Where banks really make money on IPOs

By Felix Salmon
March 11, 2013

Every time an IPO has a big pop on its opening day, the same tired debate gets reprised: did the investment banks leading the deal rip off the company raising equity capital? The arguments on both sides are well rehearsed — I covered them myself in no little detail, for instance, after LinkedIn went public, in 2011.

Back then, I had sympathy with the bankers:

If the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

Today, however, I have to take all of that back. And it’s all thanks to Joe Nocera, who has a great column this weekend, where he uncovers a bunch of documents in one of those interminable securities lawsuits against Goldman Sachs. The documents should have been sealed; they weren’t. And now, thanks to Nocera, we can all see exactly where Goldman makes its money, when it comes to IPOs. (It’s fantastic that he put those documents online, although it’s hard to read them in the browser; here’s the download link which the NYT weirdly removed from its own site.)

The lawsuit in question concerns the IPO of eToys, back in 1999. The company sold 8.2 million shares, raising $164 million; Goldman’s 7% fee on that amount comes to $11.5 million. If Goldman had sold the shares at $37 rather than $20, it would have received an extra $10 million — and what bank would willingly leave $10 million on the table?

What Nocera has discovered, however, is that Goldman was not leaving $10 million on the table. Instead, it was making more than that — much more — in kickbacks from the clients to whom it allocated hot eToys stock.

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.

eToys opened at $78 per share, which meant that Goldman’s clients were sitting on a profit of $475 million the minute that the stock started trading on the open market. In most cases, the clients cashed out — which was smart, because eToys didn’t stay at those levels for long. But if Goldman got back 40% of those profits in trading commissions, then it made $190 million in commissions, compared to that $11.5 million in fees.

If Goldman had raised the IPO price to $37 per share, then yes its fee income would have gone up by $10 million, to $21.5 million. But — assuming the stock would still have opened at $78 — its clients’ opening-tick profits would have come down to $336 million, and Goldman’s 40% share of that would also have come down, to $135 million. Total income to Goldman? $156.5 million, rather than $201.5 million. If the IPO price were higher, Goldman’s total take would have gone down by about $45 million.

All of these numbers are hypothetical, of course, but the bigger point is simple: if Goldman manages to get kickbacks, in terms of extra commissions, of more than 7% of its clients’ profits, then it has a financial incentive to underprice the IPO. And Goldman’s clients were desperate to give it kickbacks: they didn’t just route their standard trading through Goldman, since that wouldn’t generate enough commissions. Instead, they bought and sold stocks on the same day, at the same price. Capstar Holding, for instance, bought 57,000 shares in Seagram Ltd at $50.13 per share on June 21, 1999 — and then sold them, on the same day, at the same price. Capstar made nothing on the trade, but Goldman made a commission of $5,700. Capstar’s Christopher Rule says that in May 1999, fully 70% of all of his trading activity “was done solely for the purpose of generating commissions”, so that he could continue to keep on getting IPO allocations.

Goldman, of course, revealed none of this to eToys. Instead, they pitched eToys with a presentation saying, on its first page, in big underlined type, “eToys’ Interests Will Always Come First“. On the page headlined “IPO Pricing Dynamics”, they explained that the IPO should be price 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.

If you look at the chart of what happened to the eToys share price in the first few months after the IPO, the price fluctuated around $40 a share — which means that by Goldman’s own standards, it really ought to have priced the IPO much closer to $37 than to $20. And this was no idiosyncratic mistake on Goldman’s part: Goldman’s other IPOs all fit the same pattern. For instance, look at the three deals run by Lawton Fitt, the Goldman executive in charge of the deal, before the eToys IPO. First was pcOrder, which went public at $21 and opened at $55.25. Then there was iVillage: that went public at $24, and opened at $95.88. Finally, there was Portal Software, which went public at 414 and opened at $36. When eToys went public at $20, Fitt knew exactly what was going to happen: indeed, she bet her colleagues that eToys stock would hit $80 on the opening day. She knew her market: it actually traded as high as $85.

Some big names jump out from the documents here — none more so than Bob Steel, who was then Goldman’s co-head of equity sales, and who went on to put out financial-crisis fires for Hank Paulson at Treasury before going on to become the CEO of Wachovia. Steel wrote a detailed email to Tim Ferguson, the chief investment strategist at Putnam Investments, saying that he would try to help Putnam out “with regard to IPO allocations”. At the same time, however, he added that “we should be rewarded with additional secondary business for offering access to capital markets product”. Which, in English, means that if Putnam got access to Goldman’s IPOs, it would have to steer more soft-dollar commissions to Goldman.

