If Robinhood got something right, it is that he sells for free.
Before triggering a stock market storm last week, investors in Robinhood, the trading platform based in Menlo Park, California, were very happy to continue fueling its growth. Now they have no choice.
Robinhood faced crippling cash demands brought on by a subgroup of Reddit called WallStreetBets, which was raising the price of shares in companies, including GameStop and AMC, which were targets of well-known short sellers. The stated objective: tighten the shorts. The volume of orders that followed pushed Robinhood into complicated territory with his cash position, when the clearinghouse that helps the company process and settle trades asked the company to raise more capital to meet margin requirements. Robinhood responded by restricting the trading of 13 shares on Thursday, infuriating WallStreetBets investors and causing the prices of those shares to fall.
To stabilize, Robinhood, founded in 2013 by Vlad Tenev and Baiju Bhatt with the mission of “democratizing finance”, turned to early investors to raise more than $ 1 billion in a matter of hours. The New York Times reported on Friday that the bailout funds came from previous venture capitalists, including Sequoia Capital and Ribbit Capital. Meanwhile, after the platform reopened for full trading on Friday, amid criticism and a class action lawsuit alleging that it prioritized its sophisticated customers over retail investors, prices for these shares rose again. At the close of Friday, GameStop and AMC shares were up 400 percent and 278 percent to $ 325 and $ 13.26, respectively for the week.
The large stock market, however, took a beating, with S&P losing almost 2% in part because the hedge funds that shorted these companies had to sell other shares to cover their losses.
Prior to last week’s $ 1 billion infusion, Robinhood had received $ 1.7 billion from major Silicon Valley stores, including New Enterprise Associates, Kleiner Perkins Caufield & Byers and Andreessen Horowitz, as well as from famous investors like Ashton Kutcher, Jared Leto, Snoop Dogg, and John Legend. With additional rounds of financing, its valuation soared to $ 11.2 billion in August 2020, from $ 8.3 billion in May. The company had revenue of about $ 60 million in March, triple the previous year, it said Bloomberg in April. Robinhood did not respond to Inc.’s interview request.
Still, investors have limits, says David Yermack, professor of finance at New York University’s Stern School of Business. He notes that when the GameStop price drops – and will almost certainly fall – some customers will face margin calls and will not be able to refund Robinhood because they have bought too aggressively. “There is a risk that Robinhood himself will fail because they concentrated too much exposure on this high-flying action,” he says. “That’s why they went out and raised $ 1 billion from big investors.” He adds that existing investors will support him – but perhaps not forever.
The price of ‘free’
The experience may also drive one more nail into the coffin of the “freemium” business model. As a broker without a commission, Robinhood gives up what used to be the industry standard, a fee of $ 6 to $ 10 for each transaction. Yermack notes that he makes money indirectly, potentially charging higher prices than other brokers. It also charges for order flow. Robinhood’s trades, which may include stocks, ETFs, cryptocurrencies and options, are sold to large companies like Citadel Securities and Virtu Financial, known in the industry jargon as “market makers”. These market makers run Robinhood’s trades, sometimes at reduced rates, and provide a small commission to Robinhood. The process is controversial, but so far it is not illegal.
The company also makes money from its premium services. It launched Robinhood Gold in 2016 to provide features such as the ability to trade before and after hours in exchange for a monthly fee.
The freemium model has been a reference in the digital market for years. After building a customer base offering a basic product or service, it is assumed that a certain percentage of these users will purchase premium or upgraded versions. Yet other companies never count on consumers to pay. Like Facebook, Robinhood gets most of its revenue from customers willing to pay for access to its users. And therein lies the problem, says Jason Nazar, a technology entrepreneur and investor at Facebook and other companies. “Inherently, I think there is room for conflict whenever you have a company that serves two masters. You have your end users who provide data and information and then you have your customers who pay your bills. Which side do you fall on? ” he asks. “I think what you’re going to find is that more companies are likely to make mistakes on the side of their end users instead of their data partners.”
In fact, if Robinhood is guilty of anything, it is not being perfectly transparent about his revenue model, says Ethan Kurzweil, a partner at Bessemer Venture Partners in San Francisco, where he focuses on developer platforms and digital consumer technology. “I don’t know how well it was known how Robinhood makes money until this recent press round about them.” That opacity became clear when users themselves pointed out, on social media, the irony of Robinhood restricting his access on Thursday, while the company’s big clients were supposedly allowed to close their positions. The company denies this claim.
Either way, Robinhood will clearly need to repair his image. And Kurzweil suggests that other startups entering the freemium space will be kept to a higher standard of messages and disclosures as a result of this calamity. To be clear, he says, freemium is not going to disappear. “People like it for free … but maybe there are only a few companies where there is a disconnect in terms of what people believe is the cost they are paying, and maybe Robinhood is an extreme example,” he says. “I think people will definitely apply more skepticism when monetization is not clear and well understood.”
Entrepreneurs themselves are also likely to be more careful in the future, says Nazar. “What you will see is that companies with business models like this will have to be much more careful and diligent about when these conflicts can arise and how they want to deal with them,” he says. “My guess is that Robinhood is already kicking himself for the way they communicated.”
This will not be the end of Robinhood, however. If anything, says Kurzweil, the company could end up in an even stronger position, as it will be much more capitalized and will be able to deal with potentially serious cash demands more readily in the future. The Wall Street daily reported on Friday that there was excess demand from investors in Robinhood’s last round and that the company could raise hundreds of millions in the next few days or weeks. “My guess is that they are evaluating the value of their investment,” says Kurzweil. “All this attention in the end can bring more users to Robinhood.”