Robinhood nears its biggest trade of all, an IPO, after wild year

 KEY POINTS

• Robinhood is one of Silicon Valley’s most valuable private companies and is expected to go public in the coming months in a deal that could value the fintech company above $30 billion. 
• The free trading app is thriving by most standards, despite a series of crises this year. 
• Some argue the app makes it too easy to trade and turns the investment process into gambling. But Robinhood paints its critics as out of touch and says millennial and Gen-Z investors prefer to invest this way. 

Avishek Das | LightRocket | Getty Images

Robinhood's list of recent challenges are hard to count on one hand. Yet the popular stock-trading app is growing faster than ever and is on track for a multibillion-dollar IPO in the coming months. 

In the past year, Robinhood has navigated a congressional grilling, trading outages and ensuing customer backlash. It has engaged in spats with regulators and two of the most famous investors on the planet, Warren Buffett and Charlie Munger. 

Still, Robinhood is one of the fastest-growing fintech start-ups and has risen to become one of Silicon Valley's most valuable private unicorns — and it is this year's No. 1 CNBC Disruptor 50 list company. Robinhood is valued at $11.7 billion, with its biggest backers including Sequoia Capital and Andreessen Horowitz, NEA, Kleiner Perkins and Google-parent Alphabet's venture capital arm, GV. Its IPO debut is expected to garner a valuation at least three-times that amount, sources told CNBC. Ahead of a public offering, the company has added top executives with experience from Google, Facebook, Amazon and the Securities and Exchange Commission.

Kathleen Smith, principal at IPO research and investing firm Renaissance Capital, said her firm has been comparing Robinhood to other brokerage firms such as Charles Schwab, Interactive Brokers and Tradeweb, as well as analogues such as Social Capital, Lemonade and Coinbase. With the exception of Coinbase, which has been caught up in the crypto trading following its debut, "most of these stocks have traded well year to date, despite a pullback in April and May," she said.

"We expect investors will be interested in this one including, the Robinhood account holders themselves," Smith added.

Robinhood may give people investing on the app early access. Last week, the start-up said it will give amateur investors access to initial public offering shares.

First in free online stock trading

The Menlo Park, California-based company pioneered free stock trading. It was the major catalyst for online brokerage firms slashing commissions, then adjusting to zero-commission trades, now a standard in the industry. Robinhood offers equity, cryptocurrency and options trading, as well as some bank-like cash management products.

"Through Robinhood, millions of everyday people have the opportunity to participate in our financial markets," Robinhood CEO and co-founder Vlad Tenev told CNBC in an email. "We're proud to be opening up access to wealth creation for people previously left behind, and we remain committed to democratizing finance for all."

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The app was started in 2013 by Tenev, now CEO, and Baiju Bhatt. The duo met at Stanford and went on to start an algorithmic trading company, and later a financial software company that worked with major banks. Robinhood — their third start-up — was named after the English folklore outlaw, who stole from the rich and gave to the poor, in a nod to the company's motto of "democratizing" markets. 

Robinhood built a mobile stock-trading platform at seemingly the perfect time, with iPhones and Android devices becoming ubiquitous and making its sleek interface an attractive venue for a mobile-savvy generation. The stock market, meanwhile, has recovered from its pandemic-lows and continues its decade-plus bull run.

During the pandemic, Robinhood saw record growth along with the rest of the brokerage industry as new investors entered the market. Social media made stocks a form of entertainment for many while professional sports were on hold, and people had more free time while working from home, as well as stimulus checks to invest for those fortunate enough to not be living on the financial edge.

The largest valuation risks in a potential Robinhood IPO include the sustainability of a recent resurgence in trading activity, and regulators taking another look at Robinhood's key revenue source of payment for order flow.

Robinhood has mastered growing a customer base though nontraditional marketing. But bringing in a flood first-time investors could also elevate risks related to customer retention amid market volatility if portfolios turn negative — particularly with complex products such as options, leverage and trading on margin.

Michael Wong, director of equity research for the financial services sector at Morningstar, said Robinhood's IPO may be timed to take advantage of the bull market in stocks before it ends, and before regulators make any decisions related to payment for order flow. a key revenue source for the company. Wong, however, is less concerned about the retail investing phenomenon being temporary.

"We may be in a renaissance of retail investor interest in the market that hasn't been seen since the 1990s. However, this resurge in interest will likely have a happier ending than the tech bubble," Wong said. "Outside of a relatively small pocket of stocks, the market as a whole doesn't seem to be significantly overvalued. While overtrading from zero-commissions may be a problem, more and younger people becoming interested in their finances should be beneficial in the long run."

Robinhood versus the billionaires

Some financial watchdogs and market participants worry that it's too entertaining. 

Massachusetts regulators filed a complaint against Robinhood, accusing it of failing to act in the best interests of its clients and using "aggressive tactics to attract inexperienced investors, its use of gamification strategies to manipulate customers, and its failure to prevent frequent outages and disruptions on its trading platform."

