The Robinhood financial app is all about democratizing investing – and it has done something with its own initial public offering, or IPO. The broker allowed its clients to participate in its much-anticipated IPO, which began on Thursday on the Nasdaq stock exchange under the symbol HOOD. Robinhood shares were priced at $ 38, but then fell rapidly.

Robinhood’s decision to provide access to its clients is a welcome change from the typical IPO, where preferred clients of underwriting banks and other privileged groups typically get the lion’s share of the offering.

But that access might not matter much to an average Robinhood client, as he was still unlikely to be selected to participate in the IPO. Here’s how Robinhood’s unusual IPO came about and five key risks for the company’s investors.

Robinhood Hot IPO: Everything You Need To Know

Robinhood led one of the hottest IPOs of 2021, and it’s one of the biggest in the biggest year ever for IPOs. Of course, Robinhood has had its share of fame – or notoriety – over the course of the year. Paramount was his role in GameStop’s short squeeze, in which he angered customers for restricting trading in high-profile stocks and others just as the frenzy was peaking.

Now, the app that has long touted its ability to bring investment – or perhaps just trade – to the masses has itself hit the auction block. But unlike a traditional IPO, where all shares go to those with internal connections, Robinhood has reserved up to 35% of its stock for sale to its own clients, through the company’s relatively new IPO Access program. , which allows its customers to enter. on IPOs. In this case, it was Robinhood’s own actions that were accessible.

“It’s a positive thing and they strengthen their own ecosystem,” says Sam Hendel, president and portfolio manager at Easterly Investment Partners in New York. “They are true to their motto of democratizing markets and giving customers access to markets.

Who is actually able to buy the shares was hit or miss, the company said. And a quick analysis of the numbers shows that any individual investor was likely to get very little, even if the numbers look good for all of their own clients.

In fact, IPO underwriters have reserved 20-35% of the offering for Robinhood clients. With up to 60.5 million shares offered for sale, its customers saw around 21.2 million allocated to them in the most optimistic scenario. That sounds like a lot until you see how many clients the broker has quickly built up due to their no-fee trades.

Robinhood reports that he had 22.5 million funded accounts as of June 30. Thus, if the IPO shares were distributed evenly across all funded accounts, each account could have access to less than one share. Even if Robinhood had only selected 1% of its clientele to participate in the offering, they could have bought less than 100 shares each on average.

So while the intention to expand access to an IPO may be good, the net effect of this move is next to nothing for nearly all of Robinhood’s clients.

Hendel acknowledges this, but says, “The average Robinhood account is much smaller than at E-Trade or Charles Schwab, but access to even a few stocks is much more meaningful than for clients of another brokerage. He adds that Robinhood’s move could also keep these clients “stickier” to the broker himself.

5 risks that Robinhood’s IPO faces

Like any business, Robinhood comes with a number of risks, and below are some of the most important to investors.

1. Assessment

Robinhood valued its stock at $ 38 per share, giving the company a total market cap of around $ 32 billion. It looked like an exhilarating assessment by most measures.

For example, Robinhood has assets in custody of approximately $ 102 billion as of June 30. Meanwhile, his rival Charles Schwab declared $ 6.69 billion in client assets at the end of 2020. So what are investors paying for each broker’s client assets at this IPO price? stock Exchange ?

* Assumes the target price of the IPO

The table compares what an investor pays for $ 1,000 in client assets from each broker. As you can see, investors paid a lot more for Robinhood’s assets than Schwab’s. At the IPO price, they paid $ 314 for every $ 1,000 in client assets, compared to $ 19 at Schwab. In addition, Schwab relies on more diversified sources of income such as interest income, management fees for running various funds and managed portfolios, although Robinhood is also looking to diversify.

