Felix Salmon

Every time there’s a high-profile IPO, a few clever journalists will wheel out their contrarian take. LinkedIn had a huge pop? Then it’s a failed IPO, and Morgan Stanley “screwed the company and its shareholders to the tune of an astounding $175 million”. Facebook fell off a cliff? Then it’s a great success for the company, because it means it got the best price it possibly could. Matt Yglesias has a typical such post up, saying that “Mark Zuckerberg Made out Nicely in the Facebook IPO”. He explains that “for people making the initial sales an anti-pop is ideal. It means no money was left on the table. Or, rather, it means that negative money was left on the table”.

Except, at least in the case of Mark Zuckerberg, that simply isn’t true. When Facebook went public, Zuckerberg exercised all of his options, and converted them into extremely valuable stock. That stock was valued at $38 per share, and he has to pay income tax on the gain; his tax bill is likely to be north of $1 billion. The only stock that Zuckerberg sold was the stock he needed to sell, to pay his tax bill. The rest of his wealth is tied up in Facebook stock. So the degree to which he “made out nicely” is pretty much directly proportional to the secondary-market share price, and not the IPO price.

Of course, Zuckerberg owns a substantial chunk of Facebook, and Facebook is now sitting on a substantial chunk of cash. Facebook itself raised $15.8 $6.76 billion in its IPO, and Zuckerberg owns 26.6% of Facebook. So in that sense Zuckerberg has a direct claim on $4.2 $1.8 billion which is currently sitting in Facebook’s bank account; if Facebook had raised less money, then that number would be lower. But it’s not like Facebook’s going to declare a dividend any time soon: there’s basically no realistic way for Zuckerberg to get his hands on that cash.

Here’s the main reason why Zuckerberg wanted an opening-day IPO pop of at least modest proportions: the last thing he wants or needs is an adversarial relationship with his shareholders. Zuckerberg got to where he is today with the help of extremely supportive shareholders, who were happy to give him as much money as he wanted to build his company and take it to where it is today, without second-guessing any of his decisions. Facebook’s users might not always have been happy with Zuckerberg’s decisions, but he never had any tension with his non-executive shareholders.

Now, however, as the CEO of a public company, Zuckerberg has a fiduciary responsibility to his shareholders, and you can be quite sure that his shareholders are going to get very noisy and upset if he doesn’t give them what they want. Yes, Zuckerberg has an astonishing degree of control over Facebook, and so in theory he can simply ignore what they’re saying. In practice, however, that’s very hard — especially if they’re voting with their feet and sending his stock price plunging.

There are certainly CEOs out there who maintain personal control over public companies in the face of disquiet and unhappiness from external shareholders: Jimmy Dolan, of Cablevision, is a prime example. But Mark Zuckerberg does not want to be Jimmy Dolan. And what he certainly doesn’t want is to send a message to the public markets that he thinks his shareholders are muppets.

Early investors in Facebook, including Goldman Sachs, cashed out to the tune of billions of dollars on Friday; those investors, who will continue to sell their shareholdings once the various lock-up periods expire, are the ones that Zuckerberg gets on well with, partly because he has made them enormous sums of money. As his VC backers rack up their necessary exits, Zuckerberg is going to find himself surrounded by an increasing number of public shareholders, and being asked increasingly pointed questions by stock-market analysts. He can try to take the imperial approach, and ignore all such distractions while he runs his company as a personal fief; indeed, the message sent by Facebook’s dual-class share structure is that he very much wants to be able to do just that.

Zuckerberg is human, however, and he’s had a charmed life so far: he was named, for instance, Time’s Person of the Year in 2010. From here on in, by contrast, Zuckerberg is going to be judged by Facebook’s share price: a minute-to-minute plebiscite on how he’s doing. What’s more, the really important thing about the share price is not the price itself, but rather its direction: if it’s going up then Zuckerberg is a hero, and if it’s going down then Zuckerberg is a goat. This is one of the main reasons why being the CEO of a public company sucks — and the higher your profile, and the more you’re personally associated with your company, the more it sucks.

In a hyper-rational world, it would be better to be Mark Zuckerberg after Facebook has fallen from $42 to $32 than it would to be Mark Zuckerberg after Facebook had risen from $21 to $29. But this is not a hyper-rational world. And it’s increasingly looking that if Facebook was always going to have to go public anyway, it would have been better for the company and for Zuckerberg personally if it had gone public much earlier, at a much lower share price, issuing many fewer shares. That way, the general public, rather than just select insiders, could have had some small part in the big run-up — and there would have been no opportunity for Facebook, its bankers, and the Nasdaq stock exchange to mess this IPO up so badly.

So in a way it makes sense that Zuckerberg decided to get married at the same time Facebook went public. The latter means that his life as a public-company CEO is going to be reasonably unpleasant for the foreseeable future. Maybe he hopes to counterbalance that with a bit more stability at home.

It’s going to be a long time before the various lawsuits shake themselves out, but one thing’s already clear with respect to the Facebook IPO: absolutely no one has come out of it looking good. It’s worth going down the List of Incompetence here, because regardless of whether any of this was illegal, there are a lot of extremely well-compensated people who, to use a technical term, screwed the pooch on this one.

Top of that list, frankly, is Facebook CFO David Ebersman. The WSJ’s account of his central role in the offering is reasonably definitive: a lot of decisions normally outsourced to banks in the markets were made, in this case, by a tech-company executive in Menlo Park.

Ebersman didn’t make one big mistake, he made three. Firstly, as CFO, it was his job to accurately forecast Facebook’s second-quarter figures, and give the company’s banks a good feel for where they would come in. He failed so badly that he was forced to re-file the IPO prospectus just days before the deal came to market, and to whisper in his bankers’ ears that they should probably cut their forecasts for the company’s revenues.

There’s no excuse for getting that wrong, but if there was an excuse, it would be that Ebersman was too focused on the year-long process of managing an awesome IPO. Ha! He screwed that up, too, of course — not least by upsizing the deal at the last minute, raising the number of shares being sold by 25%. In hindsight, that was a very bad idea. But then, after that, he made his third major mistake: he priced the deal for perfection, at $38 per share, even as big institutional investors — the only ones who knew about the new revenue forecasts — were saying that they had no real desire to own the stock at more than $32 per share. When you’re selling $16 billion of stock, the marginal price-setters are always going to be institutions, rather than price-insensitive retail investors willing to buy Facebook on name recognition alone. And those institutions were never really willing to provide a strong bid above $38.

While most of the blame at Facebook’s end should properly be shouldered by Ebersman, that doesn’t mean Mark Zuckerberg can be let off the hook entirely. It’s his company: the buck stops with him. And he did the IPO no favors at all. First, he insisted on an unprecedented level of individual control over a $100 billion public company; institutional investors never like that. And secondly, he clearly viewed Wall Street and its investors with thinly-disguised contempt, slouching into IPO meetings — when he bothered to turn up at all — in his hoodie, and signally failing to provide the outward-facing leadership that investors crave. Zuckerberg’s refusal to play the Wall Street game is admirable, in some respects — but at the same time is completely inconsistent with a desire to sell $16 billion of shares at a $104 billion valuation.

The third member of Facebook’s leadership team who deserves some blame here is Sheryl Sandberg, the COO, and the person whose job it is to help Zuckerberg navigate the external world. Sandberg also conveniently recused herself from many IPO decisions, which doesn’t seem like a very good idea in retrospect. Either she had too much faith in Ebersman and Zuckerberg to do the right things, and should have been much more involved — or else she was deeply involved, behind the scenes, and therefore responsible for some significant part of the resulting fiasco.

Facebook’s board members and investors look very bad here, too, coming off much more short-term greedy than long-term greedy. Many of them cashed out in the IPO, in a clear sign that they had little faith in the share price going forwards. The board’s job has historically been to rubber-stamp Zuckerberg’s decisions, and to provide him with advice as and when he asks for it. Now, however, the board has a fiduciary responsibility towards all of Facebook’s investors, including the ones who bought in at $45 per share. But there’s no sign that anybody on the board saw the new investors in Facebook as anything more than muppets.

On the Wall Street side of things, the shame list is topped, indubitably, by Morgan Stanley’s technology banker Michael Grimes. He worked hand-in-glove with Ebersman, and all of Ebersman’s decisions can be considered Grimes’s decisions as well. More generally, it was Morgan Stanley’s job to understand exactly what the real demand was for Facebook shares — to sound out investors and price the company just a little bit below what the market was willing to pay. And there’s no doubt that Morgan Stanley failed miserably in that job.

