Robinhood Markets, the commission-free stock trading and investing service, has been front and center in headlines in recent years -- for both good and bad reasons. While the app has helped introduce many first-time investors to the financial markets, it has also been the recipient of severe scrutiny.
As the company gears up to go public, here's what investors should know.
The business model
Robinhood's mission is to "democratize finance for all." Ever since the company's initial launch, Robinhood has differed from its financial peers and challenged the traditional money-making path of brokerage services. By eliminating commissions and allowing its users to buy and sell securities for free, Robinhood was able to lower the barriers to entry to financial markets and attract many first-time investors.
Although Robinhood doesn't charge any upfront fees for trading, that doesn't mean the company isn't making money. Robinhood generates the majority of its revenue through a system called payment for order flow. This means that as Robinhood's users input trade orders on securities such as stocks, options, or cryptocurrencies, those orders get routed to other companies in order to be executed. These other companies referred to in Robinhood's S-1 as "market makers" then compensate Robinhood for the transactions depending on a range of characteristics including order size and security type.
While this system might sound complicated, it pretty much boils down to transaction volume. The more transactions processed on Robinhood's service, the more money Robinhood brings in.
Robinhood by the numbers
The last 12 months have helped Robinhood deliver outstanding growth financially. Fueled by government stimulus and lockdowns amid the pandemic, many individual investors poured an unprecedented amount of money into the market. For Robinhood, this meant more transactions.
Driven by a doubling in monthly active users and an annual growth rate of 321% in assets under custody (the fair value of securities held in all customer's accounts excluding margin balances), Robinhood generated $522 million in revenue in the first quarter of 2021 alone -- 309% more than the year prior. While that growth is certainly eye-popping, it did come at a cost.
Due to the rapid acceleration in users partially spurred on by the Gamestop (GME 4.33%) craze in March, Robinhood was forced to raise more than $3 billion in convertible notes to help support the costs associated with the increased transaction volume. This drove a 158% annual increase in first-quarter operating expenses for the company.
Don't overlook the risks
While the headline growth is no doubt exciting, Robinhood's business also possesses some serious risks that are worth investor consideration.
According to its own S-1, Robinhood currently has several ongoing legal proceedings that could result in potential losses for the company. While many of these disputes might not produce anything meaningful, they are still something investors should be aware of.
Some of these legal proceedings include about 50 putative class action lawsuits that have been filed against the company in various states, 1,600 jointly represented individuals who might pursue arbitration, and $70 million in penalties recently charged by regulators.
Aside from the legal risks, there are some business model concerns as well. For example, roughly 6% of the company's overall first-quarter revenue was derived from Dogecoin transactions. While the actual merits and value of Dogecoin are heavily debated, a decline in the sentiment for that cryptocurrency could lead to a significant decrease in transaction volume, and in turn, a sizable reduction in revenue for Robinhood.
Though it's certainly possible that Robinhood could continue to grow and be immensely profitable in the future, the risks that I just mentioned could also cause significant investor losses, and for me, that's enough to stay away.