Red Flags for Robinhood

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Stop me if you’ve heard this one: A tech startup raises buckets of money at a crazy valuation but then struggles to turn a profit. Along the way investors discover the startup doesn’t belong to the high-margin world of tech companies at all, but is instead grinding it out in a low-margin industry. This is the story of Uber and Lyft, and more recently of WeWork. Now, one wonders if the same fate will befall Robinhood.

If you’re unfamiliar, Robinhood is a stock-buying app popular with millennials. It has 10 million accounts as of December and has been credited by Jim Cramer and others for disrupting the brokerage industry with its commission-free trading platform. It has charismatic 30-something founders with shaggy hair and enjoys the techy gloss of other San Francisco startups. It has also raised $900 million and is valued at an eye-popping $7.6 billion—a figure within spitting distance of brokerage vet eTrade’s $10 billion valuation. An IPO is rumored to be in the works.

And yet red flags abound. Last month, Robinhood’s head of product departed barely a year into a term that coincided with a series of high profile bungles. The company’s missteps have included announcing a savings product that would pay 3% interest only to walk back the news after regulators warned it would be illegal (the product relaunched with a 2% rate much later). More recently came news of a potentially catastrophic bug that let users trade unlimited amounts on margin accounts.

Such incidents point to governance issues that, if not as epic as those at WeWork, may give prudent investors some pause. Another potential reason for unease is Robinhood’s underlying business model. It may have a slick app—as does Uber—but at the end of the day it is scrounging for revenues alongside a growing number of other brokerages that have recently copied Robinhood’s main selling point of free stock trades.

According to data shared with Fortune by one of Robinhood’s competitors, the company’s lifetime revenue to date is between $600 and $650 million, while 20-25% of its current income comes from interest on customer accounts and 55% from so-called order flow—rebates kicked back to brokerages from market makers and other third parties that execute their orders. Robinhood declined to comment on the figures, though the 55% order flow number is consistent with recent reports that say the startup has been making it an ever bigger part of its business. Meanwhile, a source close to the company said Robinhood has “a very strong balance sheet” and that the “vast majority” of the money it raised is untouched.

This still leaves the question of how the company plans to make a profit. Robinhood won’t say if it is in the black but all signs are the answer is no, despite a recent initiative to save money by building its own clearing system. While its increased reliance on order flow has juiced revenue, it’s unclear if this is sustainable—especially as Robinhood has been sending those customer orders to high frequency trading firms. This practice, say critics, raises the potential for conflict of interest since those firms are assuredly not interested in giving Robinhood customers the lowest price on shares. There is also concern that regulators, who have been uneasy with order flow arrangements in the past, may revisit the issue at a time when more brokerages are telling retail investors their service is “free.”

Finally, there is the question of how many of the 10 million accounts Robinhood is touting are active, and how much money the average one contains. The startup declined to comment on this question but it’s unlikely the value of those accounts is comparable to those at the more boring—but profitable—competitors like eTrade or Charles Schwab.

It’s too soon to say conclusively that Robinhood is overvalued. The company is pressing forward with a UK expansion, and has been addressing its governance issues by hiring a COO and CFO, and adding a former SEC Commissioner to its board of directors. Nonetheless, that $7.6 billion valuation implies a lot of future profits that show no sign of materializing anytime soon. As such, when (and if) Robinhood goes public, it will be hard-pressed to avoid a belly-flop like the ones that befell other one-time tech darlings.

Jeff John Roberts

jeff.roberts@fortune.com

@jeffjohnroberts

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