And then there’s the whole scandal of the buried revenue forecasts: the way that Morgan Stanley whispered the new numbers in select clients’ ears, without ever letting the broader investing public know about the downgrade. If you want to develop a reputation as an untrustworthy bank which plays favorites and leaves the little guy out to dry, you could hardly do so in a more effective manner.

The other banks in the deal — JP Morgan, Goldman Sachs, and the rest — don’t deserve quite as much blame as Morgan Stanley, but their actions were more or less identical — they all downgraded their forecasts in secret, and they all went along with the size and pricing of the deal, in return for multi-million-dollar fees. If you bought your Facebook IPO stock from Goldman, you’re going — rightly — to blame Goldman first and foremost if they didn’t tell you about their downgraded forecast. And more generally this deal goes to prove that Wall Street acts very much like a cartel: all the banks behaved in an identical manner, and not one was willing to make a fuss or walk away from a bad deal. They all got stars and dollar signs in their eyes, and behaved like fools as a result.

Then, of course, there’s the Nasdaq. Read Nick Carlson’s interview with an anonymous hedge-fund manager for some of the gorier details here, but in general anything that Nasdaq could mess up, it did mess up. In short: the stock never opened at 11am, as planned, because Nasdaq’s computers weren’t up to snuff. There was a five-minute delay, and then there was a second, 25-minute delay, during which time Nasdaq switched over to a second computer system.

The whole thing turned into a complete disaster. The second computer system didn’t work as planned, and there was an enormous amount of confusion — which still hasn’t been cleared up, in some cases — about where and whether various investors actually managed to sell their stock. As a rule, if you placed an order between 11:05 and 11:30 on Friday, you’re probably in a world of pain today, and you might be relying on the Nasdaq to make you whole for your losses: while you thought you were selling at $42, you might not actually have been able to sell until the shares were at $38 or even less. It seems that the opening price of $42.05 was based only on orders received before 11:05, and ignored all orders after that time, most of which were at much lower levels. Which helps to explain the initial and chaotic plunge in the stock price.

Naturally, when a stock is behaving like that, it takes a very brave investor indeed to dive in and go long at a frothy valuation. And so it’s entirely reasonable to blame the Nasdaq for the failure of the Facebook IPO. It’s their job to get this kind of thing right; instead, they got it spectacularly wrong. End of story.

Finally, there are all the investors, including that anonymous hedge-fund manager, who bought into the IPO even though they knew that the valuation was incredibly high, and are now casting around for someone else to blame for their losses. It’s impossible to feel any sympathy for these people — especially institutions who had no appetite for stock at more than $32 per share, but put in large orders at $38 anyway just because they were counting on Morgan Stanley to give them a nice opening-day pop. If you pay 100X earnings for a hyped internet stock on its first day of trading and then you lose money, you frankly had it coming.

All of which means that the winners in this whole game were you and I: the quiet skeptical masses who simply sat back and watched the farce unfold. In the game of Facebook IPO, it turns out, the only winning move was not to play.

Yesterday, it was the greenshoe — the standard feature of IPOs which also happens to be an officially-mandated case of naked short-selling. Today, it’s another odd special case: the way in which analysts’ estimates of companies’ future earnings are deliberately not made public prior to the IPO — except to select investment-banking clients who are likely to put in large orders for IPO stock.

As Henry Blodget says, this whole episode stinks. It’s almost certainly not illegal. But if you look at the Finra rules about such things, it definitely violates the spirit of the law. For instance, the rules say that Morgan Stanley analysts weren’t allowed to show Facebook their research before it was published — but they don’t say that Facebook can’t quietly whisper in Morgan Stanley’s ear that its estimates might be a bit aggressive. Obviously, there’s no need for the analysts to give Facebook advance notice of their earnings downgrade if that earnings downgrade was a direct consequence of something Facebook told them.

Similarly, Morgan Stanley isn’t allowed to publish a research report or earnings estimates for Facebook within the 40 days following the IPO. But a few days before the IPO? I guess that’s OK — even if the way the estimates were “published” meant they were only available to good friends of the bank.

More generally, the rules ignore the key point here. Retail investors, and the market as a whole, knew when Facebook had its IPO that Morgan Stanley (and JP Morgan, and Goldman Sachs) had research teams with estimates for Facebook’s future earnings. They also knew that those estimates would be made public in 40 days’ time. And if they were sophisticated enough, they probably knew that select Morgan Stanley clients were given access to the analysts and their estimates.

What they didn’t know — what they couldn’t know, because nobody told them — was that those estimates had been cut, significantly, just days before the IPO.

It’s true that retail investors weren’t buying Facebook stock on the strength of the banks earnings estimates, since they didn’t (and still don’t) know what those earnings estimates are. But here’s a material nonpublic fact about Facebook, which retail investors and everybody else in the deal deserved to know: all three underwriters cut their estimates simultaneously, in response to some very minor changes in the revised IPO prospectus.

Here’s Blodget:

Speaking as a former analyst, it seems highly unlikely to me that the vague language in the final IPO amendment would prompt all three underwriter analysts to immediately cut estimates without some sort of nod and wink from someone who knew how Facebook’s second quarter was progressing.

Hot internet stocks like Facebook are all about momentum and growth. Investors expect companies like this to surprise on the upside, occasionally; they get extremely upset, by contrast, when they surprise on the downside. Especially when such surprises come in the immediate run-up to the biggest tech IPO in the history of the world.

Why is Groupon trading 40% below its IPO price? Because people were happy to buy into ramshackle governance and accounting conventions so long as all the lines were going sharply up and to the right. But when you’re trading at massive multiples, any hint of a slowdown in growth, or of failing to meet pretty aggressive targets, is a key sell signal. These companies aren’t supported by fundamentals: they’re only supported by a general atmosphere of aggressive growth expectations and zealous bullishness. When three banks all cut their earnings estimates for Facebook on the same day, that sure ain’t bullish.

This does not mean, of course, that Facebook stock is doomed for all eternity: it could pull an Amazon, and rise sharply out of its post-IPO slump. But this does mean that shareholders should not expect much in the way of transparency or full honesty from a company which is controlled by Mark Zuckerberg personally and which has deliberately created a dual-class share structure in order to to ensure that they can be completely ignored on all decisions. Facebook was whispering in the ears of the lead managers of its investment banks, on the understanding that the results of those whispers would remain available only to select clients until after the IPO was over. That’s not cool. And as a result the company definitely deserves the latest lurch downwards in its (still frothy) share price.

Matt Levine had a very wonky post on Friday afternoon about the dynamics of the Facebook IPO in general and of the very misunderstood greenshoe option in particular. Now that we’ve all had a nice relaxing weekend, it’s maybe worth revisiting that greenshoe, because it’s actually possible, given Facebook’s tumbling share price today, that Morgan Stanley will make a substantial amount of money on it.

First, it’s worth explaining how the greenshoe option is meant to work. In the IPO, the underwriting banks — there were lots of them, but let’s just call them all “Morgan Stanley”, for simplicity’s sake — sold 484 million shares of Facebook at $38 each. At the same time, they bought 421 million shares of Facebook from the company and its investors, at $37.582 each. The underwriter’s fee of 1.1% is the difference between those two numbers: if you buy at $37.582 and sell at $38, then you end up creaming off 1.1% of the total amount raised.

You’ll note that Morgan Stanley sold more shares than it bought. That’s the greenshoe. When you sell more shares than you buy, you’re short that stock, so when a bank exercises its greenshoe option, as Morgan Stanley did in this case, it is going short the stock in question.

Why would a company like Facebook want its banks to be short its own stock? Partly because when there’s a big short in the market, that provides upward pressure on the share price. Shorts need to cover their short position — which means they need to buy stock. But more generally, the greenshoe is a way to provide the market with a nice extra slug of shares, which everybody wants if the stock trades substantially higher than its IPO price.

The greenshoe does, however, raise certain existential questions — not least, how can 484 million shares be sold, if only 421 million shares have been issued? Do those extra 63 million shares exist?

It’s a good question, and the answer is that they’re in a kind of quantum limbo, a bit like Schrödinger’s cat. In one possible world the shares trade happily on the open market, in which case Morgan Stanley will exercise its option, and force Facebook and its investors* to cough up the last 63 million shares; at that point, they certainly do exist. In another possible world, Morgan Stanley ends up buying back those 63 million shares on the open market, thereby reducing the number of shares actually trading to the original 421 million. In that world, the 63 million shares never had much of an existence: they were sold by Morgan Stanley and then bought back by Morgan Stanley, and all that’s left at the end of the day is nothing.

