Robinhood’s (HOOD Stock) IPO: All you need to know

Stockbrokers used to be boring. In fact, most still are. Consider some of the biggest ones in the US such as Interactive Brokers, Fidelity, TD Ameritrade, Vanguard, and E-Trade. They only make the news when they are involved in mergers or takeovers, such as Charles Schwab’s recent acquisition of TD Ameritrade and Morgan Stanley’s purchase of E-Trade.

In contrast, the stock trading app Robinhood is rarely out of the headlines, and usually for the wrong reasons. This doesn’t appear to have done the company much damage, however. Despite many controversies that have dogged the company during its short history, and after a failure to go public earlier this year, Robinhood filed for an Initial Public Offering (IPO) on 1st July, just one day after being hit by a record $70 million fine by its regulator. It’s not known how many shares will be made available, or the price, but it’s understood Robinhood will make 35% of them available to retail investors. Some analysts are forecasting that the IPO could put a $40 billion valuation on the broker.

What does Robinhood offer?

Robinhood won’t be the fastest company to go public from start-up, but it hasn’t taken too long. It was founded in 2013 and initially offered a snappy, gamified app where, with no money involved, its young followers could ‘trade’ various stocks and boast of their paper profits to other users. The brokerage service followed two years later. But in the interim, Robinhood boasted that it would ‘democratise’ trading and be commission-free. This certainly piqued the interest of a young crowd, as did the gamification aspect where winning paper trades were greeted by showers of confetti, just like those on popular UK bingo sites.

Robinhood quickly established itself as a disruptor. The commission-free offer soon forced the major established brokers to follow suit. On top of this Robinhood was attracting a younger demographic that found its smart and snappy trading app more user-friendly than traditional platforms. Robinhood’s democratic ‘trading for everyone’ approach appealed directly to this audience, as did the ease with which trades on company shares, ETFs and cryptos could be executed. Robinhood also offered fractional trading whereby its customers can buy a small percentage of a share, like Trade Nation’s Mini-Rolling share offer. This made highly priced stocks such as Amazon, currently valued at over $3,400 per share, accessible to a wider customer base.

By early 2020 Robinhood had 13 million reported customers, the same as TD Ameritrade which can trace its beginnings back to 1971. By March this year that had risen to 18 million funded accounts with $81 billion in assets under custody. As such, it’s understandable why there is considerable interest in its IPO. Robinhood will list on NASDAQ, the preferred destination for tech and growth stocks.

How does Robinhood make money?

Robinhood doesn’t make money through commissions from its customers but the broker does charge other fees. ‘Robinhood Gold’ account holders trade on margin so Robinhood takes payment in exchange for lending the funds to these customers.

The company also earns interest on the cash held in its customers’ accounts, but makes around half its money through ‘payment for order flow’. When customers trade through Robinhood’s app, the orders are bundled up and sent over to a third party such as the market maker Citadel Securities. They fill these bundled orders and pay Robinhood a commission. These commissions amounted to $720 million in 2020, a 514% increase on the previous year, making up around 75% of Robinhood’s revenues.

Robinhood is reported to have made $331m in the first quarter of 2021 from customers’ trading activity. Not bad considering how different the trading environment in the first three months of 2021 was compared to the same period last year.

What are some of Robinhood’s main controversies?

Payment for order flow

Payment for order flow has proved highly controversial. In fact, it is banned in several countries including the UK. This helps explain why Robinhood’s plans for global expansion are currently on hold. Also, last September the SEC investigated Robinhood’s practice of selling on clients’ orders. The company was accused of failing to disclose these payments and ended up settling the case for $65 million. This, however, hasn’t put off new customers who continue to sign up at an astonishing rate.

GameStop and Reddit

At the beginning of this year followers of WallStreetBets, a subreddit on the Reddit online social forum, rushed to buy stocks of heavily shorted companies such as GameStop, AMC Entertainment, Blackberry, and Bed Bath & Beyond. Many were following the lead of thread member ‘Roaring Kitty’ who calculated that GameStop’s shares were seriously undervalued. It didn’t take long for the WallStreetBets crowd to also work out how heavily shorted GameStop was. This was the trigger for a surge of buying which ultimately saw the stock rally from around $20 to over $480 in the space of a fortnight. The event was seen as the small retail traders taking on the might of Wall Street hedge funds.

Much of the retail buying was done through Robinhood which gained around 3 million new customers in a very short space of time. The stocks in question experienced huge volatility and then, without warning, Robinhood put trading limits on their customers’ orders, citing capital requirements. This caused huge controversy as it looked as if Robinhood, previously the small trader’s friend, was in truth allied with Wall Street. If Robinhood’s customers couldn’t buy shares in GameStop, the short-selling hedge funds were off the hook.

Lack of support for inexperienced traders

In September 2020, the Massachusetts Securities Division argued that Robinhood’s gamified app was enticing novice traders to take on risky trades without explaining to them the full dangers. Earlier that year a young customer committed suicide after believing he had lost $730,000 by using the app when he hadn’t. Robinhood was accused of failing to provide support and risk management training and was sued. According to the latest IPO filing, Robinhood has settled with the family. The broker has always defended its app as being straightforward, accessible, and able to attract a new audience to share dealing. But this didn’t stop the company from removing gamification features which sounds like a good move as the IPO approaches.

Privacy and legal issues

In July 2019, Robinhood admitted that it was storing customer passwords in a readable form across its internal systems. Later it turned out that up to 2,000 customer accounts had been hacked. Then in November 2019, a platform glitch was uncovered which allowed Robinhood Gold users to borrow unlimited funds by selling covered calls. The following month the Financial Industry Regulatory Authority (FINRA) fined Robinhood $1.25 million for failing to ensure that its customers received the best price for orders.

The company was also sued for failing to report its fractional share service. This was introduced in 2019 but the company only started publicly reporting trade executions in January 2021. In early March last year, Robinhood suffered an all-day outage as the Dow Jones made its biggest ever daily point gain in history. This was one of the issues, alongside improperly approving some inexperienced customers for options trading, leading to the record $70 million fine imposed by FINRA.

What is Robinhood actually worth?

In September 2020, Robinhood was valued at around $11.7 billion following a funding round which raised $660 million. The company raised a further $3.4 billion in February this year and given the current levels of active users, it could be in line to post revenues of between $1-2 billion. Overall estimates put a $40 billion valuation on Robinhood, although some say it’s closer to $20 billion when you take its long list of controversies into account. However, as the company has managed to bypass most issues without too much difficulty, investors may give it the benefit of the doubt. Given its popularity and the current stock market strength, it’s probably fair to look at $40 billion as nearer the mark.

Robinhood also has the advantage of being categorised as a fast-growing fintech corporation rather than a financial institution. This alone should warrant a high price-earnings (P/E) multiple. As far as its business model is concerned, payment for order flow is accepted in the US. And as for its customers, they appear to be a generation happy to divulge all kinds of personal information in exchange for free access to social media and similarly have no concerns about their personal information being sold on in exchange for ‘commission-free’ trading. Now it could get greedy in pricing the IPO, but if stock markets maintain their current strength, it looks as if Robinhood could have a successful NASDAQ launch.

Financial spread trading comes with a high risk of losing money rapidly due to leverage. You should consider whether you can afford to take the high risk of losing your money.

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