Felix Salmon

Google’s evil stock split

Felix Salmon
Apr 13, 2012 07:56 UTC

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.


For a great read on GOOG and to understand it properly, visit, vippennys tocksite . com

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How Groupon accounts for its deals

Felix Salmon
Apr 3, 2012 14:07 UTC

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.


If Dr. Kressel were clever, he would have his friends and family buy all 240 coupons from Groupon, hold them until May 19th, then surrender them all for refunds. Kressel gets $65,000 from Groupon by May 18th, his friends and family get full refunds (and maybe a 10 percent tip from Kressel), Groupon is out $65,000, and Kressel has to perform zero procedures.

Sounds like it could be easy to scam $$$$ from Groupon.

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What happened at Groupon?

Felix Salmon
Apr 2, 2012 15:42 UTC

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.


Groupon’s business plan was to insure what is commonly known in accounting as the “Allowance for Bad Debt”. It is as simple as that.

This implicitly assumes the economy is a “going concern”, which is another accounting term meaning, all things being equal and no unnatural events occur, the company is likely to survive based on this business model.

Unfortunately, if the economy crashes, a business model like that will do the same thing as any insurer that is overwhelmed with claims — it will go bankrupt.


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Strange bedfellows: Gretchen Morgenson and Patrick Byrne

Felix Salmon
Mar 26, 2012 15:44 UTC

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.


Wouldn’t these clowns have been lynched or shot by now in a different era (if not in a different country today? Even China executes financial criminals) ? It seems “rule of law” lacks meaning in the absence of morality.

Life is truly absurd.

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Chart of the day, flash-crash edition

Felix Salmon
Mar 24, 2012 00:51 UTC

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?


You are posting an important Penny Stock article. It’s most important for everybody.
Kamrun Nahar
“top penny stock picks”

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How the IPO market is broken

Felix Salmon
Mar 21, 2012 21:54 UTC

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.


How are any of the latest big tech companies IPO-ing “breakthrough” companies? Exactly what difference is LinkedIn, Zynga and Groupon bringing to the business world? Or Facebook?

VCs are pushing for “companies to grow at all costs” because that is what is going to give them a story to cash out – either by finding a greater fool privately or publicly.

Posted by Danny_Black | Report as abusive

SecondMarket’s unnecessary Facebook Fund

Felix Salmon
Mar 20, 2012 13:45 UTC

The latest sign that the Facebook IPO is going to be particularly bonkers comes from Jon Ogg, who has discovered a Facebook Fund over at SecondMarket.

This is odd, for a couple of reasons. For one thing, the SEC recently cracked down on two funds offering Facebook shares pre-IPO. (One of them was Felix Investments. No relation.) SecondMarket will obviously have learned from their mistakes, but why rock the boat like this? It’s pretty obvious the SEC isn’t a huge fan of people speculating in the pre-IPO markets.

More generally, SecondMarket has done a pretty good job of positioning itself as a way for people to trade shares in illiquid companies where they have no access to public markets.

This latest development, then, is more than a little off-brand for SecondMarket. Everybody knows that Facebook is going to IPO within a matter of weeks: it’s already started meeting with analysts. So if you want to sell your shares in the public markets, you won’t have to wait long.

But for some reason, there’s still a lot of institutional sell-side interest when it comes to Facebook. There’s a 180-day lock-up period after the IPO during which current shareholders can’t sell their stock, so if they miss the boat now, they won’t be able to sell until November or so. Clearly, that’s too long for some people to wait.

Meanwhile, there’s also buy-side interest in Facebook, from people who are convinced that they’re not rich or important enough to get an allocation of shares in the IPO. They’re not going to be able to flip their shares on day one: they, too, will be subject to the 180-day lock-up. But at least they’ll be buying in now, rather than after Facebook has already gone public.

So you can see where SecondMarket naturally comes in, here. There’s buy-side interest, there’s sell-side interest, and they’re a neutral intermediary broker-dealer which can provide weekly auctions where shares trade hand at a mutually acceptable clearing price.

But why the fund?

It turns out that SecondMarket is not like other auction houses. If I buy a Warhol from Sotheby’s, I write a check to Sotheby’s and they give me the painting. Meanwhile, Sotheby’s writes a slightly smaller check to the seller. I never deal directly with the seller. SecondMarket, however, refuses to face buyers and sellers in this manner. It acts more like a dating agency than an auction house: it works out who wants to transact with whom, and then ducks nimbly out of the way so that they can finish off the deal privately, facing each other.

