down. The company does a stock buyback to bring up the price (hey its cheap) which decreases the cash per share. The price continues to go down anyway (its a startup). The company issues more press releases. Shorty sells more stock that doesn’t exist until the price is zero. The company is finished.
Solution: Don’t let any stock leave the company for a price that is less than the current price on the market. No discounts, in lieu of compensation, sweat equity, nothing but the current price paid for with cash.
The company needs a voice to say, “excuse me, where are you going with my stock? I expect to get paid for that, going price, in cash, understand?”
The growth of total assets has a very low priority. The assets get smaller and smaller until there aren’t any.
Solution: If you want to own stock in the company with the hopes that it will go up in price, call your favorite broker and buy some with your own money.
How about a new model – doing an IPO on the web / cloud financing.
Interesting contrary viewpoint:
http://abovethecrowd.com/2010/11/15/silicon-valleys-ipo-anxiety/
Points I found interesting:
– Number and dollar value of IPOs is increasing
– IPOs since 2008 has averaged 55% return
– 74% of recent IPOs are HQ outside of Silicon Valley
– Investment banks say they have more IPO buyers than sellers; demand is strong for more “quality product”
– Investors are tired of meager return from established large tech firms
– IPO market currently paying a premium over M&A market
– IPO can help get a better future M&A deal
– Your company is not Facebook
Maybe some of Bob’s startups should read the above article.
[…] ETFs that aren’t going away?I have a plan.Here’s where it might be a good idea to go back to my last column and read or re-read it so I don’t have to write that stuff all over again. Notice the comments, […]
Thank you for the great info, i’m going to write on this too!
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Cringely,
IPOs are nice but they do cause a lot of stress. Look how Mark Zuckerberg and the folks at SAS. I would focus more on revenue and less about actual market worth for a nice living. The folks at 37 Signals are also doing pretty well.
Just my 2 cents,
It’s never as late as it seems to be if you? follow directions witch are written in this artice.
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IPOs are nice but they do cause a lot of stress. Look how Mark Zuckerberg and the folks at SAS.
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away I have from watching the spectacle of the stock market over the last decade is that stockholders do not necessarily have any interest in the health of the company they
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