$HOODJuly 30, 2021
Robinhood went public on Thursday, the old-fashioned way — via an IPO with underwriters after a roadshow. The IPO priced at $38 per share, yielding a valuation of $32 billion, and closed its first day of trading down 8.4%. The trading company’s debut is the worst on record among the 51 U.S. firms that have raised as much cash as Robinhood. (Disclosure: I am an investor in Public.com.)
So what will $30 billion buy? At first glance, Robinhood is a roaring success. In 2020 it registered revenue of $959 million, a 245% increase from 2019. RH boasted 18 million monthly active users in March 2021, up from 7 million a year prior. And in keeping with the company’s thesis, “to democratize finance for all,” female users tripled over the past year and more than 25% of users are now people of color, significantly more than at the incumbent brokerage houses.
However … I’ve written before about the problematic aspects of Robinhood’s gamification of investing. The company preys on human weakness, in particular young men’s susceptibility to gambling addiction. That’s still true, and RH’s IPO warrants a deeper dive into the firm’s business model.
What Is Robinhood?
The company operates a mobile app that enables consumers to trade stocks, options, and crypto. These orders are the company’s inventory, which it sells to “market makers” — large financial institutions that pare (execute) the trades in the market. As with Google or Facebook, Robinhood’s users are not its customers, but its supply.
This means Robinhood is incentivized to keep its users trading … a lot. The goal: make stock trading as addictive as social media scrolling. RH has enjoyed success here. The proportion of users who check it daily rivals those of Twitter, Snapchat, and Facebook.
Various financial products drive the company’s revenue, but one is especially lucrative: options. RH makes at least twice as much per options trade than it does on a stock trade. Why? Because market makers pay more for options than stocks. Options trading is less liquid than stock trading, which translates to greater bid/ask spreads for the market makers. RH relies on market makers, and market makers love options. The transitive property tells us the company relies on options, as evidenced by its revenue mix. Despite making up only 3% of RH’s assets under custody, options drive 46% of total revenue.
FYI: Options don’t provide any actual equity in a company. They only let you buy or sell a stock at a given price within a finite period. Put another way, they are 1) highly speculative and 2) risky. RH is more gaming app than investment app. Keep in mind, 43% of its users have FICO scores below 650.
Payment for Order Flow (PFOF)
Robinhood’s incentive to drive investors toward day trading options is not the only fissure between users’ interests and its own.
The transaction at the heart of the company’s model is “Payment for Order Flow” or PFOF. Because RH generates its revenue by selling orders to market makers, it doesn’t charge commissions to its consumer users. But this also creates a conflict of interest for the company, which is motivated to sell orders to the market maker that offers the highest payment for the trade rather than the best price. It’s like affiliate marketing, but for your financial future.
PFOF goes back to the 1980s, when it was pioneered by, wait for it … Bernie Madoff. Madoff relied on the practice to make his firm one of the leading market makers of its day, and when regulators raised questions about whether it presented a conflict of interest, he used his position as the chairperson of Nasdaq to prevent restrictions. (PFOF is illegal in the U.K.) There was no conflict of interest, Madoff assured his colleagues, because “there are very strict rules that I would assume most firms comply with.”
Robinhood is the latest example of an increasing trend: tech companies for whom illegality is a feature, not a bug. Uber is an $86 billion gypsy cab company. Facebook and Google have received so many fines, it’s likely the companies internally classify them as a cost of doing business. This is tantamount to replacing civics courses with prison training, because … well … that’s how we roll.
For its part, RH has racked up: a $70 million settlement with FINRA, a $65 million SEC fine (for failing to properly disclose PFOF), and a separate $1.25 million FINRA fine. And on Wednesday, on the eve of pricing its IPO, the company disclosed that its senior executives are under investigation by FINRA for failing to acquire broker-dealer licenses. In addition, another inquiry is under way into the possibility that RH employees made illegal insider trades during the GameStop frenzy early this year.
Once, that type of disclosure would have dismembered an IPO. Instead, 48 hours after it made the disclosure, Robinhood was publicly trading at $32 billion. Telling point: The company paid its chief legal officer, Daniel Gallagher, more than $30 million in 2020, even though it hired him halfway through the year. From 2011 to 2015, Gallagher was an SEC Commissioner. Our business environment has morphed from capitalism, which depends on the rules of fair play, into cronyism.
Flouting the law is now a signal to investors that a firm is “disruptive.” Established companies, which believe they have too much to lose, have spent years investing in a culture of compliance to protect themselves. Disrupters, with access to cheap capital and few legacy assets, have no such constraints. In Robinhood’s case, no less an establishment bulwark than Goldman Sachs has blessed its approach to business by taking the lead on the company’s IPO. Forget orange — criminality without consequence is the new black.
