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Spinning, Laddering, and Shorting (or, What's Wrong with our IPO System)

Spinning, laddering and shorting - they sound like exercise routines, but they're not. They're schemes used by investment banks during an IPO to take advantage of new companies. "IPO" stands for initial public offering and represents the first time a company sells shares in their company to the "public." (You'll find out later why that word is in quotes.) The best way to tell the story about IPO scandals is to hear the story about my own experience with - one of the most high profile Internet IPOs of all time. Even though the IPO was more than 4 1/2 years ago, revelations are still coming to light which demonstrate just how corrupt the whole process is.

In July of 1999, I headed out on a roadshow to kick-off's IPO. The roadshow was a three week whirlwind tour across two continents with more than 75 meetings. I was talking with money managers about digital music and more specifically about's business. After my presentations, I hoped that the investors would place a pre-order for shares. In the months prior to the roadshow we had hired an investment bank who had setup the meetings and travelled with us. A tremendous amount of work happens before a company can go public and it's the investment bank's job to oversee and assist in the process. In return for their help, they receive 7% of all money raised by the company. If this were the only monetary reward bankers received, I probably wouldn't be writing this essay. (Although some people rightly point that when every bank charges the exact same amount and has for decades, then there is obvious collusion.)

During the roadshow I met with about 100 potential investors trying to learn as much about them as they did about me and I dutifully kept a list of which meetings went well (placed into my "they get it" column) and which went poorly (into the "don't get it" column). If someone did not understand our business or did not like our business, then it would not make sense to have them as an investor since they would quickly sell the shares. Conversely, if someone appreciated our business then it would make sense to provide them with more shares since they would likely hold onto them. In addition, I had researched the previous holdings of many companies from public filings. I was surprised to see that many of the companies I was meeting didn't have any investments in Internet companies. Others had large holdings in companies like Yahoo! and Real Networks which indicated they had interest in building a portfolio of net companies for the long run.

At the conclusion of the roadshow, we had an amazing 20 times more orders than available shares and had to decide who got how many shares, which is called the allocation. The bankers are in charge of determining allocation, so I shared my research with them about which investors I thought it made sense to give shares to. I was assured that they would take my information into account when distributing shares. When the final allocation was provided to me I was stunned to find out that companies that had NO Internet investments were given a large number of shares. Others who openly were negative towards our business were given shares as well. Meanwhile, the companies I had rated highly, received only a tiny number of shares. Clearly something was wrong, but at that time I had no proof that there was unscrupulous hidden financial dealings.

More than two years later, an SEC lawsuit ripped the cloak of secrecy off IPO allocations scams. Instead of distributing shares to the best potential shareholder, bankers struck secret deals with the institutions that agreed to pay the most money by buying more shares (laddering), paying higher commissions, or agreeing to other financial transactions (spinning).

Besides allocation, banks also control the pricing of the stock which means they determine what the opening price of a share of stock will be sold for. Unfortunately the interests of the bank and the company going public are not aligned. Let's use an example to illustrate this: Say you were a car salesman and Toyota came to you and asked you to sell 100 cars for the best price you could, and they allowed you to sell the cars to anyone you wanted and to set the price. Undoubtedly most people would be inclined to set a slightly lower price for the cars making them a very good deal and then sell them quickly and easily to their best repeat customers, friends, business partners, etc. While that might be good for the car salesman, it is not good for Toyota since they're not going to be getting the best price they can for their cars. The same thing happens with bankers. They want to sell shares at a good price because they want to continue to do business with their best customers, but that doesn't help raise money for the young company. With, the shares more than doubled on the first day, demonstrating that bankers severely underpriced the shares when they set the opening price.

Earlier this month, even more corrupt dealings were uncovered related to the IPO. The bankers artificially forced the price up, then dumped more shares on the market to take advantage of this high price by shorting the stock ahead of other orders. There are even more examples of how was abused during the IPO process, but by now I'm sick to my stomach recalling all of them and you're likely tiring of reading about them. is not an isolated case, but a sign of a fundamentally flawed IPO process that exploits new companies. This is not to suggest that there are not honest bankers in the world or that all companies will be exploited like But the current IPO transaction is so riddled with vulnerabilities and conflicts of interest that there is a strong likelihood of exploitation.

W.R. Hambrecht & Co.There's a real opportunity to use technology to greatly improve the IPO process. Bill Hambrecht started his own investment bank with this goal in mind. He's built an innovative system called the OpenIPO which uses a dutch auction process designed by the Nobel prize winning economist William Vickrey. It permits any individual or company to bid on shares, not just a bank's best or largest customer. (Remember, the second letter in an IPO stands for "public" and that's who should be able to participate.) The initial price is determined by a predefined formula designed to ensure an optimum price. I'm convinced that the OpenIPO is a far superior way of doing IPOs that benefits companies and future shareholders. The sooner the investment community fully embraces it, the better.

If you'd like to know more about how an OpenIPO works, there's a great Flash demo online.

-- Michael

P.S.: Microsoft just sued in Canada. We'll have more information on this later, but in the meantime, we want to defend choice for the residents of our neighbor to the North. You can help at ChoicePC.

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