And big institutional sellers, for one, are unhappy about this. If they’re selling $10 million of Facebook shares, they don’t want to have to sign lots of paperwork facing a long list of retail investors spending $200,000 or $400,000 on stock. SecondMarket tries to match up buyers and sellers in terms of the size of the deal they want, but right now the sellers all seem to be relatively big, and the buyers all seem to be relatively small. Which makes for awkward dates.

The obvious answer to this problem — insofar as it is a problem — would be for SecondMarket to act more like Sotheby’s, and face the sellers itself, while simultaneously selling the sellers’ shares to the buyers. But it didn’t go that route. Neither did it simply turn around to the sellers and say hey, if you want to play on our platform, you have to play by our rules, how much of a pain is it, really, to have to sign a dozen different identical sale documents rather than just one or two. One would think that’s why these companies employ lawyers.

Instead, SecondMarket created a fund. If you want to buy a relatively small amount of Facebook stock — say between $200,000 and $500,000 — then you’re no longer going to participate in the auction directly. Your only choice will be to place your money in SecondMarket’s Facebook Fund, which will buy shares on your behalf at the auction clearing price, and then hold on to those shares until 180 days after the IPO, at which point it will then transfer the shares to you, to do with as you wish. SecondMarket is going to continue its weekly auctions right up until the IPO; any smaller investors participating in those auctions will end up in this fund.

The cost of buying Facebook stock via the SecondMarket fund is double what other buyers pay: everybody pays SecondMarket a 3% fee when they buy stock, but participants in the fund will also pay a second 3% fee when they finally receive their Facebook shares, 180 days after the IPO.

All of the participants are still qualified accredited investors, with at least a million dollars to throw around or a salary north of $200,000 a year. And I’m pretty sure the minimum investment is still high, at $200,000. But this whole thing smacks of speculation to me, not to mention an attempt by SecondMarket to squeeze the last drop of revenue out of Facebook before it goes public.

Facebook has been incredibly lucrative for SecondMarket, despite (or maybe because of) the fact that it’s the exception to every SecondMarket rule, the single company traded on SecondMarket which isn’t itself a SecondMarket client. But this smacks of opportunism to me. I know that there are lots of people out there who are eager to buy shares in Facebook. But they’ll have their opportunity soon enough. The secondary market in Facebook shares right now serves no real public purpose at all. Instead, it’s just putting more money in the pockets of middlemen.


Shares Post has had a Facebook fund for a long time. I assume that this is a competitive response to their fund which accepts smaller dollar investments (I believe as low as $50k).

Posted by EricG | Report as abusive

Apple’s sensible dividend

Felix Salmon
Mar 19, 2012 19:20 UTC

Historically I haven’t been a fan of people saying that Apple should start paying dividends. I didn’t like it when Jon Fortt pushed it in 2007, and I didn’t like it when Arik Hesseldahl had the same idea in 2008. (Although by that point I did concede that “a modest dividend, tied to profits, makes perfect sense”.) Fast forward to 2012, however, and I think that Apple’s announcement is a perfectly sensible one, and if anything overdue.

The problem with most people asking for dividends and stock buybacks is that they generally have a pretty stupid argument, along the general lines of “If X declared a dividend, its stock would go up. Stocks going up are a good thing. Therefore, X should declare a dividend.”

That argument doesn’t even make much sense: if cash leaves the company and goes straight into shareholders’ pockets, the value of what’s left behind goes down, not up. If a company gives a bunch of money back to shareholders and its value goes up as a result, then it has much bigger problems than not paying dividends.

Apple’s stated reason to start paying dividends is simple: it has more money than it knows what to do with. Fortress balance sheets and strategic flexibility are all well and good, but there comes a point — around $100 billion, it would seem — at which you can buy anything you could conceivably desire, and still have more than enough money left over. So if Apple can’t use that money, give it back to shareholders, who surely can.

The stated reason for Apple’s stock buybacks makes perfect sense too. A large part of Apple employees’ compensation comes in the form of equity in general, and restricted stock units in particular. When those RSUs vest, all other shareholders get diluted. So to prevent that from happening, Apple’s going to buy back roughly as much stock as it’s issuing.