Given where Facebook is trading right now, you can be sure that Morgan Stanley will not exercise its option, Facebook and its investors will not issue those extra 63 million shares, and that in a few days’ time, the free float of Facebook shares will be 421 million, not 484 million.

Which in turn means that over the course of the first two or three trading sessions, Morgan Stanley will have ended up buying 63 million shares of Facebook on the open market. It sold those shares at $38, remember. So its total profit on the greenshoe operation will be zero if it bought all 63 million shares at $38 exactly. If it bought some of the shares above $38, then it could end up making a loss. And if it ends up buying a slug of shares below $38, then it’ll end up making a profit. That’s what happens, when you go short at $38 and then buy back at, say, $34.

This is a very big trade: 63 million shares at $38 each comes to $2.4 billion. On the other hand, there’s very little doubt that Morgan Stanley was doing a lot of buying on Friday. 43 million shares were bought at $38.00 exactly, and another 28.5 million shares were bought at $38.01. It’s reasonable to assume that most if not all of that buying came from Morgan Stanley, supporting the share price.

So the chances are that at the end of the day, Morgan Stanley is going to end up pretty flat on its trade, selling the shares at $38 and then buying them back at $38. But if it bought more than 63 million shares on Friday, then it is sitting on a substantial mark-to-market loss right now. And similarly, if it bought back fewer than 63 million shares on Friday, then it’s actually making a profit on its greenshoe short.

Chances are, no one outside the company will ever know for sure what Morgan Stanley’s P&L on the Facebook IPO ends up looking like. But it would make sense, if Morgan Stanley saw a lot of selling pressure on Friday, for the bank to keep onto at least a little bit of its short position into Monday morning. At which point it could make a tidy profit on that plunging share price.

*In this case, it’s actually just the investors: Facebook wasn’t participating in the greenshoe scheme. But it could have, if it had wanted to.

Update: Levine has a great response. A taster:

The greenshoe is a non-zero-sum way of adding value with optimal risk-shifting: it takes some uncertainty about aftermarket performance from skittish investors and gives it, in the form of uncertainty about deal size, to an issuer who is probably better able to bear it (because selling 15% more shares at the price you agreed on three days ago is rarely a tragedy). The structure of the greenshoe, though, adds an additional conflict, in that banks can hoard the value of the greenshoe for themselves rather than spending it on their investor clients. The fact that they basically don’t do that suggests that motive and opportunity aren’t everything: sometimes banks just do the right thing for capital allocation and risk shifting, even when they could make more money doing the wrong thing.

567 million shares of Facebook changed hands today — that’s more than the total number of shares issued — at a volume-weighted average price of just over $40 per share. To put it another way, the whopping move from the IPO price of $38.00 to the closing price of $38.23 came with more than $22 billion of trading activity, and undoubtedly left the underwriting banks with rather more Facebook stock on their books than they had been hoping for. But that’s what it means to be an underwriter.

For anybody disappointed that they didn’t get their full initial allocation of stock, or who thinks that small retail investors can’t buy into IPOs at the same price that large institutional investors can, this is great news: Monday’s going to be a do-over, with everybody being able to buy Facebook stock at the IPO price.

This of course helps to point up just how silly all the Facebook IPO hype really was. Yes, Facebook is now a public company, but it’s still controlled by Mark Zuckerberg, and the IPO itself was a bit of a farce: delayed at the open, artificially supported by the underwriters at the close, and mainly serving to demonstrate that a brand-new company, which no one knows how to value, trading at a stratospheric valuation, can still somehow end up trading within an incredibly narrow range on enormous daily volume.

For that, you can probably thank the surprisingly old-fashioned book-building process, where a team of investment bankers took Facebook on a classic roadshow, complete with a slick and rather embarrassing video, all for a record-low fee of 1.1% of the proceeds. Still, never mind the low fee: the bankers were paid to do a job, and they did it, providing a rock-solid bid at exactly $38 per share and thereby sending a clear signal to any potential future client: we’re never going to let investors lose money on the first day. Frankly, there are worse ways of spending money to try to bolster your reputation.

But while this was an incredibly important deal for people working in equity capital markets, it really wasn’t important for the rest of us. Facebook today is the same as Facebook yesterday: a site where we keep in touch with our friends, and a means of staking out a bit of personal identity on the internet. If you think that’s a hugely valuable proposition, then there are hundreds of millions of shares available, now, for you to buy on the open market. And I’m quite sure that there’s no shortage of big investment banks who would be positively delighted to sell them to you. Ideally, for them, at a price somewhere north of $38.

Update: Everything I had here originally is wrong! SecondMarket has just updated its infographic, changing “average transaction size” to “average amount sold”. It seems that the average seller sold to 4.9 buyers, which means that the average transaction size was not 454,565 shares, as SecondMarket originally said, but rather 93,186 shares. And so most of the SecondMarket numbers here need to be divided by 4.9. Here goes:

SecondMarket has published a glossy 8-page horizontal-scrolling infographic, all about the history of Facebook on its platform; they also sent me an accompanying spreadsheet, with the data in slightly more tractable form. We now know that there were 689 transactions in all, at an average transaction size of 454,565 93,186 shares — which means that since April 2008, SecondMarket has traded a total of 313,195,285 64,205,154 shares of Facebook, adjusted for splits.

Those shares weren’t always worth as much as they are today. But if we make a few assumptions, we can start getting a first-order approximation for the amount of money that SecondMarket has made off Facebook over the past few years. And it turns out to be significantly larger than the amount of money Facebook is paying its banks to go public.

We know how many transactions there were in each quarter from the second quarter of 2008 onwards, and we also know what the share price was in each month that Facebook shares traded. (In April 2009, it was as low as $1.11 per share.) If we assume that the average transaction size has been roughly constant in number-of-shares terms, and take the average of the three months in each quarter as the average price paid in that quarter, then the total volume of Facebook shares traded on SecondMarket comes to $8.5 $1.75 billion.

SecondMarket is cagey about how much it charges in commission on Facebook trades, but in general for secondary-market operations it charges between 3% and 5% of the total transaction amount. Let’s be conservative and say that for Facebook, SecondMarket charged 3%. Then it seems SecondMarket’s total commission on Facebook trades, from April 2008 to date, will have come to roughly 3% of $8.5 $1.75 billion, or somewhere on the order of $250 $50 million.

That helps to put the $200 million valuation for SecondMarket into perspective: there’s a decent chance that SecondMarket is actually worth less than its total income from Facebook trading alone.

And it also puts into perspective the $177 million being shared between JP Morgan, Morgan Stanley, Goldman Sachs, and a smattering of other banks — they’re being paid 1.1% of the money that Facebook is raising today. This is the difference between public, transparent markets and private, over-the-counter markets: the latter are much more lucrative for brokers than the former are. Which is why investment banks don’t want derivatives moved to exchanges. And why SecondMarket is moving desperately into weird asset classes like wine, to make up for the fact that it’s not going to be trading Facebook shares any more.

At the end of Seth Stevenson’s glowing profile of Patagonia founder Yvon Chouinard, he mentions the way that Chouinard recently converted his company to a B-corp:

Registering as a “benefit corporation” lets a firm declare—in its articles of incorporation—that the fiduciary duty of its executives includes “consideration of the interests of workers, community and the environment,” and not just the bottom line.

Chouinard marched into state offices on the morning of January 3, 2012, to make Patagonia the very first company to register as a benefit corporation in California. It remains the most prominent company nationwide to have registered thus far. For Chouinard, the value of this is less about the present than the future. He can do whatever he wants at Patagonia right now, with no threat of shareholders revolting if he sacrifices a bit of profit in the name of menschy communitarianism. He owns the place in full, for as long as he’s alive. But he’s cagey about succession, and it’s clear what he fears: He never wants Patagonia to go public, or to lever itself up in search of rapid growth, as it mistakenly did before. He’s convinced that becoming a benefit corporation will help prevent that from ever happening.

I spent a bit of time researching B-corps when I was writing my Wired story on the problem with IPOs, and I think that B-corps are actually much more interesting than Stevenson is giving them credit for. The whole point of a B-corp, as I see it, is that you can go public, or lever yourself up in search of rapid growth, or give your employees lucrative stock options — you can generally behave just like all those money-chomping red-blooded capitalists, while also giving yourself a lot of freedom to do things like save the planet and ignore pesky shareholders agitating for explosive and infinite growth.

