American Business Goes Galt 3

Facebook's IPO was a disaster - because it was years too late.

There's an old song that goes, "The streets are bare, after the parade, after the parade is over."  Now that the Facebook IPO has finally launched, however, the streets aren't bare - what was supposed to be a triumphant parade has instead become a rampaging mob of angry rioters.  The Wall Street Journal published "Facebook Among the Worst Big U.S. IPO Starts in 5 Years" which said:

The stock has recovered somewhat, recently down 3% to $33. That also marks a 13% decline from its IPO price, equal to the worst three-day start for an IPO that raised over $1 billion since 2007, according to Dealogic.

The New York Times put it a bit more plainly.  The teaser for their article said:

Rival bankers and big investors have complained that Morgan Stanley botched the debut by setting the price too high and selling too many shares to the public.  [emphasis added]

Not only did Morgan Stanley raise the price just before the offer, Facebook insiders sold more of their own stock than originally planned.  When founders' stock is sold, the money goes to the founder as a capital gain instead of going to the company to be used for growth.

Rival bankers also complained that Morgan Stanley, the lead underwriter, was trying to sell as much as 25% of the stock to individuals.  That's an unusually high percentage since most IPO stock is sold to institutions and pension funds.  The Times also pointed out that Morgan Stanley will receive something like $100 million in fees.

More Money for Lawyers

Other voices are claiming that Facebook knew about problems with its revenue model before the IPO and didn't share the information in the manner required by law.  That's led to lawsuits by people who expected the stock to go up immediately after they bought it.  CNET reports:

The lawsuit charges the defendants with failing to disclose "a severe and pronounced reduction" in forecasts for Facebook's revenue growth in the run-up to Friday's IPO.

The complaint seems to be that Facebook realized that it wasn't going to have as much income as they'd claimed in the prospectus that they'd mailed out to everyone in the world who might possibly buy their stock.  When they realized that their guess was wrong, they didn't tell everyone as required by law.  The Times observed:

The steps a company takes to go public are highly choreographed and regulated by securities law. A company cannot comment or disclose new information about its business or prospects unless it does so publicly by amending its prospectus. Otherwise, it risks running afoul of regulators. The company could also be vulnerable to securities lawsuits, as investors would have to prove only that it made “material misstatements” ahead of an offering, rather than a high threshold of securities fraud.  [emphasis added]

“Morgan Stanley followed the same procedures for the Facebook offering that it follows for all I.P.O.’s,” a bank spokesman said in a statement. “These procedures are in compliance with all applicable regulations.”

The Sins of Morgan Stanley

Let's divide the complaints into two categories:

  1. Facebook and Morgan Stanley are accused of setting the offering price too high and selling too many shares.
  2. Morgan Stanley, Facebook, and Mark Zuckereberg are being sued for failing to tell investors everything that the law requires.

The second item is, unfortunately, a matter for courts and lawyers.  As the Times pointed out, the laws governing IPOs are "highly choreographed."  The resulting morass of insanely-complicated regulations has chopped America's share of IPOs from 67% in 2002 to 16% last year.  American companies are going public overseas in preference to drowning in our legal system.

The complexity not only raises the cost of managing the IPO, it reduces the number of firms who're willing to take the risks of being sued after underwriting an IPO.  The fewer entities who're willing to underwrite an IPO, the higher the price goes.  The more it costs to manage an IPO, the less money the company has for investment and job creation.

Item 2 will grind its way through the courts.  What's spent on lawyers won't be used to grow Facebook or create jobs.  There's not much anyone outside the charmed circle of securities lawyers can say about it - how would you like the job of proving that every single line of your tax return was not only correct, it fully complied with every single one of our insanely complex tax laws?  We'll have to let the courts handle that one, so let's look at the other charge.

Too Many Shares at Too High A Price?

The New York Times complains that Morgan Stanley set the price too high and sold too many shares to the public.  Bloomberg says that the 13% post-IPO drop means that Facebook is the worst IPO of the decade.

Think about that for a moment.  Set the price too high?  Sold too much stock at too high a price?  Who's Morgan Stanley working for?  Facebook.  Who pays their fees?  Facebook.  Who wants the price to be as high as possible?  Facebook.

The basis of the complaint is that Facebook shares went down after the initial sale instead of going up as earlier IPOs had done.

