Six-packs, macaroni and software

Does stuff you like make for stocks you should hold? And why do companies offer "affinity groups" cheap stock when they go public?


Mark Gimein
August 20, 1999 8:00PM (UTC)

Ken Hansen is a computer consultant in Bridgewater, N.J., who happens to have tinkered with the Linux operating system on one of his computers. When Red Hat, a Linux company, offered programmers a chance to buy shares in its initial public offering, he qualified for the program. "When I got the e-mail from Bob Young [the chief executive of Red Hat], I saw the offer as free money," says Hansen, who figured the stock would likely triple on its first day of trading.

It did better. Hansen got 400 shares at an offering price of $14 when Red Hat's stock came on the market Aug. 11. He sold 200 shares at $84 each. Hansen planned to hold on to 200 more for the long term. But on Wednesday he came into the office and saw Red Hat dropping to $60. He thought, "The geeks are dumping their shares," and within hours he was out, selling his remaining 200 shares at $70.50. Total profit: $31,000. Red Hat's goodwill, says Hansen, more than covers his plans for a year of graduate school.

Advertisement:

Red Hat's affinity program offer has drawn a lot of publicity -- not all of it good, but the company is far from the first to sell offering-price stock to a preferred group. TheStreet.com, an online financial magazine, let 5,000 randomly chosen subscribers buy shares in its offering in May. E-Loan, a mortgage broker, offered shares to every customer who had gotten a loan through the online service.

And that's just a small part of the very recent history of selling shares to your customers. Savings and loans, like California Federal, have sold offering-price shares to their depositors. Notices of an impending IPO have been put in six-packs of beer. Annie's Homegrown, a maker of all natural macaroni and cheese, told its customers about its IPO with a notice in the pasta box -- the bankers who handled the offering say people would generally discover the note as it hit the boiling water.

The traditional theory behind selling stock to your customers has been that customers who already use the product will be "buy and hold" investors -- long-term believers who like the product and expect a lot more people to use it. It doesn't hurt that, say, if you own stock in Annie's you might be a lot less likely to switch to Kraft.

Now the Internet has arrived, and like a lot of other things in the financial markets, this theory has been turned upside down. The point of giving away stock in a technology company is now not, in large part, to gain long-term investors. It's to give free money to loyal friends and users, and to create a lot of buzz in the press and plenty of positive word of mouth.

Take the case of E-Loan. At the end of June, the company offered shares to every person who had gotten a loan through the online service -- about 7,000 total. Around 1,000 people took E-Loan up on the offer and E-Loan wound up selling them 50 shares each.

The right to buy E-Loan shares at the offering price of $14 a share was a hot commodity. Speculators trolled the Net in the hopes of getting a "backdoor" password to buy shares. "EELN password/login wanted -- will trade for it!" one stock trader with the online handle "keylinm" posted in a message on the stock discussion site RagingBull.com.

Advertisement:

There was good reason for this. The stock did bounce up on the first day of trading, closing at $37 a share. In the next week, in a highly speculative market, it went as high as $63. The payoff for selling fast was big -- the stock is now near $25 a share -- and that doesn't really bother E-Loan executives. You might think that E-Loan executives feel cheated by customers who took the opportunity for a quick profit. But they don't.

"Our chief reason for the directed shares program was to reward our customers," says Sharon Ruwart, E-Loan's vice president of marketing. "Whether they used it to make some quick cash or keep it for the long term was entirely up to them. We weren't concerned, because our objective had nothing to do with whether they held their stock."

Red Hat offered a lot more shares -- 800,000 of its 6 million share offering -- than E-Loan. That makes Red Hat's offer less of a gimmick, but many of the principles involved (buzz and quick reward for a preferred group of people) are the same. Plus, Red Hat managed to expand the market for its stock with people who don't usually find themselves playing the market.

Until about three years ago, it was almost unheard of for newly issued stock to double in value on its first day of trading. Traditionally, bankers hoped for a jump of 10 to 20 percent. But in a market dominated by speculation, all bets are off.

