• 11 Mar 2013 at 10:29 AM
  • IPO

Bankrupt 1990s Internet Toy Company Still Thinks It Was Undervalued

To get a sense of how old the Goldman Sachs IPO lawsuit-and-maybe-scandal that Joe Nocera and Felix Salmon wrote about this weekend is, consider this: the alleged victim was a company named eToys. With the “e,” and the “Toys,” and the weird capitalization. Also Henry Blodget was the analyst who covered them at Merrill. Different times!

Nocera gives the basic facts and there’s something a little off about them:

The eToys initial public offering [in May 1999] raised $164 million [at $20/share], a nice chunk of change for a two-year-old company. But it wasn’t even close to the $600 million-plus the company could have raised if the offering price had more realistically reflected the intense demand for eToys shares. The firm that underwrote the I.P.O. — and effectively set the $20 price — was Goldman Sachs.

After the Internet bubble burst — and eToys, starved for cash, went out of business [in March 2001] — lawyers representing eToys’ creditors’ committee sued Goldman Sachs over that I.P.O.

The theory of the lawsuit is that Goldman screwed eToys on behalf of investors, pricing the IPO at $20 per share, rather than the $78 justified by demand, as evidenced by the fact that the stock briefly traded at $78 on the first day. An alternative theory is that Goldman screwed investors on behalf of eToys, pricing the IPO at $20 per share, rather than the $0 justified by fundamental value, as evidenced by the fact that the company went out of business 22 months after the IPO. Also it was called eToys come on.

Are you surprised that investors sued Goldman too? Of course not, right? After all, they lost a lot more money. The surprising thing to me, as a wholly post-internet-bubble capital marketeer, is that the investor suit is not so much about “your prospectus said you would deliver childhood dreams and you instead delivered full-grown bankruptcy” as it is about the laddering and commission kickbacks that Nocera and Salmon describe. (Though: imagine the shareholder lawsuits if it had priced at $75.) Here’s Nocera:

Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions, according to depositions given in the case.

Let’s stipulate that some of the explicit quid pro quo stuff is bad, as are allegations that some clients conducted wash trades to kick Goldman sufficient commissions. Bad enough that various banks settled various lawsuits over dotcom-era hot-IPO-allocation practices, including Goldman settling with the SEC in 2005 over related “laddering” charges. The dotcom era is mostly in the past and so are those sorts of practices.

Others are not. Nocera cites an email from Bob Steel – then GS head of ECM, now Bob Steel – to Tim Ferguson at Putnam, saying in part “we should be rewarded with additional secondary business for offering access to capital markets product.” This email strikes me as pretty pretty standard even today. As Salmon says:

I’m sure if a determined prosecutor went hunting for similar emails today, she could probably find them. But I don’t know what the point would be. Because there’s nothing illegal about asking buy-side clients to send commission revenue your way — or even about explaining to them how much money you’ve helped them make.

True! There’s nothing illegal about telling your clients that you’re doing a good job for them.1 Is there anything scandalous? Obviously making money for investor clients by underpricing an IPO is in conflict with raising money for issuer clients by overpricing the IPO. That is the point of IPOs. There is that conflict, and the bank is there to mediate it, and the bank’s incentive to mediate is that it makes money from both sides.2

Salmon explains Goldman’s pitch to eToys:

On the page headlined “IPO Pricing Dynamics”, they explained that the IPO should be priced at a “10-15% discount to the expected fully distributed trading level” — which means not to the opening price, necessarily, but rather to the “trading value 1-3 months after the offering”. After all, this was the dot-com boom: everybody knew that IPOs were games to be played for fun and profit, and that the first-day price was a very bad price-discovery mechanism.

Right? eToys knew that it was leaving boatloads of money on the table for investors, and it knew that Pets.com and WebNonsense and the rest of its ilk before it had also left boatloads of money on the table for investors, and that that was why investors would give $164 million to a company called eToys that had – I mean, do I need to even say this? – never made a profit, and never would. That was the trade that eToys made: it let investors have an IPO pop, and in exchange they let eToys have an IPO.

The thing about this tradeoff is that it’s totally transparent. An IPO prices, and then it trades. You can look on Google Finance – back then it was probably AltaVista Finance but you know what I mean – and actually see where it’s trading. You can ask a bank for a list of their IPOs, and then see how they traded. If Bank X’s deals all left tons of money on the table and Bank Y’s didn’t, you might consider using Bank Y. Bank Y might even consider advertising this fact to you – just as Bank X is out advertising it to investor clients.