The world's most-famous investor, Warren Buffett, said recently that Robinhood is promoting gambling-like behavior and has "become a very significant part of the casino aspect, the casino group, that has joined into the stock market in the last year or year and a half." 

His longtime Berkshire Hathaway investing partner, Charlie Munger, added that the app has created "a culture which encourages as much gambling in stocks by people who have the mindset of racetrack bettors" and called it "a dirty way of making money."

Robinhood responded to criticism from Buffett and Munger, saying the two "insulted a new generation" of investors with "elitist" comments.

Part of the pushback from critics stems from Robinhood's business model.

In order to offer free trading, Robinhood and the majority of the brokerage industry make money off of payment for order flow. It routes customer trades to high-frequency trading companies such as Virtu and Citadel Securities, which pay Robinhood to execute that trade. Robinhood makes a commission on the back end, without charging customers upfront.

Payment for order flow, in tandem with heightened trading volumes, has played a substantial role in "filling the zero commission revenue hole," according to a recent report from Piper Sandler brokerage sector analyst Rich Repetto. A subsequent review he conducted of first quarter 2021 brokerage regulatory reports shows that payment for order flow hit a record level across the board for electronic brokers. He noted brokerage firms believe PFOF is a "disclosed, well vetted & scrutinized processes (by regulators)" and part of providing the best trading experience to retail investors.

Robinhood has repeatedly said it gives customers the best price, and denies any conflict of interest within the arrangement. SEC Chairman Gary Gensler has said it's something that the agency is paying attention to.

A Robinhood spokesperson said the firm is "fully transparent" in its communications with customers over its current revenue streams and has improved its best execution processes.

Everyone versus Robinhood

Robinhood is dealing with multiple class-action lawsuits after trading outages in March 2020. While the Dow was experiencing major moves, some traders were locked out of Robinhood's platform. It has also had to content with criminals looking to exploit the retail trading boom by selling log-ins for accounts at Robinhood and other major brokerages, according to security analysts and listings seen by CNBC. 

A Robinhood spokesperson said the start-up had seen instances of accounts targeted by bad actors this year, but hacks did not stem from a breach of Robinhood's systems.

Most recently, Robinhood came under fire from lawmakers and some users after it and other brokers restricted the buy-side of trades for volatile stocks, such as GameStop, in late January. A handful of Robinhood's clients who couldn't get in touch with customer service during the chaos even drove to the start-up's headquarters in California, demanding to speak to a representative and in some cases, vandalizing the property, according to police reports.

GameStop's stock price had soared in January after traders on Reddit pushed one another to keep doubling down on buying shares, inflicting pain on hedge funds who had taken the other side of the trade by shorting it. Some accused Robinhood of colluding with hedge funds to make sure their losses didn't snowball. Robinhood said it did not shut down trades because of any outside pressure, and needed to cap trading due to unprecedented collateral requirements from its clearing house. 

Celebrities, including rapper Ja Rule, were tweeting #deleteRobinhood. Lawmakers from both major parties criticized Robinhood during those GameStop restrictions. Rep. Ro Khanna, D-Calif., a progressive who represents Silicon Valley, Rep. Alexandria Ocasio-Cortez, D-N.Y., and Sens. Ted Cruz, R-Texas, and Elizabeth Warren, D-Mass., all blasted the company's decision. CEO Vlad Tenev later appeared in front of Congress to answer questions about it in a five-hour hearing.

No. 1 in iOS app store during the chaos

During that turmoil, Robinhood was experiencing eye-popping user growth.

It soared to the top app in the iOS app store for multiple days during the GameStop frenzy and led the industry in downloads with 600,000 people downloading the free-trading app in a single day, according to JMP Securities. During January, JMP estimated that Robinhood added 3 million users.

As a result, venture capital investors rushed to fund Robinhood as it had to come up with billions of dollars to meet capital requirements. Robinhood raised over $3 billion in a matter of days.  

Robinhood has been well positioned for volatility in the cryptocurrency markets, too. Robinhood Crypto has added 3 million customers per month this year. The company reported that in the first quarter of 2021, 9.5 million customers traded crypto on Robinhood Crypto, compared with 1.7 million a year earlier. That part of the businesses also saw outages as investors poured into dogecoin.

The company has acted recently to smooth out some of the criticism. Robinhood added a support number, beefed up customer service hiring, and increased its margin requirements after a young customer died by suicide and the family sued the company.

After eight years as a private company, Robinhood filed the necessary paperwork in March to go public. Sources have told CNBC it has chosen the Nasdaq as its exchange. It remains on track for an IPO and has built out its executive teams with both Wall Street and Silicon Valley veterans.

Robinhood hired Aparna Chennapragada, who spent 12 years at Google leading product, engineering and design teams in March. It brought on former SEC commissioner Dan Gallagher last year as head of legal, and its first chief marketing officer, Christina Smedley, came from Facebook. Robinhood's CFO Jason Warnick joined after two decades at Amazon, and its chief operating officer, Gretchen Howard, is a former Google executive.