Affirm, Motorsport Games Show the Stock Market's IPO Process Is Still Broken

The stock market was on the rise Wednesday, bouncing back from early choppiness as investors started to look forward to what they hope will be a brighter 2021. There are still plenty of long-term concerns for market participants to deal with, but at least today, they largely chose to focus on the positives. By the close, the Dow Jones Industrial Average (^DJI -0.11%) had sunk back into negative territory, but the S&P 500 (^GSPC 0.02%) and Nasdaq Composite (^IXIC 0.10%) were higher.

Data source: Yahoo! Finance.

One sign that stock market participants are engaged and interested in putting their money to work with new investments is that initial public offerings are getting plenty of attention. Today, both Affirm Holdings (AFRM -2.08%) and Motorsport Games (NASDAQ:MSGM) had their IPOs, and both stocks jumped out to huge gains.

Yet what some see as healthy IPO demand is actually a diversion of capital away from ordinary investors and the companies in which they want to invest. Instead, Wall Street institutions and a select group of their privileged clients end up getting discounted prices on shares that are worth far more in the open market -- leaving most would-be shareholders left to fight over the scraps.

Image source: Getty Images.

2 more big "wins" for IPOs

Shares of Affirm Holdings opened for trading in the early afternoon on Wednesday. The stock opened at $90.90 per share, up more than 85% from where the IPO initially priced. It closed even higher at $97.24.

Meanwhile, shares of Motorsport Games opened higher by 75%. They were trading on the open market by around 11 a.m. EST, and the stock closed right where it had opened, at $35 per share.

Demand for shares of both companies had been heavy. Affirm had initially set a range of $33 to $38 per share for its offering. Underwriters boosted that higher to between $41 and $44. As it turned out, the final IPO price went out at $49.

For Motorsport Games, an initial range of $16 to $18 per share for 2.35 million shares ended up growing to a larger offering of 3 million shares with a higher range of $19 to $20. The IPO ended up pricing at the $20 mark.

Who's getting rich?

Judging from the news, you'd think that these first-day IPO pops would be good news for the companies and their investors alike. But in reality, the wealth doesn't necessarily go where you'd expect.

Take Motorsport Games. It sold 3 million shares and got $20 per share for the stock. That will mean $60 million in proceeds, less the fees that the underwriters and others helping on the IPO will charge. If it had been able to sell those shares at $35, the price at which the stock opened, then it would've gotten $105 million. That would be $45 million more in cash that Motorsport Games could use to further its video game and esports business -- cash that would raise the stock's intrinsic value.

Instead, that $45 million essentially went to those special investors who were allotted shares in the IPO. They had the right to pay $20 per share and then turn right around and dump them on the open market for $35. Doing so would've risked their ability to get IPO allotments in the future, but there was no legal restriction on their ability to do so.

Meanwhile, the underwriters got an additional bonus. Not only do they receive fees from the company, they also retained the right to buy an additional 450,000 shares at that same $20 share price. Again, Wall Street will pay $9 million for shares that would've been worth $15.75 million, another $6.75 million taken away from Motorsport Games.

The stakes were far higher for Affirm, as were the potential lost profits. Its IPO involved 24.6 million shares at $49 to raise more than $1.2 billion. Selling those shares at $90.90 each would've put more than $1 billion extra into Affirm's pocket, which it could presumably use toward growing its consumer installment-lending business more quickly. The underwriter overallotment of 3.69 million shares gives underwriters a first-day paper profit of $178 million, not a bad bonus on top of the fees they already charged Affirm.

The alternative to a broken IPO system

This ruthless siphoning of money away from companies and ordinary shareholders is a key reason special purpose acquisition companies (SPACs) have become so popular. SPACs allow investors to get in on a potential going-public transaction before the price pop. Rank-and-file shareholders can therefore participate in some of the same opportunities that currently go to elite Wall Street customers.

To be sure, the SPAC process isn't perfect, either. The SPACs themselves go through a traditional IPO process, where favored clients get cheaper shares. Moreover, institutional investors are able to jump in on an acquisition through private investment in public equity (PIPE) financing, getting to add capital at the original SPAC share price even when the actual SPAC shares have since jumped substantially.

Regardless, IPO hype distracts from the beneficial function of letting ordinary investors put their money to work in innovative new companies, and turns it into an engine to perpetuate wealth inequality. Ordinary investors don't have a lot of choice right now, but they can hope that current trends toward IPO alternatives will pan out well.