When Is An IPO Like A Ponzi Scheme?

Profitability is tied to today’s reality while stock prices are founded on tomorrow’s hopes and dreams.

DavidGrace
Apr 9 · 5 min read
Image by Clker-Free-Vector-Images from Pixabay

By David Grace (www.DavidGraceAuthor.com)

Did The Early Investors In Lyft Make A Mistake?

I recently published this column:

Are The People Investing In Lyft Brilliant Or Crazy? Is Lyft Another Google Or Another WebVan?

My answer to the first question I posed is: No, I don’t think that Lyft’s initial investors are necessarily crazy or foolish, even though I see no evidence whatsoever that Lyft will ever be profitable.

The Difference Between An Investment & A Loan

When an unsophisticated person learns that $5.1 billion dollars has been invested in Lyft, he/she may ask, “How long will it take Lyft to earn enough profit to repay all that money?”

Of course, that’s a silly question because the $5.1 billion dollars was an investment, not a loan.

While a company must repay a loan, it never has to repay an investment.

Investors Make Money By Selling Their Stock For More Than They Paid For It

Unsophisticated people often don’t understand that investors don’t expect to get their money back in the form of dividends which are distributed to shareholders from company profits. Investors expect to make a profit by selling their shares to other people at a higher price than they paid for them.

It’s The Stock Price, Not Profitability, That Counts

As long as the people who gave Lyft $5.1 billion dollars think that they will be able sell those shares to other people for more than $5.1 billion dollars, they don’t care if Lyft ever makes one single penny in profit.

When you buy stock at an IPO, you’re investing money in the company. When you later sell that stock, the money you get does not come from the company. It comes from patrons of the Wall Street Casino who are gambling that they will later be able to resell the shares they’re buying from you to someone else at an even higher price.

The theory that stock prices reflect the company’s profitability and that when companies are profitable their stock price goes up and when companies lose money their stock price goes down is not always true.

In reality, stock prices are not necessarily rigidly tied to profitability.

The Stock Price Does Not Always Reflect Profitability

Profitability is based on the company’s actual success in the market today while the company’s stock price is based on people’s predictions, assumptions, theories and aspirations about the company’s future business success in some distant tomorrow.

Put another way, profitability is tied to today’s reality while stock prices are founded on tomorrow’s hopes and dreams.

Once you realize the disconnect between a company’s profitability today and the price of the company’s shares today, you begin to understand why some people were willing to invest $5.1 billion dollars in a company (Lyft) whose costs are running at 140% of its revenues and which has revealed no plan, numbers or mechanism explaining how or when (or if ever) its income will exceed its costs.

How Long Will The Music Continue To Play?

Investing in a new company can be like playing a game of Musical Chairs For Money. The crucial factor in winning or losing is not the ratio of the number of contestants to the number of chairs. No, the key metrics are:

  • How many people you think will pay to join the game
  • How high an admission fee you think they will be willing to pay, and
  • How long you’ve calculated the music is going to last

If you figure that the orchestra is going to keep on going for another hour and you’ve got a plan to cash in your winnings and leave the building in twenty minutes, you don’t care by how much the number of contestants exceeds the number of chairs.

What Is A Ponzi Scheme?

At its heart, a Ponzi Scheme is a business model where money from new customers is used to pay a dividend to old customers. As long as the business stays alive, old customers will continue to receive money. If the business survives long enough, the earlier customers will get all of their money back plus a profit, all derived from contributions by the later investors who will not recoup their investment.

The oldest participants will make money while, eventually, the newer ones will get screwed.

How An IPO Can Be Like A Ponzi Scheme

An IPO for a company that will never make a material profit works the same way.

Selling stock in a company that has a lot of hype and sizzle but which will never make a profit is essentially the same as running a Ponzi Scheme where the older investors get paid by the newer investors until public confidence in the enterprise’s viability eventually collapses and the most recent purchasers lose all.

So, the angel investors might sell some of their shares to the VCs and the VCs might sell some of their shares to the public and the people who bought in the IPO might sell their shares to other people who think that the company is going to be another Google or Facebook, and so on, until the company’s cash runs out and it’s still not making a profit and the banks and the VCs all know that the end is near and, presto-chango, the company goes down in flames, the price of the shares falls to zero, and you have another WebVan or Pets.com.

BTW, if the ride-sharing business interests you, take a look at this column from the Chicago Tribune Uber and Lyft are losing money. At some point, we’ll pay for it.

The Bottom Line

So the mere fact that I have seen no numbers or business plan showing that there is any material chance that Lyft or Uber will ever break even, leastwise be materially profitable, does not mean that the people who were early investors in those companies are necessarily foolish.

It may just mean that they’ve calculated that the music will continue to play long enough for them to escape the building with substantial winnings before the rest of the investors are left standing around in silence and without a chair.

— David Grace (www.DavidGraceAuthor.com)

To see a searchable list of all David Grace’s columns in chronological order, CLICK HERE

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DavidGrace

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Graduate of Stanford University & U.C. Berkeley Law School. Author of 17 novels and over 200 Medium columns on Economics, Politics, Law, Humor & Satire.

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