Advertisement:

Affinity programs might have started as a way to get long-term investors, but in a case like that of Red Hat, there is an enormous amount of incentive to sell fast, as Ken Hansen did. The irony is that it's very likely that in a lot cases, people like Hansen, who take their cheap affinity-group shares and run, will turn out to be making a very wise investment decision.

Peter Lynch, one of the leading gurus of personal finance, famously has told investors that he often buys stock in companies whose products he likes. It's an appealing proposition: Surely companies with products you use have something going for them.

But it doesn't always turn out that way.

Advertisement:

The notice in the six-packs came from the Boston Beer Co., the makers of Sam Adams beer. Exactly 30,000 beer drinkers got 33 shares apiece, at $15 a share. The stock ended its first day of trading at $28. Investors who "flipped" it and sold immediately made more than $400 off their 33-share allotment.

For customers who held on to their shares, however, it was all downhill from there. SAM, the ticker symbol for the Boston Beer Co., fell below $10 a share by the beginning of 1997, and that's where it has stayed. The beer still tastes good. It's just that the market for microbrew stocks tanked.

"The general pattern," says Jay Ritter, a professor at the University of Florida and the leading academic expert on initial public offerings, "is that people have trouble distinguishing between what's a good company and what's a good investment."

Advertisement:

Investing in products you like sounds like a good idea, but the irony involved in companies selling stock to their customers is that, in some sense, the dice are loaded. You might think Sam Adams beer or Red Hat software or Annie's pasta is really good, but it's very dangerous to conclude anything from this; the fact that you like the product is the very reason you are being offered stock in the company in the first place.

Annie's Homegrown is perhaps the nightmare example. In 1995, the company did a "direct public offering" -- rather than going through underwriters to be listed on a stock exchange, it marketed its stock entirely to consumers, with pasta box inserts and a prospectus on the Internet. The public offering price was $6 a share. If you hope to find out whether the investors have made a profit or lost money by checking the stock's current price, however, you are out of luck.

Small companies without big investment banks or analysts telling investors about them tend to drop off the map because of a shortage of buyers and sellers. In Annie's case, the stock doesn't trade at all. In practice, this means that Annie's stock certificates are worthless. If you want to talk to Annie's about that, you're out of luck too. The company doesn't even have an investor relations person. Even the chief financial officer doesn't like to talk about stock issues, referring questions to the president of the company. Fat chance that you'll have much luck there either. When called for this article, the president of the company was traveling and could not be reached; company founder Ann Withey, says the Annie's operator, "almost never gives interviews to the press."

Was Annie's disingenuous in selling its customers shares that turned out to be no more than pieces of paper? It's hard to say. The pasta, after all, is still just as good as ever.

Advertisement:

It's not likely that E-Loan or Red Hat will be another Annie's, but thinking they'll soon get above their stratospheric early prices is a very risky bet. As Hansen asks: "Is Red Hat really a $6 billion company?"

The big irony of efforts like those of E-Loan and Red Hat is that, finally, companies that sell stock to their friends and customers are getting exactly the investors they deserve. Financial types have long known that their customers are a much easier sell than gray-suited institutional investors. The funny thing is that the customers now seem to approach the process with as much cynicism as the companies themselves. The companies sell shares cheaply to generate buzz, the customers flip them quickly to generate quick cash, and nobody is the loser except, in some cases, for the few patsies who thought that it was all great products and long-term growth.


Mark Gimein

Mark Gimein is a staff writer for Salon Technology.

MORE FROM Mark Gimein

Related Topics ------------------------------------------

Linux

BROWSE SALON.COM
COMPLETELY AD FREE,
FOR THE NEXT HOUR

Read Now, Pay Later - no upfront
registration for 1-Hour Access

Click Here
7-Day Access and Monthly
Subscriptions also available
No tracking or personal data collection
beyond name and email address

•••


Fearless journalism
in your inbox every day

Sign up for our free newsletter

• • •