B-corps—Maryland was the first to charter them in 2010—can still have public shareholders, dividends, stock offerings, and all the other tools in the modern financial arsenal. But unlike other public companies, whose sole legal duty is to maximize profits for shareholders, executives at B-corps are also required to consider nonfinancial interests when they make decisions. Indeed, the company has to create a material positive impact on society and the environment.

That has the potential to rewire one of the most dangerous things about being a public company today: the requirement to keep growing, no matter what. B-corps can and will be listed on stock exchanges, just like any other public company. And there is no reason that they shouldn’t perform like normal shares. But investors and employees can take pride in the fact that their company is not just concerned with short-term financial gain. Best of all, the pressure to grow at all costs dissipates, and it becomes a lot harder for angry or litigious shareholders to agitate for changes just because they’re unhappy about the stock price.

There will undoubtedly be a discount applied to any B-corp looking to go public — its valuation won’t be as high as if it were a conventional company. But once it has gone public, there’s no reason its share price shouldn’t grow just as fast as any other company. If the discount stays constant, then the return to shareholders is exactly the same as it would have been at a full valuation. And if the “menschy communitarianism” of the company, in Stevenson’s words, actually ends up helping the company’s bottom line, then the discount might well shrink, thereby boosting total shareholder returns.

If Chouinard “never wants Patagonia to go public”, then, registering as a B-corp is not going to help him. But I suspect the idea here is that by registering as a B-corp, Chouinard is creating a company which can go public without losing its soul. And, without resorting to non-voting share classes and the like.

You think markets are efficient? Check this out: Barnes & Noble stock opened 2012 at $14.75 per share and falling fast; by January 5, the opening price was just $9.50. At that price, the entire company was worth just $550 million, and there was a very real fear that the entire company could go to zero, following in the footsteps of Blockbuster and other real-world retailers selling content more easily bought online.

Today, of course, all that has changed. Barnes & Noble has sold a 17.6% stake in its digital and college businesses to Microsoft, for $300 million — a deal which values B&N’s remaining 82.4% stake at $1.4 billion. And while the $300 million is staying in the new joint venture and therefore not available to help the bookstore chain with cashflow issues, the news does mean that Barnes & Noble won’t need to constantly find enormous amounts of money to keep up in the arms race with Amazon. That’s largely Microsoft’s job, now.

This deal is a bit like one of those high-profile investments by Warren Buffett in a distressed company: a vote of confidence by someone powerful enough to be able to fund the struggling firm through its troubles. Except in this case, the Microsoft investment is much bigger than that, since it comes with deep integration into the Windows 8 operating system. Barnes & Noble no longer needs to sell Nooks, or persuade people to download the Nook app on their iPad: everybody with a Windows 8 device will have the Nook reader built-in.

The e-book market is still young; if Amazon continues to be seen as the enemy, there’s no reason in theory why the Nook shouldn’t become just as popular, if not more so. It’s true that you can’t read Kindle books on your Nook, or vice versa, but over the long term, we’re not going to be buying Kindles or Nooks to read books. Just as people stopped buying cameras because they’re now just part of their phones, eventually people will just read books on their mobile device, whether it’s running Windows or iOS or something else. And that puts Amazon at a disadvantage: the Windows/Nook and iOS/iBook teams will naturally have much tighter integration between bookstore and operating system than anything Amazon can offer.

All of which has lit a real fire under the Barnes & Noble stock price, which opened at $25.79 this morning and looks as though it’s going to close somewhere between $20 and $25 per share. That’s an increase of much more than $300 million in market capitalization, and there’s upside, too: the valuation of the parent is now equal to the value of its stake in the subsidiary. So if the subsidiary rises in value, or if the rest of the company is worth anything at all, then the shares can rise further from here.

The one thing you can certainly expect, though, is volatility. Because Barnes & Noble is no ordinary stock. There are 60.2 million shares outstanding, but of that total the free float — the shares freely traded on various stock exchanges — is just 26.82 million. Meanwhile, at last count, the short interest in Barnes & Noble — the number of shares which had been borrowed by people selling them in the expectation that they would fall — was a whopping 19 million shares.

This, ladies and gentlemen, is what is commonly known as a short squeeze. All those shorts have lost a fortune today, and they’re going to have to cover sooner rather than later, driving the price up artificially. So at least for the next few days, it’s probably worth taking any market valuation for Barnes & Noble with a bit of a pinch of salt: technical factors are likely to overwhelm fundamentals until the shorts have retreated, licking their wounds.

After that, however, we finally have a real three-way fight on our hands in the e-book space, between three giants of tech: Apple, Amazon, and Microsoft. And that can only be good for consumers.

One of the more intriguing concepts to come out of the INET conference was Steve Keen’s idea for what he calls “Jubilee shares”. It’s not exactly new — he’s been writing about the concept since October 2010 — but he refined the concept for INET, and it has a bizarre kernel of genius to it, for all its flaws.

Here’s how it works. Right now, shares issued by a company represent the permanent equity capital of that company. If a company raises new equity capital, then the people buying that stock will have an ownership interest in that company in perpetuity. Under Keen’s proposal, none of that changes. But when those shares get sold, things start getting interesting.

At companies like Google, one class of shares automatically converts to another class when they’re sold. In Keen’s world, all companies would be a bit like Google. Not in terms of voting rights: each share would still carry the same voting weight. But there would be different share classes, all the same. Eight of them, to be precise.

As a rule, when companies issue Jubilee shares, they issue Class A shares — the highest class. And the way that Jubilee shares work, Class A shares would automatically convert to Class B shares when they were sold.

Now that wouldn’t be much of a change. Class B shares have all the same ownership and voting rights of Class A shares; the only difference between Class A shares and Class B shares is that when Class A shares are sold they become Class B shares, while Class B shares convert to Class C shares when they’re sold.

You can guess what Class C shares are like: they’re exactly the same as Class A shares and Class B shares, except that they convert to Class D shares when they’re sold. And so on and so forth, until you reach Class G shares. They convert to Class H shares when they’re sold, and Class H shares are actually very different indeed from all the others. Because Class H shares are not permanent equity capital at all: instead, they expire, worthless, on their 50th birthday.

If you hold Class H shares, you can trade in and out of them as much as you like: there’s no Class I. And you get full dividend payments and voting rights. But you also hold a piece of paper with an expiry date. As far as the cashflows from Class H shares are concerned, it’s basically just 50 years’ worth of dividends, and that’s it. (Although, if the company is sold, you get full participation rights.)

For a company like Berkshire Hathaway, which has little prospect of being taken over and which doesn’t pay a dividend, Class H shares would be close to worthless. On the other hand, for a company which is in clear decline and which is probably going to fail or get taken over in the next decade or two, Class H shares — at least the ones still far from expiry — would trade at only a very modest discount to Class A.

For companies going public, issuing Jubilee shares would be quite attractive, in some ways. The founders of Google and Facebook would feel much less need to give themselves super-voting rights, or to worry that IPO allocations are silly because they just end up getting flipped on day one, because the structure of the Jubilee shares would encourage shareholders to act like long-term owners rather than short-term traders.

For investors, Jubilee shares would also be attractive. Any company with Jubilee shares would have a very low stock-price correlation with the market as a whole — and investors like low correlations nearly as much as they like liquidity. And besides, Jubilee shares would be cheaper than normal shares, and it’s always nice to be able to buy equity in a company at a discount.

As for traders, Jubilee shares would be a very mixed bag. On the one hand, volumes would plunge. But on the other hand, bid-offer spreads would rise, and there would be a lot more opportunity to generate alpha and outperform the market by smartly navigating the various classes of stock.

Jubilee shares would work like a financial-transactions tax: on a mark-to-market basis, you’d take a loss every time you bought a stock. Shares would trade in seven main classes: A/B, B/C, C/D, and so on, with the first letter representing what the seller is selling, and the second letter representing what the buyer is buying. Since each class would trade at a lower price than the one before, the cost of doing a round-trip trade — of buying a stock and then selling it immediately — would be substantial. And I haven’t really thought through what might need to be done in the area of shorting and securities lending.

