One week ago, shareholders of Poway's deeply troubled computer marketer Gateway blew an opportunity to rein in one of capitalism's ugliest abuses: cheap insiders' stock.
In initial public offerings (IPOs), company founders -- executives, venture capitalists, investment bankers -- get shares for pennies while the public pays hard dollars. Also, executives regularly get cheap shares through options grants.
A proposal presented to Gateway stockholders would have forced insiders who get their stock for low prices to hold on to at least 75 percent of them. After all, if an executive or board member pays a penny a share for stock, while the public pays $15, the insider can still make a bundle of money by selling shares before a collapse.
Gateway opposed the motion. And despite management's dismal recent record, institutional shareholders and friendly stockholders in Sioux City, Iowa, the original headquarters, sided with management. The reform proposal got only 23 percent of the vote at last Thursday's annual meeting.
The motion by the American Federation of State, County, and Municipal Employees pointed out that in 2001, Gateway chief executive Theodore (Ted) Waitt had received stock options worth $22 million. His predecessor had received options worth $20 million in 2000 and $75 million in 1999.
The union's proposal referred to one of San Diego's most egregious national embarrassments. The September 2, 2002, online issue of Fortune magazine featured five executives, called "The Greedy Bunch," on its cover. These were insiders who had massively unloaded their companies' stocks as they plummeted in price by at least 75 percent from January 1999 through May 2002. Two of the five were San Diegans: Waitt, who had jettisoned $1.1 billion of Gateway stock, and John Moores of Peregrine, who had dumped $646 million of his company's shares.
Waitt and his brother founded Gateway on an Iowa farm in 1985. The company went public in late 1993. Waitt's founders' stock cost-per-share was very slight. Of the $1.1 billion worth of stock he sold, all were founders' shares except $25 million worth of option shares.
Moores was not a founder of Peregrine, but, adjusted for splits, he had paid only 33 to 59 cents a share.
Waitt was truly diversifying. He still owns about one-third of the stock of Gateway, which has plunged from above $80 to around $3. But Moores sold almost all of his Peregrine shares, which plummeted from around $80 to well below $1. (Both companies are now under criminal investigation for financial fraud.)
For many years, company founders have received their stock for pennies each. The practice isn't necessarily illegitimate but can be a license to steal. For fast-buck artists, the idea is simply to peddle shares in an IPO, whether the company is truly operational or not. As soon as buyers gobble up the super-hyped IPO, the insiders are fabulously wealthy without having put significant money into the pot.
However, in days of yore, a company would not go public until it was profitable, or close to making money, and had some assets. That changed with certain techs, and particularly biotechs, in the past several decades.
Beginning in the 1970s -- and escalating in the 1980s and wild 1990s -- biotechs would go public and state that they wouldn't make money for ten years or so. There are restrictions on how fast insiders can dump shares, but a ten-year window gave them plenty of time for big talk and even bigger selling.
Biotechs would say they were working on a cure for lymphoma, say. Wall Street would estimate how much of the lymphoma market the company would garner in ten years, and then conclude that the stock was worth $XXX in current dollars. That $XXX was invariably well above the offering price in the IPO -- one of several reasons, including manipulation, why the average IPO soared 75 percent on its first day in 1999.
San Diego has had its dillies. In 1989, Immune Response, seeking a cure for AIDS using techniques of the renowned Dr. Jonas Salk, announced it would go public for $13. The prospectus revealed that insiders had received their shares for one-fourth of one cent each. Salk had received 400,000 shares for that puny price. Kevin Kimberlin had received 900,000 shares for a fourth of a cent in 1986 and sold them a year later for $2 each.
Market conditions delayed the offering, but the company finally went public in 1990. Insiders who had received shares for a fraction of a penny continued to sell. Outside investors lost big. Through the end of last year, the company had a cumulative operating loss of a whopping $257.8 million and had never generated a penny of revenue from commercialization of a product. Its accounting firm had serious doubt about its ability to continue as a going concern.
Another biotech, Advanced Tissue Sciences, filed for bankruptcy last fall. Five founders got shares for a penny each, and four bailed out above $10, but Gail K. Naughton, a scientist and now dean of the College of Business Administration at San Diego State, didn't sell -- to her credit, although some shareholders criticized her for taking loans from the company.
In July of 2000, biotech Illumina went public at $16. The first trade was almost $30, and the stock closed on that day at $39.17.
The chief executive, Jay T. Flatley, received one million shares for nine cents each. David Walt, a founder, received his one million for a penny each. Venture capitalist and founder John R. Stuelpnagel received his 550,000 shares for between a penny and 40 cents each. Ditto for founder Mark S. Chee. Founder Anthony W. Czarnik got 425,000 shares for a penny to nine cents each. Founder Lawrence Bock received 68,750 for a penny each, and Richard T. Pytelewski received 109,167 shares for three to nine cents each.
In 2002, the company lost $40 million. It has never made money and has an accumulated deficit of $90 million. The stock is now below $2.50. There has not been major insider selling.
The concept of founders' shares has its defenders. North County's Herb Greenberg, a columnist for Fortune and TheStreet.com, says founders' stock can be a good tool for emerging companies to use in attracting scientific and management talent. "I would be more concerned about the guy who runs a company and goes from startup to startup and plays the game, sucks investors in -- he can make money each time." San Diego has several such promoters, says Greenberg.
Attorney James Krause, who specializes in investment fraud, says founders' stock has its uses. For example, he doesn't criticize Naughton, who hung on to her Advanced Tissue shares. But it's a red flag if the founders got their cheap stock a couple of months before the public offering. Also, "The risk is that they go public without the hope of a product," says Krause.
In decades past, "Companies used to have book value per share before they went public," says corporate-compensation expert and former San Diegan Graef Crystal. "Now they have a lab, intellectual assets. Somebody comes up with cockamamie valuation metric. It's a dirty game -- use some phony price, go public, get a huge bump, make millions."
Securities fraud attorney Mike Aguirre says that the dumping of cheap founders' and options-acquired stock is especially noisome when earnings are puffed up through financial engineering. When con artists, parading as venture capitalists, take a bunch of companies public, get cheap shares, and bail out of them for enormous profits before the inevitable implosions, then it's a case for criminal authorities, Aguirre says.