Now the kind of people who look at Apple as a stock first and as a company second are not going to be happy about this. And weirdly, leading that charge today is the Wall Street Journal, and its Marketplace editor Dennis Berman. Shortly after Apple’s dividend was announced, the flagship @WSJ Twitter account, with more than 1.5 million followers, told them all that “Apple’s cash pile exceeds the GDP of more than two-thirds of the world’s countries.” That’s a classic case of comparing apples with oranges: the cash pile is stock, while GDP is flow. And it’s exactly the kind of unhelpful and misleading statistic that the WSJ should be trying very hard to avoid.

Shortly afterwards, the same @WSJ account retweeted SmartMoney:

Apple’s dividend looks so stingy, writes @jackhough, that the company belongs on “Hoarders.” http://t.co/2cgCC931
Mar 19 via TweetDeck Favorite Retweet Reply

And the griping didn’t stop there.

Apple’s 1.81% dividend yield is hardly exceptional. A comparison: AT&T: 5.61%, Verizon 5.09%, MSFT 2.42%, HP 2.01% http://t.co/JHBfcGDs
Mar 19 via TweetDeck Favorite Retweet Reply

It’s almost as if the WSJ doesn’t understand that Apple’s dividend yield is not under its control. Apple can set the level of its dividend; it can’t set the level of its share price. Is the WSJ really implying that Apple should wish for a lower share price, so that its dividend yield goes up? After all, at $10.60 per year, Apple’s dividend is fully 3% of where its stock was trading as recently as November. What’s more, at $9.9 billion per year, Apple’s dividend is very close to being the highest in the world. Here’s the league table, as of Friday:

Company Annual dividend
(billion US$)
AT&T 10.17
Telefonica 9.97
Exxon Mobil 9.02
Vale 9.00
PetroChina 8.41
Vodafone 7.08
Royal Dutch Shell 6.88
Total 6.77
General Electric 6.46
Pfizer 6.23
Johnson & Johnson 6.16
Chevron 6.14
Procter & Gamble 5.77
HSBC 5.59
Verizon 5.56

If you look down this list, it’s not really the kind of company that Apple particularly wants to keep. AT&T is returning more than $10 billion a year to its shareholders; I’m sure that all of us who use its service could think of a few areas that money could easily be put to good use. And five of the top eight companies on this list are in the commodities business; the other three are telecoms. Not a single company on the list could realistically be considered a growth stock or a hotbed of innovation.

But the people who prefer financial engineering to, well, real engineering are never going to be happy with Apple’s conservatism. Dennis Berman made his own Cracker Barrel barb, and then followed up with this:


There is no reason for Apple to issue debt: companies issue debt when they can invest it and get a good return on their investment. But as we’ve seen from Apple’s cash pile, Apple has essentially nothing to invest in at all. So long as there’s a cash pile, issuing debt would only make that pile go up, rather than down, while forcing the company to pay interest for no good reason. Having a cash pile and issuing debt is a bit like having a CD and running a balance on your credit card: idiotic.

And Berman’s wrong if he really thinks that Apple could issue debt cheaper than the US government. Companies which can borrow more cheaply than the US government are a bit like those faster-than-the-speed-of-light subatomic particles: if you look more closely, they turn out not to exist after all. The US Treasury can borrow more cheaply than anybody else just because the US Treasury market is much more liquid than the market in any other fixed-income name. Which in turn is a function of the fact that there are $11 trillion of Treasury bonds outstanding. I think we can safely say that Apple’s never going to borrow anything near that much money.

Now Apple could, if it wanted, declare a monster special dividend, get rid of all its cash, borrow lots of money, use that money to buy back stock, and generally lever up in the name of financial engineering. That would be rather worrisome, I think, to the vast majority of Apple’s shareholders — and it would certainly be worrisome to any potential buyers of Apple’s bonds. Basically, Apple has two choices when it comes to debt. It can issue debt while it’s already sitting on lots of cash, which is redundant and stupid. Or it can get rid of all its cash before it issues debt, in which case it could no longer borrow at ultra-cheap rates, and it would lose a lot of strategic flexibility at the same time.

So well done to Tim Cook for announcing a sensible dividend at a sensible time, when Apple’s throwing off enormous amounts of cash and there’s nothing obvious to spend the money on. And well done too for ignoring the noise coming from the financial media, who think that his company is simply a stock price. It isn’t, and I sincerely hope Apple never ends up that way.