Still, there would surely be active trading, and the biggest profit opportunities, in Class H shares. Those shares would be highly specialized financial instruments, not least because they wouldn’t be fungible: each one would have a unique expiry date, and would be priced accordingly. Broker-dealers would trade them on the OTC market — it would be incredibly difficult to trade them on an exchange — and would tempt merger arbs and anybody else in the special-situations space with the promise of enormous profits. Dividend-related announcements would take on huge market importance, much more than they do now, and the difference between dividends and stock buybacks would go from being negligible to being enormous.

For all the active trading in such instruments, however, what you would not get would be a speculative bubble. The price of Class H shares would always be capped at the price of Class A/B shares, and Class A/B shares would be almost impossible to speculate in because volumes in that market would perforce be extremely low.

And so I think that Jubilee shares would indeed achieve what Keen intends them to achieve — the end of stock-market bubbles. They would also make investing in the stock market extremely difficult — something which can probably be considered a feature rather than a bug. Most investors would be forced to do their homework and really understand what they were buying; you wouldn’t get people logging on to E-Trade and buying thousands of dollars of a stock just because of something they saw on CNBC. And the huge current volume in ETFs — most of which is accounted for by speculative day-traders — would disappear overnight.

There are two ways that Jubilee shares might be introduced, neither of which is going to happen. One option would be for them to simply be imposed on the market by legislative fiat; that seems to be what Keen has in mind. That wouldn’t just be bad politics, it would be bad policy, since stock-market bubbles aren’t actually all that much of a problem. As we saw in 2000, they can wipe out enormous amounts of wealth when they burst, with surprisingly modest macroeconomic consequences, thanks to the fact that most stock-market investments are unlevered.

More to the point, legislating Jubilee shares would only make debt even more attractive than equity, as a funding source for companies — and that’s exactly what we don’t want to achieve. Unless and until Congress first abolished the tax-deductibility of corporate interest payments, the introduction of Jubilee shares would cause more harm than good in the markets as a whole, giving companies even more incentive to borrow money rather than to fund themselves with equity.

There is another way for Jubilee shares to arrive, however, and that’s for companies to issue them voluntarily. As far as I can tell, there’s no reason why a company couldn’t issue Jubilee shares rather than common stock tomorrow, were it so inclined. The market capitalization of any such company would certainly suffer: a founder wanting to maximize the mark-to-market valuation of her own stake in a company would never opt for such a structure. But for CEOs who prefer long-term control to paper wealth, Jubilee shares could be an attractive alternative to the current modish option — dual classes of shares with the founders’ shares having many more votes than everybody else’s.

But founders don’t need to issue Jubilee shares, now, thanks to the passage of the JOBS act. It’s now much easier for founders to retain control: with the 500-shareholder rule no longer in effect, founders can simply elect to stay private indefinitely, with a right of first refusal on any share sales and essentially complete control over where, how, and even whether their stock is traded. Given the attractions of private markets and the new powerlessness of the SEC when it comes to requiring companies to go public, it seems like Jubilee shares are to a large degree a solution to a problem which no longer exists.

Still, I’d love to see just one company try them out, if only to see what happens. Existing corporate stock can remain untouched, but new shares, be they sold directly to the public or given out to employees or used to buy some other company, could still be issued in Jubilee form. It would be fascinating to see where and how they traded.

Count me in with Robert Cyran: there’s something a little evil about the way that Google is splitting its stock, and in so doing creating a whole new class of non-voting shares.

There’s a long history of such things: they were outlawed in the 1920s, when they were commonly used by unscrupulous managers. The New York World even wrote a poem on the subject:

Then you who drive the fractious nail,
And you who lay the heavy rail,
And all who bear the dinner pail
And daily punch the clock—
Shall it be said your hearts are stone?
They are your brethren and they groan!
Oh, drop a tear for those who own Nonvoting corporate stock.

Dual-class voting shares were illegal for most of the 20th Century, but came back in 1986. James Sterngold’s NYT story on their reintroduction is well worth a read, featuring as it does comments against the new rules from both Felix Rohatyn (”The one-share, one-vote rule is pretty fundamental to the market”) and T Boone Pickens (”Let’s face it, managements want this because they want to entrench themselves. They went to Congress to get protection and they didn’t get it. So they went to the exchange to get protection, and they got it.”)

Even then, however, there were safeguards, including the crucial one that a majority of independent shareholders — excluding management and some directors — had to approve the move. The basic idea was explained ten years later:

The defining principle of current American corporate law seems to be, if the existing shareholders agree to the creation of a new type of shares with no voting rights, why should we object?

Google has, now, clearly violated the spirit of the NYSE rules, if not their letter. It took 15 months for the independent directors on the board to be persuaded of this, in long and secret deliberations:

In January 2011, the board established a special committee, comprised of independent, non-management board members to consider a new class of stock, or other alternatives. This committee retained its own financial and legal advisers to assist with its deliberations, and met on numerous occasions over the 15 months that the special committee considered the proposal separately from the board. The committee recommended, and the board unanimously approved, today’s proposal.

The proposal is subject to the approval of a majority of the voting power of Google’s common stock, voting together as a single class, at our annual meeting on June 21, 2012. Given that Larry, Sergey, and Eric control the majority of voting power and support this proposal, we expect it to pass.

My key problem with the proposal is that it’s being pushed through without common shareholders being given the opportunity to object. I would be OK with it if it was being voted on a one-share, one-vote basis. But instead, Google’s Troika has decided that having ten times the votes of any other shareholder isn’t good enough for them, and that what they really want is a whole new class of shareholders — including new employees — who have no votes in the company at all.

Given the way that this is being done, I’m with Cyran that we can place no store whatsoever in the “stapling” provision which says that as the Troika sells their stock, they will be forced to sell down their super-voting stock commensurately. Such provisions tend to last until they’re needed, at which point the controlling shareholders simply use their control to get rid of them.

Non-voting shares are rare things, and Google’s news comes not long after Telus decided to move the other way, giving votes to all the holders of its non-voting stock. There’s no need for this to happen now — or ever, for that matter — and the letter from Larry and Sergei is pretty unconvincing on the subject of why they’re doing it.

We have a structure that prevents outside parties from taking over or unduly influencing our management decisions. However, day-to-day dilution from routine equity-based employee compensation and other possible dilution, such as stock-based acquisitions, will likely undermine this dual-class structure and our aspirations for Google over the very long term. We have put our hearts into Google and hope to do so for many more years to come. So we want to ensure that our corporate structure can sustain these efforts and our desire to improve the world.

It’s worth putting this theoretical fear in perspective. Common shareholders currently have just 32.6% of the voting stock at Google, with Larry and Sergei Sergey between them controlling 57.7%. If Google doubled the number of common shares outstanding, the Troika still wouldn’t lose control. And in any case, as Steve Jobs has shown, you don’t need control of the stock to have complete control of the company.

This move, then, is basically a way for Google to try to retreat back into its pre-IPO shell as much as possible. It never really wanted to go public in the first place — it was forced into that by the 500-shareholder rule — but at this point, Google is far too entrenched in the corporate landscape to be able to turn back the clock. It’s too big, and too important, and has been public for too long. That’s the thing about going public: it might suck, but once you’ve done it, you’ve done it. And at that point, if you try to pull a stunt like this, you risk looking all too much like Rupert Murdoch.

That said, however, I can’t say I’m wholly surprised by this development. Google hasn’t always been evil, but it has been evil since January: this news just confirms what many of us suspected when they closed down the Kaffee Klatsch in Davos. Which just goes to prove, I suppose, that the World Economic Forum really does give you advance notification of important corporate developments.

It’s another bad day for Groupon: not only is Andrew Ross Sorkin using the company as Exhibit A in his opposition to the JOBS Act, but more worryingly the WSJ is now reporting that the SEC is examining the earnings revision which Groupon announced yesterday.

Vipal Monga has explained exactly what the problem is here, but his story is very hard to access online, so I’ll try to summarize. The issue at hand is that of refunds, and how they’re accounted for. Let’s say that Groupon has managed to sell 240 coupons for “cool sculpting”, at $500 apiece. That’s a total of $120,000. The coupons expire on September 19, in six months’ time.

Let’s also assume that, as per usual, Groupon keeps 50% of the proceeds, and gives the other 50% to the merchant. In this case, it would keep $60,000 for itself, and remit $60,000 to Dr. Aron Kressel. But Dr. Kressel wouldn’t get all the money up front. He gets one third, or $20,000, immediately. He gets another $20,000 after 30 days. And then he gets the final $20,000 after 60 days. That’s May 18.

