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Bankrupt 1990s Internet Toy Company Still Thinks It Was Undervalued

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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 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 lawsuitsover 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.