Meanwhile, if you didn’t toe the investment banks’ line, they would cut you. Toby Lenk was the CEO of eToys, and in a 2006 deposition he was asked whether he ever “voiced any displeasure” with Goldman about the fact that they left so much money on the table. He said no — and added “a little story” about why it was never a good idea to annoy a big investment bank. In 2000, Lenk explained, when eToys was desperate for money, it raised some cash through a convertible debt offering:

We initially selected Merrill Lynch to be our lead convertible debt underwriter, and Goldman Sachs came in and put a strong foot forward to take that away, and Merrill Lynch we kept as a secondary underwriter in the secondary position and kept them in the deal. They were in the deal, and I believe it was the morning of the deal going into the marketplace, or the night before, or right around that time, Merrill Lynch’s lead internet analyst, Henry Blodget, downgraded our stock as that was going into the marketplace, and made it extremely difficult for that placement to happen.

The investment banks have punitive power over us. We need them to raise capital. You don’t go complaining to investment banks because they will crush you, and that is a perfect example. We got penalized by Merrill Lynch. We got slapped hard, and it nearly sank that offering, and I can tell you that nearly sank the company.

This is just the flipside of pumping up companies in order to get investment banking business: if you lose that business, then you do the opposite, and downgrade the company just when doing so causes the most pain. As a result, as Lenk says, you didn’t cross the bankers — and you certainly didn’t cross Goldman.

All of which puts Goldman’s 7% fee into very interesting perspective. Goldman likely made much much more money on the eToys IPO from its buy-side clients than it did from eToys itself. Indeed, it could have offered to run the IPO for free, the IPO would still have been very lucrative for Goldman. But of course eToys would never have given Goldman the IPO mandate if Goldman had offered to run it for free — because then it would have been obvious where Goldman’s loyalties resided.

The real purpose of the 7% fee, it seems, was to make eToys think that it had hired Goldman and that Goldman was working for eToys — and also to tie eToys into a close relationship with Goldman. (Lenk, for instance, became a personal client of Goldman Sachs shortly after the IPO.) As Andrew Clavell once put it:

If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The 7% fee is a very large shiny object, which diverts everybody’s attention from where the real money is made — or at least did, back in 1999. Have things changed since then? Here’s Nocera:

The documents are old. Some will dismiss them as relics of another era. But I continue to believe that the mind-set created by the I.P.O. madness of the late 1990s never really went away. To this day, an I.P.O. with a big first-day jump is considered a success, even though the company is being short-shrifted. To this day, investors know that they are expected to find ways to reward the firms that allocate them hot I.P.O. shares. The only thing that is truly different today is that few on Wall Street are so foolish as to put such sentiments in an e-mail.

That’s the one point at which I’m willing to disagree with Nocera. Nothing ever changes much on Wall Street, including the degree of professional foolishness. 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. eToys’ creditors might ultimately win this case against Goldman, or they might not, or the two sides might settle. But whatever happens, the implications for sell-side equity capital markets desks will be minuscule. Because the amount of money they’re making right now will always dwarf any potential litigation risk 15 years down the road.

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24 comments so far

And to think that people mocked Google when they went with an auction for their IPO.

Posted by AngryInCali | Report as abusive

Felix -

tomorrow you should write an article about how, since ETYS went bust in short order, it was the BUYERS of stock, not the SELLERS, who got ripped off…

ps – ditto AngryInCali’s comment about GOOG – demands mentioning in any article about the IPO process

Posted by KidDynamite | Report as abusive

I’m a bit surprised that neither you nor Joe Nocera mentioned the most famous/infamous recent IPO: Facebook.

Of course that might have disrupted the narrative… Should IPO underwriters be trying to raise as much as possible for the issuing firms, or not? Goldman is being criticized for failing to do so with eToys and other dot-com era offerings, while Morgan Stanley was criticized largely for doing too well at this task with the Facebook IPO.

Maybe we should accept the fact that at best, underwriters can make a decent guess at first-day pricing and demand, but that nobody really knows what markets are going to say until they are given a chance to speak.