Morgan Stanley used the hype to sell Facebook stock at the peak just as Chrysler was sold to Daimler at the peak.  What's wrong with that?

Suppose you hire a real estate agent to sell your house.  Your agent's job is to find a customer, help you follow all the laws that are making it harder and harder to sell houses, and get as much money as possible.  You and the seller are competitors in a zero-sum game - every dollar you get is a dollar the seller pays.  You want a high price, the seller wants a low price. 

After much negotiation, your real estate agent persuades you to accept a price that's lower than you wanted.  The sale goes through, you pay your agent.  A week later, the seller flips the house for 30% more than the price your agent persuaded you to accept and pays your agent another commission.

Are you going to be happy?  Or are you going to call a lawyer because your agent left so much money on the table?

That's what commentators are saying Morgan Stanley should have done - priced the IPO low so it would go up 30% in three days.  A Wall Street Journal article had a chart showing that when Visa went public on 3/18/2008, the price was up 36% three days later.  When VMWare went public on 8/13/2007, the price was up 97% in three days as opposed to the 13% drop Facebook experienced.

VMWare's experience is like your agent, whom you're paying, urging you to sell your house for $100,000.  You accept the deal and pay the fees.  Three days later, the buyer sells your house for $197,000 and pays your agent another commission.  If I were VMWare, I'd feel badly ripped off - my sales agent got me to accept a price which was about half what my company was worth and then helped flip it for twice as much.

Morgan Stanley did what they were paid to do.  They ably represented the interests of their client, Facebook.  The got the maximum possible value for the shares and sold the maximum possible number of shares.  That's what Facebook hired them to do - get the most money for the product just as your sales agent is supposed to get the most money for your house.  Anything less would be dishonest.

Conflict of Interest

The world of IPOs is different from real estate.  Not only are the laws more complex, it takes a lot of hype to sell shares to the public.  The Facebook IPO allocated an unusually high percentage of shares for public sale - 25%.  The rest had to be sold to institutions, pension funds, and the like.

This puts the lead underwriter in an impossible conflict of interest.  If you set the price high enough to realize value for your client who's going public, institutions who buy the shares won't get a quick pop.  That will make them less likely to buy the next IPO you underwrite.

If, on the other hand, you price it low so your pals get the pop, you've ripped off your client.

Facebook has profited from the fact that our laws are making it so expensive and so risky to go public that fewer firms are doing it.  Knowing that there wouldn't be another big IPO any time soon, Morgan Stanley was free to get value for their client as opposed to ripping off their client by letting their pals profit from the pop.

Unintended Consequences

Facebook put off going public as long as possible.  They didn't need the money - they have few employees relative to their sales and they can fund their server farms out of cash flow.  As the Economist explained:

Mark Zuckerberg, Facebook’s young founder, resisted going public for as long as he could, not least because so many heads of listed companies advised him to. He is taking the plunge only because American law requires any firm with more than a certain number of shareholders to publish quarterly accounts just as if it were listed.  [emphasis added]

More unintended consequences.  Mind-bending American regulations made it impossible to go public when Facebook was small.  Zuckerberg had to get money from well-connected wealthy individuals such as Russian oligarchs.  The regulations which claimed to protect the public locked ordinary individuals out of Facebook.  All the profit went to wealthy people who could get into Facebook before it went public; small investors took the losses.

Facebook went public only when it got so big that it had to follow the same regulations as if it were a public company.  This gives businesses a huge incentive not to let in lots of stockholders - whatever that "certain number" is, if they let in just one more, they'll have all the burdens of being public even if they aren't.  American regulations are not only driving IPOs offshore, they're locking the common man out of the most profitable parts of the market.

The switch from public companies to private companies has become an issue in the Presidential campaign as Mr. Obama accuses Mr. Romney of "vulture capitalism."  The secretive world of "private equity" is entirely a creation of government regulation - if companies could be publicly traded without jumping through too many hoops, they wouldn't go private.  If start-ups were able to raise money publicly instead of getting politically-connected loans, we'd have fewer Solyndras.

The next article explains just how completely our government is saying they're protecting investors while destroying public companies and stock markets, the two engines which grew our economy and offered small investors a path to riches.

