Blind Pool Bonanza for Some Investors, Gamble for Others

When Discovery Associates went public in February, the investors who put their money into the company didn’t know whether they would win, lose or draw. So far, they are ahead.

The 46 people who already owned Discovery stock, however, never had to sweat it out last winter. For them, the initial public offering was a bonanza, at least on paper.

Here’s why: Before going public, Discovery was owned by founders Harvey Bibicoff and Stephen S. Berglas along with 44 other private shareholders.

Those private investors acquired 675,000 shares shortly after the firm was established in August, 1984, for $176,900, or an average of 26 cents a share. Simply put, they got in cheap.

Not so for the investors who acquired stock later, in the public offering. They paid $2.3 million, or $3 a share, for another 776,250 shares. These securities came with warrants giving holders the right to buy more stock over a limited period at $3 a share.

At that price, the original public investors--who are in the black, given Monday’s closing bid price of $4.87 1/2--paid 11 1/2 times more per share than the private investors.

Because the company was almost nothing but cash, the public offering instantly boosted Discovery’s liquidation value from 13 cents per share to $1.45 per share.

Likewise, it increased the value of the stock held by Bibicoff, Berglas and other early shareholders. But it also meant that the public investors’ capital was redistributed and diluted--the company was left with only $1.45 in cash per share for every $3 the public investors just put in.

Norman Fosback, editor of the New Issues investment newsletter based in Fort Lauderdale, Fla., called that sort of dilution typical of blind pools, but nonetheless “disgraceful.” (Blind pools, or blank checks, are shell companies that sell stock to the public without disclosing specific business plans.)

“It’s a lot like buying a mutual fund for twice what it’s worth,” Fosback said. You’re putting in $3 and only $1.45 is working for you.”

As it sometimes does with highly speculative investments, the California Department of Corporations restricted the initial trading of the Discovery shares issued in February. First of all, the California investors who bought stock at the public offering had to be wealthy: They either needed to have a net worth--not including the value of their homes, furnishings and cars--that exceeds $150,000, or a net worth exceeding $100,000 and annual income of more than $65,000.

In addition, the investors who bought those shares were required to sign a statement indicating they understood that Discovery’s stock is speculative, that its founders acquired their shares at relatively low prices and that the company has not disclosed how it will use its funds.

Although those requirements no longer apply, California investors who want to sell that stock still are required to get permission from the state.

All that notwithstanding, Discovery’s stock has traded above its offering price ever since the company went public, a situation Bibicoff and Berglas attribute to investor confidence in the concern. Bibicoff and Berglas defend the structure of the public offering, noting that the private investors bore a greater risk because they were prevented by securities law from trading their shares for two years.

“When we got it for nothing, that’s probably what it was worth,” Bibicoff said.

Bibicoff said the 44 private investors that he and Berglas lined up were friends and business associates they believed eventually could help Discovery: investment bankers, stockbrokers, lawyers and business executives who might be able to find acquisition candidates. They each were allowed to invest up to $5,000.

“What I wanted them to have was a rooting interest,” Bibicoff said.

Bibicoff said he does not know who most of the current investors are. He said he suspects they were brought into the stock by brokers familiar with his work as a financial public relations specialist.

John C. Baldwin, director of the Utah Securities Division, who is a critic of blind pools, said many blind pool investors “know they’re gambling. They’re just banking that the stock will rise and that they’ll get out” before the stock collapses.