Posted by AlexR | Report as abusive

Here’s a quick chart to remind folks that the Street is in the momentum business: http://rp-pix.com/od

Posted by tombrakke | Report as abusive

The IPO racket run by investment banks described here was a central plot theme in my novel HIGH FINANCE. Clients traded solely to raise their commission profile to get IPO allocations in shares that were deliberately set to pop for an instant windfall. It was blatantly corrupt – and standard operating procedure. Read the book – at least you’ll be able to laugh at it all!

Posted by Eli_Lederman | Report as abusive

How the heck did Capstar Holding manage to lose 10% in commissions by simply buying and selling at the same price?

Posted by absinthe | Report as abusive

KD – surely you understand that Felix’s point is not about the absolute preciseness of the offering price estimate by the underwriters, but the clear and convincing evidence that the underwriter purposefully mislead their client about the underwriter’s best guess, knowing that their bread was better buttered by other clients.

I mean: “Part of their evidence for the calculated underpricing of eToys, according to the plaintiffs’ complaint, was that Lawton Fitt, the Goldman executive who headed the underwriting team and was thus best positioned to gauge the market demand, actually made a bet with several of her colleagues that the price would hit $80 at the opening.”

If the CEO of EToys was not told by Fitt about Fitt’s $80 target and knowingly decided to agree to a $20 offering price in spite of that (for whatever reasons), how can you defend that action? Is there no concept of duty that investments banks won’t abrogate for profit? Is there no concept of professionalism, at all?

I can’t wait to see Epicurean Dealmaker’s response. He’ll simultaneously and elegantly decry the problem, make noises about how it’s bad, explain why the i-banking structure encourages this behavior, then throw his hands up and say everyone should know better but buyer beware and read the fine print. The entire industry is sodden with sociopaths.

Posted by SteveHamlin | Report as abusive


http://dealbreaker.com/2013/03/bankrupt- 1990s-internet-toy-company-still-thinks- it-was-undervalued/

aside: Felix, I’d love for you to get Henry’s take on the accusation that he sabotaged the converts offering…

Posted by KidDynamite | Report as abusive

I don’t 100% agree with all Felix’ claims about the general structure of IPOs, or that the intrinsic conflicts of interest are nefarious (rather than being a good market solution to what would otherwise develop into a serious market-for-lemons problem). But anyone trying to defend late 1990s practices in tech IPO allocations is crazy.

Posted by dsquared | Report as abusive


Matt Levine writes: “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”

So, pointing me to Levine is you saying you agree with me?

Levin wrote “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 was the trade that eToys made: it let investors have an IPO pop, and in exchange they let eToys have an IPO….Now perhaps “totally transparent” overstates it a bit.”

Or perhaps quite a bit, when the gal I hired to advise me on selling sandbags me so that she looks good to future buy-side clients. I feel much better knowing I was sacrificed on the alter of the efficient IPO markets.

Can, should – they’re the same thing, right? Trust is clearly for suckers.

Posted by SteveHamlin | Report as abusive

yes, I thought that was an odd post by Matt – “Let’s stipulate that [the entire prosecution case!] – other than that, nothing too bad”. The problem here is that we in the industry are trying to defend a practice that looks on the face of it rather shonky but is actually probably defensible as a least-worst solution as long as everyone acts with good faith and integrity, in the context of a world in which everyone (and tbh can you blame them) is not really in a mood to accept our word for it on the whole “good faith and integrity” thing.

Posted by dsquared | Report as abusive


the key sentence from Levine is this one, that sums up the entire situation:

“That was the trade that eToys made: it let investors have an IPO pop, and in exchange they let eToys have an IPO”

if you want, you can add the few sentences before that:

“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. “]

You seem to be missing the point that that’s WHY investors bought these dogsh1t deals time after time – BECAUSE they could make money on them.

to me, the ONLY part of this story worth discussing at all is the optically terrible part about Fitt’s $80 bet. that *looks* bad, but still doesn’t make me want to grab a pitchfork and march in the street. I did open the link to the docs, but didn’t read far enough to find the actual quote about Fitt’s bet – if you have it, please do point me to it. The rest of what I found in (my albeit brief perusal of) the doc link was a big pile of non-surprises, non-red-flags, and standard capital markets conversations. The fact that hot IPOs go to the best clients is a surprise to exactly NO ONE who has ever worked in the business.

by the way – i have in the past been a client of GS… my group couldn’t participate in IPOs, but we could do secondaries;. We found that the only deals we got allocations on were the crappy ones: the ones that were going to trade terribly. So, sensibly, we stopped participating to avoid the adverse selection.