Now perhaps “totally transparent” overstates it a bit. The banks are masters of data-cutting, so they’ll focus you on the deals they want you to focus on (“joint books deals since 1998 excluding online pet product retailers”3). The “fully distributed trading level” blather is an example of that: 300% one-day pops look bad, so you focus clients elsewhere.

And investors have some advantages in their tug of war with issuers. They’re repeat players, for one thing, and they think about capital markets all day, so they have more incentive and ability to pay attention to which banks are systematically underpricing or overpricing deals. Also money: as Felix Salmon points out, Goldman likely made a lot more from investors kicking back 30-50% of their first-day eToys pop in commissions than it did on eToys paying its 7% fees. Even assuming explicit wash-trade kickbacks are gone, investors might still have the upper hand: at Goldman, for instance, 2012 equity underwriting revenues were a little under $1bn, and total investment banking advisory revenues were a little under $5bn, while equities division revenues – market making, commissions, and prime brokerage – were over $8bn.4 The more the trading side runs the place, the more its clients will tend to win out against issuers.

Nonetheless the right model is “constant tension,” not “one-sided screwing of issuers by investors.” One way to tell: if the issuers constantly got screwed, there’d be demand for things like direct auction IPOs that bypass investment banks. There is not. Issuers know that the model of banks currying favor with investors gets them better capital markets access, even if their stocks are the currency used to curry favor.

Another way to tell: if the issuers constantly got screwed, and the investors constantly made out like bandits, you’d see a lot of eToys-type lawsuits brought by issuers, and very few Facebook-type lawsuits brought by investors. That is not the case. There are more investor lawsuits over the Facebook IPO than there are issuer lawsuits over any IPOs.5 That suggests that the issuers are doing okay.

Rigging the I.P.O. Game [NYT / Joe Nocera]
Where banks really make money on IPOs [Reuters / Felix Salmon]

1. Also, like: you’re the head of equity sales or whatever at a bank, and you go meet Putnam, and you ask yourself: what do I tell them about why they should give us more business? I submit to you that things like “our guys have taken you out to some great dinners,” “we reply to your Bloombergs promptly,” and “our research is nicely formatted” are all considerably less impactful than “we bring you IPOs that you make a lot of money on.” Capital markets deals really are a big part of the service that big banks offer their investor clients.

2. Thus eToys’s contention that Goldman owed it a fiduciary duty as underwriter is sort of nuts. Nocera:

As for the litigation itself, Goldman has argued that, contrary to popular belief, underwriters do not have a fiduciary duty to the companies they are underwriting. In recent years, this argument has held sway in the New York court system, although it has yet to be argued before the Court of Appeals.

What popular beliefs about underwriter fiduciary duties in IPOs do you think exist? And what could those duties be? If a bank’s duty was to maximize price on every IPO then it would screw investors over and over again and they’d get sick of it and lowball the banks’ next deals. Given that banks and issuers know more about their stock than investors, you’d end up with a market-for-lemons problem, and issuers as a class would be worse off. The point of the bank is to curry favor with investors – sometimes by leaving a little bit of money on the table for them – in order to help sell the next deal. That’s why you go to a bank: because they have a good relationship with investors. How do you think they got that relationship?

3. I once reviewed a fee run with a little footnote accurately describing it as “excluding REITs,” which would be fine (REITs are weird and many data runs exclude them), except that we were showing it to a REIT. I can’t quite remember, but I want to believe I had it changed.

4. IBD page 60, equities page 62, of the 10-K.

5. Are there? I totally made that up. Seems like it might be true though. Or at least defensible rhetorical exaggeration.

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Comments (30)

  1. Posted by Icahn's Eyebrows | March 11, 2013 at 11:19 AM

    What was that about undervalued?

  2. Posted by @phoneranger | March 11, 2013 at 11:26 AM

    I thought Henry's fucking up the secondary was way more interesting. But it's all so long ago.

  3. Posted by Irate REIT Guy | March 11, 2013 at 11:27 AM

    So you had the data run corrected or just had the footnote removed?

  4. Posted by Guest | March 11, 2013 at 11:56 AM

    all well and good, but the 27 paragraphs and footnotes notwithstanding, an IPO should be underpriced by 15-20%, not 400%. kind of a big difference. 15-20% is a nice giveaway to investors that average high single digit annual returns over the long term.

  5. Posted by Guest | March 11, 2013 at 12:17 PM

    I miss the 90's.

  6. Posted by Corey Feldman | March 11, 2013 at 12:21 PM

    You and me both.

  7. Posted by quant me maybe... | March 11, 2013 at 12:26 PM

    You know, you can hate on the name, but it's awesome. It's the underlying product that was wrong. If these guys had sold sex toys, their investors would have seen a great return on capital.