Now, Kressel might not get all of his $60,000. Let’s say that some of the people who bought a coupon turn up for their initial consultation before May 18, and are told that they’re not medically suitable for the treatment and therefore can’t have it. Those people — let’s say there are 20 of them — are eligible for a full refund from Groupon. So Groupon gives those people back their money, $10,000 in all, and holds back from Kressel his $5,000 share of that money. As a result, Kressel’s final payment is not $20,000 but rather $15,000, and he ends up getting paid $55,000 in total by Groupon.

And at the same time, of course, Groupon’s own revenues from the deal are also reduced to $55,000: the economics of selling 240 coupons and refunding 20 of them before May 18 are basically the same as the economics of selling 220 coupons and refunding none of them.

After May 18, however, things change. At that point, Kressel is paid out, but Groupon still has the Groupon Promise. As a result, if anybody gets turned away from Kressel’s office after May 18, Groupon eats the whole refund. Let’s say that appointments become easier to come by after May 18, and a further 50 people end up being told that they’re not eligible for the procedure after that point. Remember that Kressel has already been paid $250 by each of those people, and doesn’t need to repay the money if he finds them ineligible.

Those 50 people still get their refunds from Groupon — a total of $25,000. But in this case, all of that $25,000 comes out of Groupon’s share of the revenues, and none of it comes out of Kressel’s cut.

So what’s the situation on September 19, when the deal expires? 240 coupons will have been sold, for an up-front total of $120,000. 70 of those coupons will have been refunded, bringing total revenues down by $35,000 to $85,000. And of those revenues, Kressel will have received $55,000, while Groupon will have received just $30,000 — a 65/35 split in favor of the merchant, rather than the 50/50 split originally envisioned.

And in fact it’s possible for Groupon to lose money on the deal, if there are enough refunds after May 18.

How is all this accounted for?

The way that Groupon does its accounting, it adds up its share of the gross revenues — that would be $60,000 in the cool sculpting example — and books it as revenue immediately, minus the quantity of refunds it expects to have to issue after applying a model which tries to predict such things. If you look at Groupon’s new 10-K, you’ll find this chart (click on “Notes to Financial Statements” and then “Accrued Expenses”):

The line you want to look at here is “refunds reserve” — the number which was $13.9 million in 2010, and $67.5 million in 2011. If you add up all of the deals that Groupon issued in 2010 — that’s some $745 million in total — Groupon reckons that it’s going to have to refund $13.9 million, or 1.87%.

Then, in 2011, a lot of things changed at Groupon. It sold a lot more deals than in 2010, for starters. It also moved into higher-priced deals, things like cool sculpting, which are more likely to be refunded. And it started selling travel deals, too, which are also more likely to get people asking for refunds, especially if they turn out not to be able to book travel on the days they want.

So in 2011, out of $3.985 billion in total revenues, Groupon reserved $67.452 million for refunds. Now note these are the revised figures, which were released after Groupon realized that its initial estimates for refunds were too low.

But do the math, and it turns out that $67.452 million is just 1.69% of $3.985 billion — the anticipated refund rate actually fell from 2010 to 2011. This does not make much sense, since by all accounts — including Groupon’s — it should by rights have gone up, quite substantially.

Now there’s an easy way of dealing with this problem, which doesn’t involve any predictive algorithms at all. Here’s Monga:

Forensic accountant Howard Schilit told CFO Journal that the mistake reflects a misapplication of accounting rules, in particular those outlined in financial accounting standard 48, as set by the Financial Accounting Standards Board. The standard dictates how companies are allowed to estimate revenue for refundable products.

Under the rule, companies are allowed to set aside reserves against potential refunds based on reasonable estimates. But Schilit argued that Groupon couldn’t “reasonably” estimate the refunds because it is so young and follows a relatively new business model. Lacking that historical perspective, the company shouldn’t have recognized any revenue until after the end of their refund period.

“Everything would have to be deferred revenue until the end of the refund period,” he said. “Either [Groupon's executives] didn’t know they had to defer, or they wanted to continue to show as much revenue as they could.”

This, then, is probably what the SEC is investigating at Groupon. If it sells 240 coupons for cool sculpting, should it book $60,000 in revenue? Or $50,000? Or $30,000? The fact is that Groupon doesn’t know how much if any money it’s going to end up making from that deal until the deal expires in September. So there’s a case to be made that the company shouldn’t book any revenue at all until September, just to be on the safe side.

What happened with the earnings restatement is that Groupon discovered that the refund reserve it had been using was too low; when it increased that reserve, it ended up losing more money than it had originally reported. But should it have booked any revenue at all, so long as that revenue was subject to potential refund? I have a feeling that the SEC is going to be asking Groupon that question in quite a pointed manner.

I bought Rocky Agrawal brunch on Saturday, at a cost to myself somewhat smaller than the amount I’m going to have to shell out if I lose my bet with him. Which is looking increasingly likely. I lose the bet if Groupon’s market capitalization on October 31 is less than 30% of the market capitalization of Priceline. When Groupon went public, the ratio was 72%, which gave me a very healthy cushion. But as of today, I’m underwater: the ratio is now just 24%, thanks in large part to an astonishing and quite unexpected run-up in Priceline’s stock, which is now comfortably over $700 per share.

Still, the proximate cause of the ratio dropping below 30% came from Groupon, not Priceline: it revised its 2011 results downwards, in a pretty opaque manner. “The revisions are primarily related to an increase to the Company’s refund reserve accrual to reflect a shift in the Company’s fourth quarter deal mix and higher price point offers, which have higher refund rates,” says the press release, in a marked departure from Groupon’s normal habit of communicating in plain English.

The official SEC filing is a tiny bit clearer:

At the time revenue is recorded, we record an allowance for estimated customer refunds. We accrue costs associated with refunds in accrued expenses on the consolidated balance sheets. The cost of refunds where the amount payable to the merchant is recoverable is recorded in the consolidated statements of operations as a reduction to revenue. The cost of refunds when there is no amount recoverable from the merchant are presented as a cost of revenue.

To determine the amount of our refund reserve, we track refund patterns of prior deals, use that data to build a model and apply that model to current deals. Further analysis of our refund activity into 2012 indicated deviations from modeled refund behavior for deals featured in late 2011, particularly due to a shift in our fourth quarter deal mix and higher price point offers. Accordingly, we updated our refund model to reflect changes in the deal mix and price point of our deals over time and we believe this updated model will enable us to more accurately track and anticipate refund behavior.

Groupon is explaining how it accounts for the money it sets aside to cover customer refunds.

Groupon basically has two business models: the US model, and the European model. In the US, Groupon sells a bunch of deals for a given merchant, gets lots of revenue as a result, keeps roughly half that revenue for itself, and then passes on the other half to the merchant in question. In Europe, by contrast, Groupon keeps the merchant’s share of the revenue until such time as the buyer redeems the Groupon.

Obviously, the US model is much more attractive to merchants than the European model is. But it also creates much bigger dangers for Groupon, thanks to Groupon’s refund policy. “If the experience using your Groupon ever lets you down, we’ll make it right or return your purchase. Simple as that.”

That policy is good business for Groupon: it gives people a lot of confidence to buy a Groupon for merchants who might otherwise seem a bit sketchy. But it also creates dangers, because if Groupon does a deal with a sketchy merchant, then Groupon can be on the hook for a lot of refunds. And even if the merchant is entirely legitimate, if for good reason a lot of people end up being disappointed with their deal, Groupon can still end up massively out of pocket.

What happened in 2011 is that the price of Groupons started going up — and it turns out that Groupon ends up issuing refunds on a significantly higher percentage of high-ticket Groupons than it has historically done on low-ticket Groupons. I’ll let Rocky explain why:

Groupon is selling bigger and bigger deals and many of these have requirements for use. Some deals have medical qualifications. The former salesperson told me about Groupons for a procedure called “cool sculpting”. In this procedure, fat is frozen off the body. In order to get the treatment, patients must be medically qualified. But Groupon has no way of medically qualifying purchasers and will sell it to anyone. When they go to the doctor and find out that they aren’t eligible, they call Groupon for a refund. If this is several months later, after Groupon has paid out the entirety of what it owes the provider, this can mean a refund loss for Groupon.

Travel is another risky category for Groupon. Unlike Expedia, Travelocity, Priceline, Jetsetter and nearly every other major travel provider, Groupon does not require consumers to pick their dates and confirm availability at the time of purchase. When a consumer finds he can’t use his Groupon months later, he calls for a refund. Groupon also hides material restrictions on travel deals, something I pointed out in September and Groupon still hasn’t rectified.