Posted by KidDynamite | Report as abusive

Just noting a typo: “Finally, there was Portal Software, which went public at 414 and opened at $36.” You forgot to hit the shift key to get “$14″.

Posted by Auros | Report as abusive

“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.”

As Michael Kinsley said: The scandal is what’s legal.

We really need a strong, principles-based regulator in the market, who can say, “I know a betrayal of fiduciary duty when I see it,” and throw a bunch of these people in jail, or at least take away all their licenses and ban them from the markets forever.

Posted by Auros | Report as abusive

KD – You confuse investor with fence. *investors* didn’t buy these dogsh1t deals time after time because they made crazy first-day money. Other, better trading clients of i-banks were GIVEN these fantastically underpriced and profit-assured deals under the agreement that they kick back 50% of their 4-hour, risk-free trading gains as vig to the bookrunner, who was the one who underpriced to begin with, and allocated to those who would kick back the most. Time after time.

[The investors were the capital providers who ultimately financed this IPO (the buyers of the flips on the secondary; those who held on day 30). In this instance, I'm not sure I care about them one way or another, absent prospectus fraud.]

You can spin that set of facts anyway you want, but it looks and smells corrupt, where the party with the least information and who is paying for the malintended advice is being intentionally duped by their advisor, who has the most information and who actually has opinions they are withholding from their client. Fraud is the intentional misrepresentation for profit. It might not be clearly illegal here, but it is still fraud. I understand that you don’t see the wrongness, but I don’t understand why you don’t.

If your contention is that this institutionalized graft is required for the smooth functioning of the markets, and that it is unfortunate but necessary that certain issuers get screwed so that others may live, then just say so.

As to your point that eToys knew it was leaving boatloads of money on the table, I’ll quote a comment to the DealBreaker article: “an IPO should be underpriced by 15-20%, not [3]00%. kind of a big difference.”

I’m sure the eToys CEO would have been to happy to play the game at a 20% discount to some GS-perceived sustainable trading price. Do you think he would have jumped at the chance had he known what his paid-for adviser ACTUALLY thought?

“The fact that hot IPOs go to the best clients is a surprise to exactly NO ONE who has ever worked in the business.”

The fact the i-bankers don’t seem to see the inherent problem with this set of facts is a surprise to exactly NO ONE who has observed the business.

(no particular offense meant; I do enjoy your contributions to the econoblogosphere)

Posted by SteveHamlin | Report as abusive

Steve –

no offense taken. I am, however, quite confident that Nocera could have (and probably has) written posts about how GS (or others) OVERPRICED these tech IPOs that never should have been brought to market in the first place. And that’s really my point: ETYS was a joke of a company. I happen to remember this, because it was my first big profit on the short side of a trade – I owned puts on it. You should talk to Herb Greenberg about it – he was the axe in identifying the craptasticness.

So I find it incredibly ironic that mainstream authors make a career out of writing “Goldman (or insert other bank) ripped off the buyers of XYZ” articles (see: the entire ABACUS story, the Facebook IPO, etc)… and when that angle slows down, they just reverse it and now claim that it’s the sellers who are being ripped off.

l.o. effin’ l.

still, though, I think the most interesting story here is the accusation that Henry Blodgett sabotaged the converts deal because his bank got pushed to second billing. Felix has pretty good contacts, and Henry is pretty accessible, so i’d LOVE to hear Henry’s comment on that allegation…

finally, I return to GOOGLE – because if you don’t like the IPO process, you can try to do it yourself like they did. But again, as Levine noted, there’s a reason Ibanks still do the underwriting, and they haven’t been replaced by DutchAuctionIPOs.com….

Posted by KidDynamite | Report as abusive

Felix – how do you think this played out with/contributed to/impacted the Facebook IPO?

Posted by DonaCollins | Report as abusive

@Steve – Felix’s implication that major decisions about eToys’ IPO were made by the company’s CEO is extremely misleading. The CEO may have been a capital markets neophyte, but here are eToys’ 5 largest pre-IPO shareholders from its S-1/A – idealab, Highland Capital Partners, Sequoia Ventures, DynaFund Ventures, and Intel. Those 5 firms cumulatively owned 58% of eToys prior to its IPO. The CEO owned 8%. It’s very clear who was making the decisions about underwriter selections and IPO’s, and it wasn’t the CEO. It was 5 sizable, sophisticated VC firms – I assume that Intel’s investment was through its VC arm, Intel Capital – who were all repeat players in the IPO market at that time.