  8. Posted by J. Gundlach | March 11, 2013 at 1:09 PM

    They also would have found some very receptive fixed income investors.

  9. Posted by Shazared | March 11, 2013 at 1:25 PM

    Lynn T., is that you?

  10. Posted by fatty Mcbutterpants | March 11, 2013 at 1:41 PM

    I had to testify in a few arbitration cases over this IPO. Just stupid.

  11. Posted by HighFrequencyHater | March 11, 2013 at 2:06 PM

    I liked the "we'd be rich if we didn't go bankrupt and you did something, so you owe us money" legal argument before it was cool.

    ~Hankster Greenberg

  12. Posted by Corey Haim | March 11, 2013 at 2:09 PM

    you and him and me especially

  13. Posted by PermaGuestII | March 11, 2013 at 2:55 PM

    …says the guy who was likely not in the business in 1999.

    -Guy who couldn't get a client to sell ICGE at 125 1/2 because it was "way too low"

  14. Posted by Common Sense | March 11, 2013 at 3:06 PM

    It was overpriced by 100%…..argument is moot

  15. Posted by Guest | March 11, 2013 at 3:24 PM

    actually i was. even then i thought the entire concept of "hot" IPO allocations was strange, and the "it's all very complicated" explanations BS.

    if there were 4x as many people trying to buy lemonade from your kid's stand as he had lemonade, might you suggest he raise the price? yeah, thought so.

  16. Posted by reality | March 11, 2013 at 3:46 PM

    so in Nocera's perfect world, here's what should have happened: EToys should have raised 4x as much cash in the IPO resulting in Goldman's underwritting fee being 4x larger and the IPO buyer's losses being 4x larger when this train eventually crashed which was innevitable given its flawed business model. Think before you write Joe. Goldman did the investing universe a favor pricing a hyped business plan in a frothy market at a not so insane level.

  17. Posted by bob | March 11, 2013 at 4:11 PM

    neither. we fixed the glitch.

  18. Posted by eOptimist | March 11, 2013 at 6:22 PM

    They ran out of cash though, as the article states. If only the IPO had been priced even higher they might have been able to tick over that little bit longer until profitability

  19. Posted by guasto | March 11, 2013 at 6:26 PM

    there are sensible arguments to be made on gs's behalf here. this is not one of them.

  20. Posted by Guest | March 11, 2013 at 7:34 PM

    The valuation on the eToys IPO was that a company with LTM revenue of $30 million and an LTM net loss of $30 million) went public with a market cap of about $2 billion (101.8 million shares outstanding post-IPO). That's the number that Nocera and Salmon say was crazy fucking low, because the price popped to $78. So please tell me how the hell someone was supposed to predict that turd of a company should have been worth almost $8 billion? You couldn't, it was a pure momentum trade with people flipping shares into a speculative bubble. The price increase fed on itself because people bought on the way up with no concern for company fundamentals.

  21. Posted by Johnnie Cochran | March 11, 2013 at 8:53 PM

    OJ wasn't guilty either! If the gloves don't fit, you must acquit!

    Surely bankers bore no responsibility for pump-and-dumping Internet stocks.

    Wondering how disgraceful a banker has to be before their body oil boy Matt can't find a way to get them off (in more ways than one).

  22. Posted by Guest | March 12, 2013 at 12:22 AM

    The NY Times having exhausted decades worth of hellacious acts by the vampire squid of finance goes back to the era of Livin' La Vidaloca and Austin Powers to find new ways to bash GS.

  23. Posted by lewy14 | March 12, 2013 at 5:42 AM

    Bullshit. Hindsight.

    People invest in all kinds of businesses which haven't yet made a profit.

    Could eToys have made it with 50% or 100% more runway? Maybe not, but it would have had a lot better chance. An IPO of $30 or $40 would have given them that.

  24. Posted by Student | March 12, 2013 at 9:13 AM

    From Felix Salmon's piece (http://blogs.reuters.com/felix-salmon/2013/03/11/where-banks-really-make-money-on-ipos/):

    "Goldman … pitched eToys with a presentation saying, on its first page, in big underlined type, “eToys’ Interests Will Always Come First“"

    Given what we know, this was fraudulent misrepresentation. That is all.