Because these are higher ticket items that cost hundreds or thousands of dollars, consumers are more likely to ask for a refund than on lower ticket items. In the short term, it means a revenue boost to Groupon, which the company needs as its once torrid growth cools. In the long term, it means refund losses.

Pretty much all of these problems could be addressed quite simply if Groupon simply moved its high-ticket US sales to a European-style system where it paid the merchant only after the deal was successfully redeemed. If Groupon hasn’t done that, then that implies that there might be less merchant demand to run Groupon deals than Groupon likes to imply — and that Groupon needs to be able to promise a large amount of cash up front in order to be able to sign up the merchants it needs.

Groupon, as an intermediary, is in the business of balancing the interests of merchants and consumers. The problem with the high-value tickets is that it’s trying to have it both ways: giving merchants a lot of money up front, while also giving very strong consumer protections to the people buying the deals. The result is enormous contingent liabilities for the middleman — Agrawal estimates that Groupon has more than half a billion dollars in liabilities which aren’t showing up on its balance sheet.

I suspect that what’s going to happen is that Groupon will start tightening up its standard contract with high-ticket-price merchants, to make it easier for Groupon to have recourse to the merchant when it needs to issue a refund. Will that scare away the merchants Groupon wants? If it does, then there are much deeper problems at Groupon than simply refund issues. Because a Groupon without a steady supply of merchants wanting to do deals would surely be a company in very big trouble.

Update: Groupon’s Mike Buckley calls to say that only about a third of the money payable to the merchant is paid up front, and that “a significant portion” is held back until the customer actually redeems. And that as a result, Groupon never loses money on a deal, it just ends up selling fewer than it originally thought. But there are still some question marks over when exactly the merchant gets the last payment, and whether it’s before the Groupon expires — I’m hoping to nail those down shortly.

Today’s story from Gretchen Morgenson, about Goldman Sachs and short selling, is notable for two things. One one front, it fails to deliver: Morgenson seems to be trying to make a case that Goldman might be guilty of naked shorting, but she doesn’t really come close. On a second front, however, it’s a great leap forwards for Morgenson.

The whole article is based on the transcript of a deposition given by a hedge-fund manager turned chicken farmer named Marc Cohodes. “His testimony, which has not been made public, was obtained by The New York Times,” writes Morgenson — and indeed “Mr. Cohodes declined to comment beyond his deposition”, which means that the deposition is the sole source for Morgenson’s story. Wonderfully, for the first time that I can remember when Morgenson was working off a non-public primary source document, she has actually posted it online.

As a result, it’s possible to read the full testimony of Cohodes, which turns out to be a very long way from a damning indictment of naked shorting on the part of Goldman Sachs. Here’s how the subject is initially broached:

Q. And did you ever come to believe that Goldman Sachs had not been borrowing stock when you were short selling stock?

MR. FLOREN: Objection, vague and ambiguous.

MR. SHAPIRO: Objection, lack of foundation.

THE WITNESS: That’s just speculation on my part at this point in time.

BY MR. SOMMER: Q. Well, I’m asking for your belief, so just tell me what your belief is one way or the other.

MR. FLOREN: Same objection.

MR. SHAPIRO: Don’t speculate; just say what you — answer the question about what you know. You’re here to testify, as a fact witness, what you know from seeing, hearing –

THE WITNESS: I don’t know. I just don’t know. I mean, I just — I don’t know.

This sets a pattern. Questioners representing Overstock — a company extremely hostile to short-sellers of any stripe — will try to ask Cohodes whether there was naked shorting going on; Cohodes will say, at best, that he talked about the possibility, but that he had no evidence of such activity at all. Or, to put it another way: Cohodes is angry at Goldman, and Overstock is trying to use that anger to get him to accuse Goldman of naked shorting. But he never actually does so.

Indeed, it turns out that the allegation that Goldman Sachs might have been engaging in naked shorting doesn’t really originate from Cohodes, or his deposition, at all. Instead, it’s contained on page 300 of a book by a former colleague of Cohodes, Richard Sauer, which was published in April 2010. Here’s the excerpt:

This is actually a vastly better explanation of the highly-circumstantial “evidence” of naked shorting than that provided by Morgenson. Here’s her attempt:

Failing to borrow shares on behalf of customers is illegal because of concerns about market manipulation. But it can also leave a brokerage firm’s client who is short a stock dangerously exposed to an escalating price in the shares. If a stock shorted by an investor began to trade higher and the shares were not borrowed, closing out the transaction would require the fund to buy them in the open market. That could propel the already rising price of the shares even higher, adding to the costs of the trade.

This doesn’t really make any sense. If a fund which is short a certain stock needs to cover that short, then it needs to buy those shares in the open market. That’s true whether the short is naked or not. And yes, when shorts are forced to cover, that can force the price up even further. That’s known as a short squeeze, and it’s exactly what caused the downfall of Cohodes’s fund. And again, you absolutely don’t need naked shorting to have a short squeeze.

Reading the deposition, it’s clear that while Cohodes is furious at Goldman Sachs, his fury has essentially nothing to do with naked shorting. This is absolutely not clear from Morgenson’s characterization of the deposition, which is why it’s so great that she uploaded the deposition so that we can see for ourselves. Cohodes is furious at Goldman for one main reason: that after Lehman Brothers went bust, there was some very crazy price action in the market. Most stocks were plunging, but a handful of stocks — the ones he was short — were going up, rather than down. It was a classic short squeeze.

In a short squeeze, the fight is simple. The fund which is short tries to stay solvent, while the market drives up the price of the stocks in question so much that the shorts are forced to sell at the top of the market. Once they capitulate in that way, the stock tends to plunge. A fund like that being run by Cohodes, which was massively short going into Lehman’s bankruptcy, should by rights have made a lot of money: Cohodes calculates it at a cool billion dollars. All he needed to do was wait for his stocks to plunge, and then cover his short positions.

But that’s not what happened. Instead, Goldman presented him with a huge and unprecedented margin call — not the kind of margin call required by federal regulations, mind, but rather a “house call” declared unilaterally by Goldman Sachs over and above what the regulations require. As a result of that call, his fund went bust, just days before it would have made a fortune. Here’s Cohodes’s deposition:

A. I can remember Goldman closing us out of American Capital Strategies at $33 on that Monday, and when they stopped doing whatever they had to do, when the smoke cleared, we finished covering the thing four weeks later at 2, something like that. We finished covering it at 2 but they took us out of eighty percent of our position in the thirties, and when they were done, we covered at 2. They took us out of Tempur-Pedic at 16, covered that, the rest of it four weeks later, at 3. I mean, it was insane.

So it’s kind of like I played the entire thing for a complete collapse, got the collapse and was closed out, closed out right before and during.

Q. If Goldman Sachs & Co. had not made these house calls and had extended you more credit during this time period –

A. We didn’t need more credit. All they had to do was not make the house calls.

Cohodes feels, then, with some reason, that Goldman Sachs did him in by foisting huge house calls on him during a point at which the stock market in general was going down rather than up. To make matters worse, when he tried to get out of the calls by moving his entire account to a different prime broker, UBS, Goldman wouldn’t let him do that. And when he tried to move his positions to a hedge fund with deeper pockets, Farallon Capital, he says that the CFO at Farallon got a phone call from Goldman warning him off.

So it’s easy to understand why Cohodes is very ill-disposed towards Goldman Sachs, and even suspects that Goldman’s prop desk might have been orchestrating the short squeeze. But there’s really nothing here at all to indicate that Goldman was engaging in any kind of naked shorting.

This testimony is mildly embarrassing for Goldman: no one likes seeing their former head of prime brokerage being described as “just a motherfucker”, as Cohodes describes Ravi Singh in this deposition. But Goldman’s argument for keeping the testimony sealed — “that their release would disclose trade secrets about the business” — is extremely weak. And Morgenson’s case that the deposition somehow indicates that Goldman might have been involved in naked shorting is even weaker.

Naked shorting is likely to become something of an issue in the news again soon, now that a documentary on the subject, called The Wall Street Consipracy, is being screened quite widely in finance and media circles. The documentary, like the deposition, is all part of a campaign by Overstock CEO Patrick Byrne against what he’s convinced is a massive conspiracy to bring down his company through illegal means.*

And that’s the main reason why I’m uncomfortable with Morgenson’s story: it seems to play far too neatly into the hands of Byrne, who’s really completely bonkers. But at least she posted the primary document, which is great, because it means that the rest of us can see much more clearly what the truth of the matter is.

