Alibaba IPO set to be the biggest ever. What's behind the hype?

Alibaba, China's leading e-commerce company, has priced its shares at $68 each, raising at least $21.8 billion,  and investors are eager to buy its shares that it could easily become the world's biggest initial public offering when it begins trading Friday. Alibaba's IPO, though offering huge potential, comes with some unusual risks. 

Investors are clamoring to get a piece of Alibaba, the online shopping website based in Hangzhou, China, often referred to as "China's Amazon."

Interest is so high that when Alibaba begins trading in the US Friday, a whopping $21.8 billion could rapidly change hands on the New York Stock Exchange. If underwriters decide to issue another 48 million shares on top of the 320 million already planned, the initial public offering would reach up to $25 billion – the largest in history, beating out the record $22.1 billion IPO of Agricultural Bank of China Ltd. in 2010.

Investors are excited by the prospect of finally having a way to profit directly from the online shopping potential of China's burgeoning middle class. But Alibaba, which will trade under the ticker BABA, represents an even bigger step for Chinese tech companies.

“Alibaba’s IPO could well be the end of US dominance in the world technology sector," Qing Wang, a professor at Britain's The University of Warwick, said in an e-mailed statement. "Alibaba’s annual growth rate of more than 30 percent shows that the gap between the Chinese companies, Alibaba and Tencent, and US companies is getting ever closer. In fact, with Alibaba's imminent listing, the Chinese internet companies are already sharing the top four spots with the US."

Investors believe that the company poses a threat to US-based online retailers Amazon and eBay because it can provide lower prices due to its access to cheaply made Chinese goods. That could spur customers to chose it over its competitors.

"It's hard to find it cheaper than on Amazon," Martin Pyykkonen, now an analyst at Rosenblatt Securities, told Bloomberg in 2013. "If Alibaba could come in and, at least for Chinese-made goods, offer a cheaper price, that's interesting. That might be their edge."

Compared with the US giants of e-commerce, Alibaba has relatively low revenues. The company only made $8 billion in revenue in 2013. EBay made $16 billion and Amazon made $75 billion during the same year. The figure seems so low because it only accounts for the commission and fees Alibaba takes on sales. A better measurement is to look at the $248 billion in merchandise sold through various properties – double that of Amazon. In the second quarter of 2014, the company recorded $2.5 billion in revenue, a 46 percent increase over the previous year. 

“Alibaba continues to innovate in many areas of their business to keep existing customers happy and attract new customers," Mr. Wang said. "This ability to understand customers intimately and continuously innovate should enable them to expand overseas with US dominance in the world technology sector gradually being broken.”

Beyond the lure of buying into the huge company, some investors are betting on Alibaba's founder, Jack Ma. Many credit Mr. Ma, a former English teacher, with Alibaba's success and innovation. From a one bedroom apartment in 1999, Ma and 17 colleagues founded Alibaba to help small businesses sell products. It has since become one of the largest online retailers in the world. 

"Investors believe Jack Ma is going to be the next Steve Jobs, and I think that perception is baked into the price of Alibaba's IPO," says Andrew Stoltmann, a securities attorney at Stoltmann Law Offices in Chicago.

Even with the hype around the IPO, big questions remain about the viability of Alibaba's stock. The biggest revolves around what investors are actually getting. Normally, when investors buy a stock in a business, they own a part of the business. But when investors buy stock in Alibaba, they don't own a part of the company. Chinese law prohibits foreign investors from owning assets in Chinese companies. So Alibaba, using what's called "variable-interest entity,"  will allow investors to own part of an entity in the Cayman Islands that is under contract to receive some of Alibaba's profits.

In October 2012, China's Supreme Peopleʼs Court ruled that Hong Kong investors could not use VIE-type contracts to invest in China Minsheng Banking Corp. It isn't clear if that ruling will impact Alibaba's VIE setup. The company said in its Security and Exchange Commission filings in May that "there are substantial uncertainties regarding the interpretation and application of current and future (People's Republic of China's) laws, rules and regulations." Even if Alibaba is able to straighten out its legal issues, some investors see this type of venture as too risky.

"[S]uch a structure means that if shareholders in the United States want to enforce their rights, they will have to do so based on contracts between a Cayman Islands entity and one based in mainland China," Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, wrote in a Deal Book blog. 

Mr. Stoltmann says investors should have other reasons for concern. Alibaba has a massive problem with counterfeit products, which could deter Americans from using the website. Others have pointed out that Chinese companies have underperformed in the US market. Ma also has a very tight grip on the company, and doesn't want to let go of that.

"The perception exists that Alibaba will take the US by storm, and investing now will be the equivalent of getting into eBay or Amazon at the ground level, but that’s a folly," Stoltmann says. "They are competing against the world's largest tech companies, who are entrenched in this market. Taking on these behemoths is going to be very difficult for Alibaba to do." 

Though bigger investors are eager to buy stocks in Alibaba Friday, Stoltmann says average investors should stay away.

“I think a lot of investors are going to jump head first into this IPO," he said. "[But] I think [they] will be burned and likely end up with significant losses."