  25. Posted by Ben Johnson | March 12, 2013 at 10:56 AM

    The problem then and now is the banks are simple after their own profits, not the issuers, not the investors and for that reason alone Wall Street is and will remain corrupt and the small investors will continue to get screwed.
    The rich will keep getting richer, hence and point EToys. Companies are going public too early and with no clear sign of success, Groupon (GRPN) is a prime example, amongst hundreds from dot com bust and today's new bubble. Let's face it PE and VC are simply looking for a higher exit regardless of the consequence to the next guy holding the investment. If Wall Street or the Feds set standards for compensation, this and nearly all bubbles would get resolved but the hands of politicians are too deep in the pockets of Wall Street. Every known crash or bubble burst in the history of time is attributed to one thing, greed. GREED is the root of all evil and no one is more greedy than Wall Street's Big Banks!
    Don't get me wrong, I am all for capitalism, real capitalism though not monarch capitalism, where the richest (Goldman and other big banks) simply wipe out losses or IPOs/offerings as this article explains with new more profitable ones regardless of the long term effect on investors. These types of offerings with continue, investors will get screwed and continue to and on every 5th-8th deal they may make money and Wall Street has the canning ability to make us all believe as if they are doing nothing wrong. It's a joke and it is on us, the individual investors. I strong suggest reading Mark Cuban's piece on private equity and VCs and how it is no different than a ponzy scheme. Good luck all! Visit our new site http://www.StockMarketCrash.com to provide your insight on the market; bubbles and the next big thing or things…
    Ben Johnson
    Editor

  26. Posted by Necessary Proper | March 12, 2013 at 5:33 PM

    This was a great post. I linked to this in my own post on Nocera's column.
    http://thenecessaryandproperblog.blogspot.com/201

  27. Posted by james hanbury | March 12, 2013 at 10:31 PM

    Keep in mind that when a company goes public it only sells a fraction of the shares outstanding. The remaining shares are owned by the company and its investors, and they can benefit immensely from an under priced IPO. Why? Because the very fact that the stock went up a lot after the IPO argues that the company is successful or at least its stock is and the insiders can sell tons of stock at much higher prices. Often the amount of stock in the IPO was set deliberately low so as to goose demand. Asking for more business is done every day but the IPO trade was nothing less than commercial bribery, and those who participate in it should go to jail.

  28. Posted by laserhaas | March 15, 2013 at 12:42 AM

    For those of you who have NO idea, I'm the guy who tried to fire Goldman Sachs in eToys; while also trying to get them and their cohorts (Bain Capital) – INDICTED.

    The http://www.MNAT.com is on public record "confessing" that they lied to the Chief Federal Bankruptcy Court Justice in eToys 15 times (DE Bankr 01-706) – about (secretly) also working for Goldman Sachs.

    The LAW of the land at the time (March 7, 2001 – when the bankruptcy was filed) – was that WHEN you handle the IPO of a company, you can NOT represent them in bankruptcy (hence MNAT had to LIE in order to become eToys Debtors counsel).

    MNAT's other secret is their partner from 1999 to August 2001 (the infamous "retroactive" era)

    That's Right! MNAT also represents Bain Capital/Romney issues (secretly) in Delaware.

    MNAT nominated their cohort in crime to prosecute Goldman sachs in NY Sup Ct (601805/2002) – but as Joe Nocera pointed out – the ENTIRE case is Under SEAL (so that you can NOT see the facts that Goldman SAchs is [in essence] suing Goldman Sachs!

  29. Posted by laserhaas | March 15, 2013 at 12:43 AM

    Also, MNAT, along with other Bain Capital, cronies, cohorts etc, helped reduced the prices for tens of millions of dollars that my company forced Romney CEO/ Bain Capital pay for eToys stuff.

    MNAT submitted (I kid you not) paperwork for me (court approved to do so) – to the DE Bankruptcy Court, stating I "waived" my rights to be paid and gave up my control. Doing so even AFTER the Goldman Sachs/ Bain Capital law firm – CONFESSED – to lying under oath 15 times.
    .
    But they got away 'Scot Free', because Colm Connolly, the MNAT partner from 1999 to August 2001, became the United States Attorney on August 2, 2001, then Mitt Romney resigned as CEO of Bain and announced his entering the Mass. Governor race August 22, 2001.

    For the next 7 years, MNAT's former partner, hid the fact, while he was US Attorney, that he wored for the 2 companies I was asking him to investigate and prosecute (Goldman Sachs and Bain Capital).

  30. Posted by laserhaas | March 15, 2013 at 12:43 AM

    By the way, to Make SURE there would be NO investigation and/or prosecution, one of the items that MNAT obtained permission to do, while Lying Under Oath, was to DESTROY the eToys Books & Records http://petters-fraud.com/MNAT_Motion_Destruction_

    BECAUSE – eToys was NOT really Bankrupt!

    Here;s more (ancient) news apropos —
    http://www.nypost.com/p/news/business/collusion_c