The Soul of the New Machine
Robinhood made its “customers” feel special by reserving a third of the offering for them. But the deeper into the insider circle (early investors and employees) you go, the more special (and wealthy) it gets.
In February, RH issued $2.55 billion in tranche 1 convertible notes, which are to be exercised at 70% of the IPO price: That’s $26.60 a share vs. $38. This means the convert buyers saw an instant and guaranteed 43% gain when they woke up yesterday morning. There’s also $1.03 billion in tranche 2 converts that get the same deal. In addition, 27.8 million shares are reserved for future stock-based employee compensation. That’s more than $1 billion reserved, again, for the real insiders.
As for the RH users who were looking to capitalize on their “head start,” the immediate 8% loss will sting. But that’s what happens when your IPO values you at 33x annual revenue. By contrast, Charles Schwab is worth 11x revenue, despite yielding profits 3x greater than Robinhood’s revenue.
In practice, Robinhood’s activities look more like the dispersion of financial risk than the “democratization of finance” — kind of like if a for-profit prison claimed to be “democratizing housing.” As both an app and as an investment, RH makes more sense in the context of gambling than investing. Its business model depends on active traders, but research shows the more active traders are, the more money they lose. Likewise, the casino isn’t making much off the blackjack player who sits at the $5 table cadging free drinks, but it hopes the lure of easy money (and the lubrication of those free drinks) will loosen his pockets eventually.
Greater gambling access is becoming a trend. The illegal sports betting market, estimated at $150 billion a year, is rapidly moving to legal online forums. You can now place a sports bet from your couch in 20 states and counting, and mobile gambling apps are reaping the rewards. Since its SPAC listing in April 2020, DraftKings’ stock is up 160%. I don’t have a problem with this, as these firms state what they’re made for: gambling.
Another market that’s benefited from our insatiable appetite for risk? Crypto. Robinhood caught that trend early and introduced crypto trading to its platform in February 2018. Since then, the global crypto market has grown from $450 billion to $1.9 trillion. In the first three months of 2021, 6% of RH’s revenue came from Dogecoin trades. If that sounds like an unstable business model, trust your instincts.
Here’s what we’re saddled with: A trend of companies that prey on our financial naiveté, with no regard for law or morality and infinite amounts of capital. What can we do?
First, it’s long past time for the rule of law to reassert itself. Five years ago, admissions to elite universities were awash in bribery and fraud. Then the feds put some wealthy lawyers, investors, and television stars in jail. Did it work? I’d venture that if any parent receives an offer of a “side door” for their kid to get into an elite university today, the parent hangs up, crisply.
Second, we need to arm ourselves, and particularly our young people, with financial literacy. Everyone should be fluent in the basics of markets and how to build financial security. My NYU colleague Aswath Damodaran believes the best regulation is life lessons. Perhaps basic lessons in finance (e.g., not to trade on an app that harvests its orders for revenue) would lessen the pain of these lessons. If we can offer computer science and Mandarin in schools, we should offer courses in financial literacy. The English-as-a-second language course in any capitalist society ought to be in money.
In November 2017, Wisconsin passed a law requiring that personal finance classes be incorporated in K-12 curriculums. In 2019, New Jersey followed suit: Financial literacy education is now required every year of middle school. A start.
But according to PwC, only 24% of millennials have basic financial literacy. Meanwhile, the median age of the Robinhood user is 31. The company is covering its bases with an investing education website, Robinhood Learn, but that does little to nullify the toxicity of its platform.
The federal government hasn’t done enough either. The best the Financial Literacy and Education Commission could come up with was … another website. Its flagship education product, MyMoney.gov, received a whopping 700k page views in 2020 — less than a tenth the number of daily Robinhood users.
We’ve implemented policies in the U.S. that have resulted in a halving of the wealth of Americans under the age of 40 (as a percentage of household wealth) over the past three decades. With so much less to lose, today’s young Americans are justifiably looking for new asset classes and embracing volatility. Put another way, there is cause for a rebellion. The food industrial complex wants you to be fat, social media wants you to be divided, and RH wants you to believe you can get rich quick by day trading. Rebel.
Life is so rich,
P.S. Disruption is hot right now. I’m all for breaking the norms of both financial literacy and education to make them more accessible, and so I invite you to check out my next Section4 Strategy Sprint on Sept. 27. This two-week intensive course is designed to give you the tools you need to up your business strategy game. Sign up now.