Here's 1 Big Reason IPOs Are Risky

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Initial public offerings (more commonly known by the exciting, caps-lock scream of potential investing opportunity, IPOs) can be risky for many reasons. Here's one big reason many investors may forget to take into account: corporate governance policies that stink right out of the gate.

Although there are exceptions, many companies that have just gone public are relatively youthful corporate entities. You'd think they'd be untarnished by shoddy governance practices of their older corporate brethren and willing to do business in a more highly evolved way. Unfortunately, the new blood's been tainted by the old school; some of the hottest IPOs around these days have some pretty nasty corporate governance policies.

The trend's not shareholders' friend
Institutional Shareholder Services recently pointed to law firm Davis Polk & Wardwell's report on corporate governance trends at IPO companies. Unfortunately, most trends aren't moving favorably toward shareholder-friendly policies.

The firm looked at the 50 biggest newly public companies that went public between the beginning of 2009 and this August and compared them to a study they conducted on such companies in 2009.

Its most recent findings revealed that 78% of the companies had classified boards, 94% had plurality voting standards in place, and 74% required supermajority shareholder approval to amend corporate bylaws. Even worse, just 34% of the newbie companies had separated the chairman and CEO roles, a terrible backslide from 52% that had done so in the 2009 survey.

Hot IPOs' cold view of shareholders
Internet IPOs have been particularly hot stocks right out of the gate lately. Unfortunately, even at this early point, you can guess shareholder friendliness probably isn't big on their agendas -- even though one would assume these corporate managements appreciate investors plowing money into their businesses. (I know, I know, a lot of speculative investors pop in and pop out of 'em, which is part of the problem in the first place.)

Here's one danger sign we can glean already: these hot IPOs' managements desire access to public capital without ceding much if any power and control. Take recent high-profile IPO LinkedIn (NYS: LNKD) . It has a dual-class stock structure, which means regular shareholders like you and me have very little voting power. Some blazing-hot Internet IPOs past, present, and theoretically future also have this structure in place, including Google (NAS: GOOG) , Groupon (NAS: GRPN) , and Facebook.

Zynga, which makes the addictive Facebook game Farmville and is poised on the brink of its own IPO, actually has bucked the trend by doing things in a new and different way -- unfortunately, it's a way that's bad for shareholders. It's put in place an unprecedented three-tier stock structure, which would give CEO Mark Pincus 70 times more voting power than the suckers -- I mean investors -- who snap up shares should it go public.

The dangers of duality
Dual-class stock structures stink from a corporate governance standpoint. Although these structures don't necessarily mean you have to avoid the stocks altogether, investors should ponder how much they trust the managements of companies that have these shareholder-unfriendly policies in place.

Media companies like News Corp. (NAS: NWS) , Washington Post (NYS: WPO) , and TheNew York Times (NYS: NYT) are fond of these structures too; the recent scandal surrounding the News Corp. and the Murdoch media empire has underlined why shareholders might desire just a bit more sway at the companies they've invested in.

Along the lines of pondering management quality, investors should definitely think twice (or even 20 times) before buying into Groupon. Beyond its dual-class structure, Groupon only sold a miniscule 6% stake to the public. Even worse, the company used what TheNew York Times termed "adventuresome accounting" even before it went public, using gimmicky metrics that give investors almost no useful information.

Groupon's also given another very clear indication that management's out for itself. According to The New York Times, "Groupon founders and other insiders took $940 million that the company needs to revitalize its growth by selling stock back to Groupon in two separate transactions last year. That represented 84% of the total money raised until then." This was described as an unprecedented amount "clawed back" by insiders in historical comparisons to other companies, including Google and LinkedIn.

Investors, beware.

IPO pioneers fail on the corporate governance front
Fortunately, the news isn't all bad. The Davis Polk & Wardwell report spotted a few hopeful glimmers in the trends. For example, the survey discovered an average director independence of 74%, an improvement over 66% in 2009. Furthermore, among companies surveyed that have separate CEOs and board chairs, 65% had an independent chairman, versus 19% in 2009.

Still, investors who covet the hottest IPOs must be aware of the pitfalls, even beyond obvious risks such as lack of profitability, nascent technologies, tough competitive landscapes, and short-term stock price volatility. Given recent indications that negative outcomes (like the financial crisis) could be avoided through better corporate governance policies, managements at companies that are currently going public could have decided to carve more responsible paths in this area, but indications show they haven't.

If you're buying into a business for the long haul, keep an eye on the kind of corporate governance policies these newbies are putting in place. Otherwise, that hot IPO could leave you out of luck.

Check back atFool.comevery Wednesday and Friday for Alyce Lomax's columns on environmental, social, and governance issues.

At the time this article was published Alyce Lomax does not own shares of any of the companies mentioned. The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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