What 2017's Worst IPOs Have in Common

Sixty days after going public, shares of YogaWorks (NASDAQ: YOGA) and Chicken Soup for the Soul Entertainment were down by at least 40% from their IPO price. Shares of toy manufacturer Funko (NASDAQ: FNKO) fell 41% in just the first day of trading.

These businesses -- yoga studios, video curators, and toy producers -- have virtually nothing in common, except for how they went public. They were sold to the public through "mini-IPOs," raising less than $50 million under Regulation A+, a special type of public offering process with fewer restrictions and less regulatory oversight.

Investors who want to avoid the worst IPOs might want to write off Reg. A+ IPOs in wholesale. Here's why.

The upside to Regulation A+

Regulation A+ is well intended, put into place by Title IV of the Jumpstart Our Business Startups (JOBS) Act of 2012. The rules allow for really small companies to raise up to $50 million in a 12-month period, with fewer restrictions, making it easier, and more cost-effective, for small companies to raise capital.

One of the biggest differences is that Regulation A+ enables businesses to sell shares direct to the public, raising funds from ordinary people, rather than professional investors. Whereas large companies are restricted from marketing their shares, many Regulation A+ companies have gone so far to solicit investments from the public on Facebook and other social-media sites.

It's seemingly a win-win deal. Small companies find it easier to raise money, and individual investors get the opportunity to invest in companies at the ground floor, rather than see the gains accrue to venture capital investors on Sand Hill Road.

The Wall Street Journal summed up the subject succinctly, using virtual-reality company Oculus VR as an example of how Main Street investors missed out on big investment wins because companies couldn't sell securities direct to the public:

The downsides of Regulation A+

Many of the advantages of Regulation A+ are also disadvantages. Anyone can invest in Reg A+ IPOs, and where there are limitations, investors have to simply "self-certify" that they aren't investing more than they can afford to lose.

The ability to advertise shares for sale to the public makes issuing stock easy, but it also means average Joes who can't tell the difference between an income statement and balance sheet are being pitched shares of money-losing companies.

Companies that sell less than $20 million of stock to the public can even save money by avoiding auditing costs, which makes Reg. A+ IPOs cheaper, but it also leads to questions about how much you can trust the financial statements in the first place.

All these risks, though, are plainly disclosed, assuming investors read the long prospectuses that accompany one-sheets and marketing materials pitching bite-sized IPOs. The real risk is hidden: What if Reg. A+ IPOs are inherently a last-ditch fundraising method for companies that have no other choice?

Reg. A+'s fatal flaw

In my view, the fatal flaw with Reg. A+ is simple adverse selection. Good companies have a myriad of ways to raise $50 million privately and easily. That leaves the "bad" companies to sell direct to individual investors by way of a Reg. A+ offering.

Understandably, $50 million may sound like a lot of money, but on an institutional level, it's peanuts. Thousands of companies and funds exist for the sole purpose of making similarly sized investments in small American businesses. More than 50 publicly traded business development companies invest in Reg. A-sized businesses day after day.

Last year, private equity funds collectively invested in 748 small business deals with a combined value of $36 billion, according to Pitchbook. That's $48 million per deal, on average, in line with the $50 million maximum raise through a Reg. A "mini-IPO."

If you see a pitch for a Reg. A+ IPO, perhaps the best question you can ask is, "why me?"

With so many easier ways for companies to raise amounts up to $50 million, it's likely that the companies that choose to raise small sums from the public are the companies that simply had no other choice. Investors who want to avoid the worst IPOs should run from Reg. A+ companies like the plague.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.