My father-in-law always used to say, “If you sleep with dogs, you wake up with fleas.”
Well, increasingly, it seems many founders – and their early investors – are discovering how painfully true that is, as the promise of an early IPO turns into a death trap for their businesses.
The Allure of Regulation A+
In 2012, the JOBS Act introduced Regulation A+ (Reg A+) as a means for small companies to raise capital from the public, without the regulatory burden associated with a traditional IPO. The idea was to democratize access to capital and enable emerging businesses to grow.
To a large extent, Reg A+ works as intended.
However, some founders have been tempted to use Reg A+ in ways that, in my view, undermine its original purpose. They rush from their Reg A+ to a direct listing on an exchange like the NASDAQ. They often do so prematurely, without a solid financial foundation or support from analysts or institutional investors, and with expectations of rapid growth that may not materialize. The results can be catastrophic: market caps virtually wiped out, share prices pummeled to penny stocks and limited options for additional capital.
Sleeping With Dogs…
How do you explain the decision to go public prematurely when the consequences can be so dire?
Some may not fully grasp the complexities of capital markets, or fall prey to pressures for liquidity, or simply feel overconfident in their business. In many cases, though, I believe unscrupulous bankers and broker-dealers play a pivotal role in orchestrating a financial death trap for these businesses.
Here’s how I believe the scheme typically unfolds:
Direct Listing and Small Broker-Dealers: Rather than pursuing a traditional IPO, many companies opt for a direct listing. This decision is driven by the desire for a faster exit. These companies engage small broker-dealers to handle the listing process.
Promotion of a Flip on First Day Scenario: The small broker-dealers actively promote a “flip on the first day” scenario to their clients. This scenario involves buying shares at the IPO price and quickly selling them when the stock begins trading on the NASDAQ. The broker-dealers pitch this strategy as low-risk because early investors often cannot transfer the shares they purchased into their brokerage accounts before the company’s listing – meaning there’s a delay before they can sell and exert downward pressure on the share price.
Listing Priority for Small Broker-Dealers: Small broker-dealers have the means to expedite the listing process with the transfer agent, allowing them to start trading on the day of the public offering. This creates a vacuum in the number of shares available for sale initially, artificially inflating the stock price.
Rapid Price Increase and Original Shareholders’ Selling: The stock price soars during the initial days of trading, with only the small broker-dealer clients selling their shares. However, this price increase is short-lived, and when the original shareholders are eventually able to sell their shares, the sudden influx of selling pressure causes the stock price to plummet.
Savvy Hedge Funds Shorting the Stock: Recognizing the lack of analyst and investor support and the impending price drop, savvy hedge funds short the stock. They profit from the decline in stock price, compounding the company’s troubles.
Once a company falls into this death trap, too often it’s management and early investors who are left grappling with the aftermath of the failed public offering. Meanwhile, the same bankers and broker-dealers they relied on turn a tidy profit.
How to Avoid the Death Trap
In the first place, I urge founders considering Reg A+ to use it in the spirit in which it was intended: access capital to grow your business, but don’t be blinded into taking a false shortcut to the NASDAQ.
In the second place, CEOs contemplating hiring a broker-dealer or a banker should go to https://brokercheck.finra.org and look up the broker’s regulatory record, and also look up the company. Making a decision on who to hire is critical, and far too frequently, bankers advise businesses without disclosing their discipline history.
It’s like my father-in-law always said, “if you sleep with dogs, you wake up with fleas.”
Howard Marks is the former co-founder of Activision Studios and is currently the founder & CEO of StartEngine, one of the largest equity crowdfunding platforms in the US. StartEngine was launched in 2015 with the mission to help entrepreneurs achieve their dreams while enabling everyday people to access private investment opportunities. Combined with its recent acquisition SeedInvest ($470M in historical funding), today StartEngine has a joint community of 1.8 million that has collectively committed over $1.2 billion in startups.¹ Beginning in 2020, Shark Tank’s Kevin O’Leary also joined StartEngine as a strategic advisor and spokesperson.2