A few months ago, Olympus fired their recently promoted CEO, and said he didn’t fit in with their culture, as he was British. But he claimed it was because he asked uncomfortable questions about where the company had been spending money, and it turns out they were falsifying their accounting, and had lost hundreds of millions of dollars (it might have been billions, but it was a very material amount). For example, they had bought a face cream company for over $700M, and it was worthless. Ultimately, the COB and other execs were fired, and the multiple governments are investigating. The scale of the cover-up was shocking, as it went far beyond expense account fraud.

Most telcos and carriers’ finances are scary, but you have to believe that people will keep their phone service even when the economy tanks. In addition to DT, I also have TEO, which is small but doesn’t seem to have a lot of debt, pays a big dividend (there’s a catch with it, and I don’t know it, but I don’t have a lot invested there).

Posted by KenG_CA | Report as abusive

Did the market know about Apple’s announcement?

Felix Salmon
Mar 19, 2012 05:47 UTC

On Tuesday March 6, Apple shares opened at $523.66. On Thursday March 15 — eight trading days later — they opened at $599.61. Which means that over the course of those eight trading days, the market capitalization of Apple increased by more than 70 billion dollars.

Let’s put that in perspective: the market capitalization of Molson Coors is $8 billion. The market capitalization of Staples is $11 billion. The market capitalization of Yahoo is $18 billion. The market capitalization of eBay is $48 billion. The market capitalization of Nike is $51 billion. The market capitalization of Goldman Sachs is $63 billion.

Apple isn’t just worth more than those companies.  (In fact, it is worth more than double all those companies combined.) The point I’m making here is that if you take the amount that Apple was worth on Thursday morning, and subtract the amount that Apple was worth eight days earlier, the difference is more than the total value of any of those companies, up to and including Goldman Sachs.

To a first approximation, there was no news about Apple that emerged over the course of those eight days. The only real thing we learned was that the new iPad had sold out, which, well,  would have been more surprising if it hadn’t.

Now, however, there’s news — real, market-moving news, about what Apple’s going to do with its $100 billion or so in cash. As Chris Tolles drily puts it, that news is evidently “so huge that it propagated backwards in time”.

aapl.tiff Apple stock closed on Friday at $585.57 per share, after a run-up all but unprecedented in the history of mega-caps. Back in November, when I was remarking on how cheap Apple seemed, the stock was $363 per share; since then it has added $208 billion in market cap. That’s more than the valuation of Google. So one way of looking at the crazy price action of the past couple of weeks is to chalk it up to the astonishing power of momentum.

Alternatively, you could just say that the stock market has been slow to price in what has been clearly evident since February 23, when Apple CEO Tim Cook said at the company’s annual meeting that Apple has more money than it needs, and that he and the board were nearing a decision about what to do with it.

But still, it is a little bit suspicious that Apple’s big announcement is coming immediately after one of the largest and fastest rises in market capitalization that the stock market has seen since the dot-com bust. Or even during the bubble, for that matter. Look at Apple in the famous context of Amazon. On December 16, 1998, when the stock was trading at $242, Henry Blodget put a price target of $400 on the company. On January 6, 1999, Amazon hit $400. Amazon had grown its market capitalization by $13 billion in 14 trading days, which means that its market cap was increasing at a rate of just under $1 billion per trading day. If you look at those eight days of Apple trading, by contrast, the company’s market cap was increasing at a rate of $8.9 billion per day.

Given how unusual it is for a company to see its capitalization rise so astonishingly quickly, it’s reasonable to raise an eyebrow at the timing here. On Monday, Apple will make its announcement, and the stock will rise, or it will fall. But if it falls, that won’t necessarily mean that the market is disappointed in what Apple is announcing. It might just mean that the announcement got more than fully priced in, over the course of the past couple of weeks.


KenG_CA has a valid point, about actual ability to realize the full potential of wireless.

Regardless, I was just ruminating on Apple’s decision. Both parts: The dividend ($40bil? $45bil?) and the share buyback ($10 or $15bil? I’ve seen different breakouts). I couldn’t find any recent history of Apple stock repurchases. Given the company’s inclination to hold on to cash after the bad times in 1995, I suppose that’s consistent. There are various reasons to do a share buyback. Poor stock price performance clearly isn’t one of them for Apple! Is there any significance to this decision, the share buyback now?

Posted by EllieK | Report as abusive