So why were the VC’s OK with underpricing the IPO? Remember at the time that huge first-day pops were seen as a branding exercise, especially for consumer-focused retailers. Also remember that the first-day pop was itself managed and somewhat artificial, because the offering size was small. (For eToys, the post-IPO float was only 8.3 million shares out of 101.8 million total.)

So what you had was a series of people selling these shares relying on greater fool investing – company to IPO purchasers, IPO purchasers to other public shareholders, those shareholders on down the line to other shareholders. The VC’s were hoping it would last long enough that lock-ups would expire and they could get out.

To put some numbers to just how crazy this valuation was – eToys opened at a $7.9 billion market cap ($78 times 101.8 million shares outstanding). In the twelve months prior to close, it generated $30 million of revenue and net loss of $28.6 million. (Pro forma for a merger with a competitor, revenue was $34.7 million, and the net loss was $73.1 million.) And Nocera and Felix are saying that piece of dog crap was obviously undervalued at $20 per share?

I’m not saying Goldman’s behavior is good, just that we have a whole series of unsympathetic parties trying to leave someone else holding the bag when the bubble inevitably burst.

Posted by realist50 | Report as abusive

The difference between bankers and street thugs is that street thugs have a sense of right and wrong. (Also, the money isn’t as good.)

Posted by Kaleberg | Report as abusive

I certainly have a hard figuring out why auction sales like GOOG shouldn’t/won’t work. In a perfect world, everybody can see the offering documents on the SEC’s website and decide they have a value. Then the issuer can sell off the new stock down through the bid list like any other seller.

There are only two understandable reasons for companies paying that 7%, vs. DutchAuctionIPOs.com or whatever:

1. The underwriters know people who will buy the stock to pump it up to sell to other people who will buy and pump it up to sell to other people until it finally finds a buy-and-hold investor (if it ever does, in the case of 90′s dot-com investors).

2. Owners desire the first-day pop, which may increase publicity for the stock. Warren Buffett once said that if Company A buys Company B with A’s stock, the headlines should really read “Company A sells off part of itself to buy Company B.” Similarly, the IPO pop cannot conceivably actually add intrinsic value to a business. It only really serves to maybe keep the stock’s value high, and ideally high for at least six months. That’s not when the firm would issue more stock, but instead when the owners can sell out.

There’s a lot of “Efficient Market” things violated for how and why we still use underwriters. For one thing, even if the owners were selling out in six months, they would want to use the cheapest IPO possible because the IPO price would otherwise be cash available to the firm. That means a higher intrinsic value, which means a higher stock price after lock-out IF the market truly reflects underlying value.

On another note, saying there are many more lawsuits from investors is a red herring. There are many more laws protecting buyers instead of sellers, but the investors really have themselves to blame. The fact that the Facebook IPO sparked lawsuits despite being the most publicized IPO since Google says everything about those investor’s culpability. Even if GS could get off on some technicality in the eToys case, it’s far more reprehensible to go behind the client’s back and get money from hurting the client directly compared to nearly any buyer grievance.

Posted by mwwaters | Report as abusive

Another note for those focusing on the “eToys was crap at $20 anyway” angle. eToys just happened to have the lawsuit to show what was surely endemic Wall Street behavior.

For some context to a “real” company, Amazon’s IPO price was $18 and popped up to $30 before settling to $23. A near-100% pop was better than most, but still left a good bit of money on the table. The 7% would also have cost Amazon $1.26, and so their real money raised was around $16-17.

Posted by mwwaters | Report as abusive

It’s sad that so many business leaders in the non-financial sector refuse to do much as their cousin executives in the financial sector make so much by basically creating distortions and economic rents at the expense of others, including non-finacial sector executives!

Posted by EconMav | Report as abusive

Just stay tuned for the federal Big Bang criminal charges to come in the eToys case!

Posted by laserhaas | Report as abusive


interesting analysis. Could you elaborate a little on how you got to the 40% on trading commissions?


Posted by rutgerg | Report as abusive
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