2. Profitability

Investors will also want to get a sense of how profitable Robinhood is, although they may not. In 2020, the broker reported a profit of $ 7.5 million, after losing more than $ 106 million in 2019. The numbers for 2021 are going to look thorny, however, mainly due to technical accounting details, and management. sees a loss of between $ 487 million and $ 537 million in the second quarter, according to the recently revised prospectus.

Besides the technical aspects of accounting, the company identifies increasing costs due to a 190% increase in staff and increased cloud infrastructure. Both are due to the surge in clients, so they should be welcome, at least as long as the broker makes a profit on these new clients.

Considering all the numbers moving right now, it might be better to look at earnings, and it peaked – up around 129% in Q2 (median estimates). The 2020 income surge has helped Robinhood go from a loss of the previous year to a small profit, which may well be the case beyond 2021 if income continues to grow rapidly. That said, 2020 was the first year Robinhood has actually made a profit, so its record of earnings is uneven.

3. Double share class

Robinhood has a dual class of shares, a structure that many investors do not like. A dual share class allows insiders to own a type of stock that has more voting rights than what is granted to regular investors, removing insiders and giving them more control over the company. But these are features, not bugs, for insiders that benefit, as many recent tech IPOs have the structure.

In the case of Robinhood, insiders have access to Class B shares, which gives them 10 votes per share. During this time, regular investors can buy Class A shares, which offer one vote per share. The CEO and chief creative director together will own around 15.8% of the total capital, but they will have more than 65% voting control of the company, given the structure.

So what they say is fine, at least on the issues that are put to a vote. This structure annoys many investors, who see it as a way to take their money without giving them so much control.

4. Fearful investors

Giving your own clients access to up to 35 percent of your stock in the IPO is a bold move. Will a large portion of these stocks be immediately sold on the market? Will these investor clients look for an IPO on Day 1 and then sell if they don’t get it? Or are they there for the long haul? The reaction of this group of investors could affect the performance of the stock and similar future IPOs.

The answer isn’t entirely clear here, but if the IPO is successful – defined as a rise in shares in the following days, weeks, and months – it may be of interest to other companies looking to raise. funds from individual investors or through Robinhood’s Access IPO.

“It’s a little too early to say if this will become a normal thing, but with all the activity from Reddit and retail investors in the market, companies can be looking to see if they can access these investors,” said Hendel. “Having access to these distribution channels can be helpful for businesses that fundraise. “

And, of course, a rise in the share price would benefit Robinhood itself.

5. Risks related to the economic model

Investors should take a close look at Robinhood’s business model, which relies heavily on payment for the flow of orders. Paying for Order Flow is a technical way of saying that Robinhood is paid by trading companies to get their customers’ orders to them. These companies ultimately profit by charging investors a little more on their purchase of a security and offering them a little less on their sale.

It’s a conflict of interest, of course, but many companies do. But the real point for Robinhood is that that revenue stream accounted for 81% of its total sales in the first quarter, according to the prospectus, as the SEC begins to take a closer look at the practice while weighing potential stocks. If the SEC makes significant changes, it could hurt the business model of the company.

However, Hendel considers the SEC unlikely to take meaningful action, although he says if they do, it could be seriously damaging to the broker’s business.

But even though the rules on order flow payment don’t change in a major way, Robinhood still depends substantially on high levels of trading activity. There is therefore a strong incentive to encourage clients to trade, even though active investing tends to be less profitable for individuals than passive investing.

At the end of the line

As with any IPO, investors need to ask, “Why is the company involving the public in the deal if it’s such a good thing?” And “Why go public now?” In the case of Robinhood, the answer to the last question may be that the market is white-hot, after more than a year of gains fueled by low interest rates, massive government spending and animal spirits.

So it’s no surprise that a financial app that thrives on trading activity uses the hottest IPO market ever to help bolster its business while it has it. occasion. The fact that Robinhood is cutting off clients for part of the stock is perhaps less a matter of democratizing finance and more of selling its stock on terms that are very attractive to the company itself.

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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past performance of investment products is not a guarantee of future price appreciation.