*Update: Lewis Goldberg, the PR guy for The Wall Street Conspiracy, tells me that Patrick Byrne did not fund the movie, he just appears in it.

ZeroHedge has the chart of the day:

What you’re seeing here is the price of shares in BATS, at 11:14 this morning. The white spots are trades: there are 176 of them altogether. They start just below the IPO price of $16, and then just fall lower and lower and lower until the stock is trading for mere pennies. But the key number you want to look at here is not on the y-axis. Instead, it’s the chart report at the very top:

Elapsed Time: 900 Milliseconds

This is what happens when stocks are traded by algorithms rather than humans. The parabolic trajectory of the share price is downright elegant; indeed, if you’re going to crash from $16 to 4 cents within 900 milliseconds, you could hardly do so in a lower-volatility manner. The scary thing here is the sheer speed involved, and the fact that no human intelligence was stopping to think whether these prices made any sense at all.

Of course it’s too early to work out exactly what happened here; a formal statement from BATS talks vaguely about “a software bug”. But the big picture is clear. Most people think there are only two stock exchanges in the US — NYSE and Nasdaq. And indeed those are the only two exchanges where stocks are listed. But there are more than 50 venues, including two different BATS exchanges, where stocks are traded; they all communicate with each other to work out what the best global bid and offer in any stock is at any given time. (This is known as NBBO, for National Best Bid/Offer.)

This fragmentation of trading venues is good for competition, but, as we saw first in the Flash Crash of May 2010 and then again today, when one of those venues encounters problems, very nasty things can happen.

BATS was meant — if everything had gone according to plan — to be the first stock listed on the BATS exchange. They’re not going to try that stunt again in a hurry; as finance professor James Angel told Bloomberg, this was “like seeing an airplane crash on takeoff”. On the maiden flight of a new airline. You can imagine how much appetite anybody would have to fly that airline thereafter.

One obvious similarity between today’s events and what happened in the earlier flash crash is that both involved exchanges declaring “self help” — basically saying that the information coming from some other exchange was so delayed or otherwise unreliable that it couldn’t be used any more as part of the NBBO system. When that happens, you can find order flow sloshing violently around various different exchanges; such moves don’t need to be accompanied by extreme price action, but they make such action much more likely.

There is some good news here. The first bit of good news is that no one was really harmed today: the BATS IPO has been pulled, and the institutions which were trying to sell their shares — foremost among them the estate of Lehman Brothers — will just have to hold on to them for a while longer. And the second bit of good news is that we have a lot of valuable real-world information about exactly how markets fail in today’s high-frequency precincts. I just hope that we’re going to be able to learn from what happened today, and put in measures to prevent it from being much worse next time. Can anybody say Tobin Tax?

Pascal-Emmanuel Gobry has a very smart response to my Wired story about IPOs.

Gobry has one main point. VCs aren’t bad for pushing their portfolio companies to grow at all costs he says; indeed, they have to be that way.

Breakthrough technology startups are different from other kinds of businesses in that they either create a new market or violently disrupt an existing one. This means that they almost invariably require to spend lots of capital in order to stake out a defensible market position against their numerous competitors. In particular, many technology markets have winner-take-most or winner-take-all dynamics, either because of network effects or economies of scale…

Felix writes that Groupon had a profitable Q1 2010 and “it’s easy to see how it could have grown steadily from that point onward.” Except that given the characteristics of the daily deal business, particularly the need for scale, what would have happened if Groupon had tried to “grow steadily” and profitably, is that the company wouldn’t be around anymore.

It’s LivingSocial that would have raised over a billion dollars and be worth $10 billion today, Groupon would have been sold for scrap like BuyWithMe and plenty of other daily deals also-rans, and Andrew Mason would be back to doing yoga on YouTube. Groupon would be a footnote.

This is a good point. If you think about big technology companies, they’re very frequently in markets with just one or two players: if you’re not the biggest, you won’t succeed at all. And so it makes sense, in such markets, to aggressively push to get as big as possible as early as possible. One way of looking at Apple vs Microsoft in the 1980s is that Apple concentrated on quality and failed, while Microsoft concentrated on quantity and succeeded.

But the fact is that the overwhelming majority of VC-backed companies don’t become Groupon or Facebook or Microsoft. Indeed, most of them don’t even IPO. As I note in the piece, 52 VC-backed companies went public last year; 429 were acquired.

It’s certainly true that Silicon Valley is full of ambitious men (and a handful of women) wanting to build enormous companies which will change the world. But from a public-policy perspective, that’s not actually the best way to run an entrepreneurial economy. For one thing, it artificially maximizes failure — many more companies fail than need to. And even the companies that survive do so in a brutal fashion: according to Harvard Business School’s Noam Wasserman, the majority of companies getting to their Series C funding round have already fired their founder from the CEO position, and 18% are on their third CEO or more. Here’s the chart from his book:

This is why smart entrepreneurs avoid VC funding where possible, and if they can’t avoid it, try to maximize the amount of control that they have. They tend to want to build and run their companies for the long term; their backers just want to get the fastest and greatest possible financial return. Those two interests are rarely aligned.

It’s incredibly easy to overestimate the importance of huge companies in the US economy. Here’s a chart showing the S&P 500 as a percentage of total US GDP: I’m not entirely clear exactly what the numerator is, but I’m comfortable saying that the 500 biggest companies in America collectively account for less than 20% of GDP, and quite possibly less than 10%. Meanwhile, the contribution of small businesses to GDP, while shrinking, is still well over 40%

Another way to look at this question is to compare US fight-to-be-number-one capitalism with the kind of capitalism practiced in undeniably successful countries like Germany, Korea, Brazil, and Japan. Those countries don’t have nearly as many world-beating behemoths as the US does, but overall their economies and current accounts are doing very well on a bedrock of medium-sized firms and family-owned corporations.

So in a way, Gobry is making my point for me. The IPO market and the VCs who feed off it are playing a game which might make a small number of people extremely rich, and which will create a very small number of hugely successful world-beating companies. They’re not playing a game which is good for founders; they’re not playing a game which is good for healthy, long-lived companies; and they’re not playing a game which is good for the economy as a whole. That’s kind of the point I’m making in the piece when I say that “Silicon Valley is full of venture capitalists who have become dynastically wealthy off the backs of companies that no longer exist”.

I agree, then, with Gobry when he says this:

Felix also notes that according to a study, most of the fastest-growing (in revenue) companies in the US aren’t venture-backed. Here’s the thing, though: you haven’t heard of most of those companies. Not to diss any of them, which we’re sure are great businesses founded by great entrepreneurs, but when you take the world-changing companies, the ones that come up with radically new products and create new markets or disrupt existing ones, almost all are venture-backed. Those are the breakthrough technology companies. There’s nothing wrong with other kinds of companies. But breakthrough technology companies operate in a specific way which means they will have a huge appetite for capital, which means they’ll need VC and IPOs.

I just disagree with Gobry if he thinks that placing long-odds bets on breakthrough technology companies is a sensible way of running an economy. And certainly the IPO market, and the stock market more generally, should exist to do much more than just serve that tiny sliver of corporate America.

Gobry has some secondary points, too. I simply disagree with him on the degree to which private markets will ever display the kind of correlations we’re currently seeing in public markets. That’s one advantage of private markets: they’re off-limits to index funds, which drive correlations ever upwards. And yes, the HFT algo-bots also serve to increase correlations in the stock market as a whole.

And to answer another of his questions, yes, I’m still worried about the way in which the move to private markets will essentially remove from most of us the opportunity to invest in America’s fastest-growing companies. I say in the piece that the US stock market worked very well from about 1933 to about 1998; there’s no reason we can’t somehow return to those halcyon days. But as Gobry and I agree, the stock market is broken right now, at least with respect to its primary function of providing equity capital to growing companies which need it.

Gobry thinks that I want to make it harder for companies to go public; that’s not true at all. One of the main things I complain about in my piece is that it’s so hard to go public, the role of injecting equity capital into early-stage companies has been taken on by the VC industry instead. We would be better off if that role reverted to the public markets, even as many entrepreneurs managed to fund medium-sized companies without putting themselves on an IPO path, thereby remaining closely held and being much less at the mercy of violent market swings. That’s how other successful companies do it, and that’s how many successful medium-sized US companies do it, too. And even huge ones, like Mars and Cargill. It worked in the past; it can work again in the future.