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Beware of the Hidden Risks in Owning Shares in Alibaba’s IPO

Alibaba’s Unique Structure fraught with Danger for Potential Shareholders

Caveat emptor is a term that fits the upcoming IPO of China’s e-commerce giant Alibaba. The risk is due to the unique ownership interest in the company. This is an interesting IPO because it is a foreign entity and the American Depositary Receipts (ADRs) that will be offered in the IPO do not represent interest in the shares of Alibaba. In fact, the shareholders are a small group of under 20 Chinese individuals, including Jack Ma, the company’s chairman and co-founder who will see his net worth skyrocket when he sells only a small portion of his holdings, retaining a stake of nearly 8 percent. Ma could gain $803 million in the IPO, and his remaining shares would be valued at nearly $12.2 billion.

The ADRs represent interest in a Variable Interest Entity (VIE) that has contracts with Alibaba, not ownership interests of the company. First, a lesson on what is an ADR and VIE. An ADR is a stock that trades in the U.S. but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American stock markets just like regular stocks, and are issued/sponsored by a U.S. by a bank or brokerage. A VIE is an entity (the investee) in which the investor holds a controlling interest that is not based on the majority of voting rights. It is used by companies to transfer risk to the VIE and away from its parent company.

Alibaba is preparing for a splashy coming out party that will stretch from New York to Hong Kong and back again. The company plans to kick off a long-awaited roadshow for potential investors this week that is the start of a formal effort to entice interest in what could be the biggest stock market debut ever in the U.S. if Alibaba succeeds in raising its target goal of $21.1 billion. At the midpoint of its expected price range of $60 to $66 in the ADR, the company will be valued at nearly $156 billion. That is not far behind and more than e-Bay, LinkedIn and Twitter.

The price range filed with the SEC last Friday gives investors an important hook for valuing Alibaba. At $66 a share, the company would be trading at around 40 times its earnings for the 12 months through the end of March. That ratio is high compared with the broader stock market. But 40 times is below that of other fast-growing technology companies. Facebook’s shares, for instance, traded at over 80 times its earnings in the 12 months through June 2012.

So what are the unique risks in acquiring shares in Alibaba’s ADRs? Investors in the offering won’t have title to most of Alibaba’s Chinese assets because of Chinese prohibitions on foreign ownership. Instead, investors will wholly own the ADRs. Alibaba will wholly own its non-Chinese assets, which provide the bulk of its revenue, according to the prospectus filed with the SEC. Alibaba will not own most of its Chinese assets including Taobao Marketplace and So the companies that are the core of Alibaba’s Chinese operations – the main reason for the anticipated heated investor demand – will not even be owned by Alibaba.

The cannot ban offerings for being “too risky” or even for potentially being illegal. The only thing the SEC can do is require disclosure of the risks, which it has done here. Alibaba, in its prospectus, states that if the VIE structure is ruled illegal, then Alibaba’s business may be significantly harmed and substantial fines might be imposed. In addition, the Internet company acknowledges that the VIE structure may “not be as effective in providing control…as direct ownership.” The bottom line is potential investors should be aware of the risks of ownership including that the owners of Alibaba elect the Board of Directors of the company.

The biggest “red flag” for me is that through an internal reorganization, Alibaba reshaped its corporate governance structure and hired advisers to help prepare for the stock sale. This year the company hired an unheard-of six lead underwriters – Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley and Citigroup – to help plan the underwriting. The banks are expected to share to in an underwriting fee of about 1 percent, according to people with knowledge of the deal, or just over $200 million if the stock sale prices at the high end. All but one lead underwriter would reap about $31 million.

For me the ethical issue is rather than conduct due diligence, the banks stand to profit handsomely because of its conflict of interest that makes the ownership of Enron stock look like a walk in the park.

Blog posted by Steven Mintz, aka Ethics Sage, on September 9, 2014. Dr. Mintz is a professor in the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at:

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