More Evidence of Pre-IPO Valuation Shell Games (LNKD, RENN, GSVC, P)

We have said it before… Some of the current initial public offerings with very low share floats and some of the valuations of these private (semi-public) companies are in some cases no different from the tracking stocks of the late-1990s.  If you want some evidence that the valuations are getting stretched, don’t just take our word for it. BDO USA has a study out today that hints at more and more skepticism about high valuations in the pre-IPO sector today.  What makes this study unique is that it gets into the mindset and opinions of investment bankers.  24/7 Wall St. has its own take here that is only magnified by this, and we have some direct examples pointing to this.

While we did not see figures of the numbers, this is within the investment banking community itself.  The study was in telephone interviews where interviewers “spoke directly to capital markets executives within a scientifically-developed, pure random sample of the nation’s leading investment banks.”

BDO is of course the former home of the former Bill Seidman, and this firm is very well-respected.  BDO USA’s study indicates that “capital markets executives at leading investment banks clearly have conflicting opinions of pre-IPO Internet businesses and the private marketplaces where their shares are traded.”  Again, this is based upon banker survey results, so it is similar to interviewing the fox that gets to watch over the hen-house.

While some 79% of the investment banking community feels private marketplaces are having a positive influence on the U.S. IPO market, BDO noted that 75% feel that “the multi-billion dollar pre-IPO valuations of many Internet businesses are not justified.”  Again, “the multi-billion dollar pre-IPO valuations of many Internet businesses are not justified.”  If you want it in a different way, 62% of those surveyed “feel the chances of a second dot-com bubble, similar to the 1990s, is at least somewhat likely.”  Our only comment is that when you add in “at least somewhat likely” that it leaves too much wiggle room.

Lee Duran, a Partner in the Capital Markets and Technology Practices at BDO USA, noted, “…looking beyond the offering transaction, the bankers clearly feel the limited volume of shares in the private market is inflating valuations of these businesses to the point that they have concerns that a bubble may be developing.”

Another figure is that 71% of those surveyed feel that the small volume of trades in the private, pre-IPO marketplace “has served to inflate the value of these businesses and a majority (64%) of the capital markets executives are in favor of the SEC easing constraints on the number of shares that can be issued and the amount of capital raised prior to these businesses being forced to go public.”

The report’s results are shockingly not very self-serving either.  BDO said that 38% of the investment bankers said their own industry would be the primary industry hurt if more regulations come down on pre-IPO situations.  The two others hurt would be VCs and private equity.  What is odd is that 20% of the responses from bankers did not really believe any one group would be disproportionately affected.

Here is where the BDO report defines the valuation bubble.  Some 34% cited share scarcity in pre-IPO markets as hyping demand.  Another 25% attributed the valuations to the growth of the Internet itself and another 22% cited the profitability of the businesses creating the valuations.  Another 19% responded that the positive performance of recent Internet offerings is the primary driver behind these valuations.

Jay Duke, a Partner in the Capital Markets Practice at BDO USA, noted, “At the same time, any comparisons between today’s market and the dot-com crash of the late 1990s are simply not accurate.”  The difference is that there are sound business models now rather than just concepts.  with real customers, real revenue and real profits. Moreover, they all benefit from the enormous growth of the social and mobile Internet market over the past decade.”

So, where does this leave us?  24/7 Wall St. is not alone in questioning some of the pre-IPO and some of the post-IPO valuations.  LinkedIn Corporation (NASDAQ: LNKD) just re-hit $100 again for the first time since its IPO.  Its actual float is so small that the $9.4 billion valuation is not representative of the actual market.  Our belief is that the valuation would be at a considerable discount if the company would have sold 40% to 70% of its shares.

Groupon’s IPO will be similar, as will that of Zynga.  LinkedIn may trade at a premium, but it does have barriers to entry.  Groupon and Zynga have good well-known and well-respected names, but there is quite literally zero barrier to entry.  Local.com just proved that yet again yesterday.  Both companies (Zynga and Groupon) also either have a complicated share structure or only plan to float a small percentage of the authorized shares at the time of the IPO.

Renren Inc. (NYSE: RENN) was valued very high from the start, but after “The Facebook of China” turned out to be “The Face%^&* of China” after its growth was overstated and after its audit committee head resigned it suffered some of the same.  Renren will also face high dilution ahead and the founder is still the majority owner.

Pandora Media, Inc. (NYSE: P) was another “gap and crap” IPO that came public with a fairly low-float IPO that has since recovered handily from the lows.  We even called this one a “value trick” on its pricing. This one hit $26 on the IPO date and rapidly cratered to under $13.00.  Now shares are close to $18.50.

What the real valuation of Facebook is depends upon whom you ask.  A a company called GSV Capital Corp. (NASDAQ: GSVC) recently announced that it was taking a small stake in Facebook and the value then was somewhere around $70 billion.  GSV’s shares have soared ever since.

Another business development company launching in a closed-end fund soon looks to avoid the greatly overvalued companies is Keating Capital, which plans to have a public float of its shares later this year.  It specializes in pre-IPO situations, but it also sure sounded like it does not want to endlessly chase valuations if they get out of whack with reality.

Our suggestion is the same as it always has been… KNOW WHAT YOU ARE INVESTING IN.  If you are comfortable with the risks, then fine.  If you buy just because you want a piece of a company at any cost, don’t be shocked when you are complaining to your friends at the bar about how the Web 2.0 bubble ate your money.

Back to the BDO study… If this survey was just coming from multiple investors and market pundits, we would note that it is another bit of guesswork.  This study was conducted with investment banking professionals which are also the ones who help decide what prices IPOs or pre-IPO M&A should be.  If the foxes watching the hen-houses are telling you that there is reason to worry about the hens, then what more do you need to hear?

JON C. OGG