Will Offensicht is a staff writer for and an internationally published author by a different name.  Read other articles by Will Offensicht or other articles on Business.
Reader Comments

Let's address the offering at MS. Facebook did not need MS. They should have used the Dutch Auction IPO as Google did. That way it is offered to everyone, the number of shares, an approximation of the share price but not locked in stone and everyone would have to belly up to the bar to make their own decision, no blaming anyone else because you don't make money from day one. I can't believe that Facebook, which after all is a virtual company online, didn't use the net as did Google. Huge mistake. They still could not get around not reporting all the facts if that indeed happened which I seriously doubt.

I think the main story here is not MS or Facebook but the convoluted laws that we have to put up with. Laws are written by lawyers for lawyers and until we awaken to that fact we will be continually put into these non-competitive positions. May I suggest that lawyers cannot be elected to Congress because of a conflict of interest and start electing farmers?

June 1, 2012 4:04 PM

I disagree with you basssboat. MS was paid $100 million. They brought in 16 billion. 100 / 16 is 6.25. It cost 6.25 million per billion, or per thousand million, they brought in. That is .625%. VERY LOW fee.

Remember, Zuckerberg got a billion in cash so his share of the MS fee was 6.5 million.

If they'd run a Dutch auction, the auction would have resulted in a more accurate price. MS got 20-25% ABOVE the real price due to all that hype. We know the real price now because it's fallen a bunch.

25% of 16 billion is 4 billion extra. MS got 4 BILLION more than an accurate auction would have brought in. Even if you allocate the entire 100 million fee to the extra 4 billion, it's still a VERY LOW finders' feed.

I think MS did a sterling job. UR right about the convoluted laws, however.

June 2, 2012 10:17 PM

I wasn't complaining about the fees that MS made. I think that they should charge all that they can. I wasn't complaining about the money that the investors lost, there are no guarantees when you buy a stock unlike some think. My only point, apparently not clear enough, my fault, was that the Dutch Auction would have been a better discovery method for the stock when it came out of the chute. They of all people didn't need an MS to help them where less known and sophisticated companies would need an MS.

June 3, 2012 12:44 AM

I agree with you that the Dutch auction would have been a fairer and more accurate way to determine the price. IMO, the price it settled down to which is about 80% of what it opened at is where the Dutch auction would have gotten them.

HOWEVER, by riding the hype, they got a 20% premium over the "realistic" price. That was worth more than a billion dollars. Worth riding the hype.

Thus, if you aren't sure what the price ought to be and you don't have much hype, as Google didn't, the Dutch auction is the way to go, particularly if you have webby connections. If you as an insider think that hype can get you a premium, go with hype.

What you don't want is to let your underwriter sell you out to his friends.

June 3, 2012 3:06 PM

We're pretty much on the same page, particularly the part about underwriters screwing you. This next comment is a little off subject but I am still amazed that the underwriters didn't incur the wrath of the SEC during the dot com days. Those offerings were really shaky. While I agree that the buyer needs to do his own homework I personally lost all respect I had for those banks. Anyone with walking around sense could tell that most of them were bogus. The big banks certainly have a step up on everyone. I would not regulate them nor would I bail them out. See GS during the 2009 bailouts. Talk about capital cronyism, it made me sick att stomach.

June 3, 2012 4:05 PM

It turns out Scragged was right -0 it ws a rok of genius, not a disaster:

As Facebook's stock continues to collapse, the volume of whining is increasing.
Four months ago, you will recall, Facebook was viewed as "the next Google." Now, with no major change in the fundamentals, it's viewed as an over-hyped disaster. Meanwhile, there is ever-louder grumbling that 26-year-old Facebook CEO Mark Zuckerberg is in over his head and should be relieved of command.
As I listen to all this whining, I have a simple question:
Didn't anyone even read Facebook's IPO prospectus?
The answer, I can only assume, is "no."
Because if anyone had read the Facebook IPO prospectus, they would have learned, among other things, the following:
Facebook's growth rate was decelerating rapidly.
Facebook's user-base was rapidly transitioning to mobile devices, which produce much less revenue.
Facebook's operating profit margin was already an astounding 50%, which suggested it had nowhere to go but down.
Facebook's CEO had a nearly unprecedented amount of control over the company.
Facebook's CEO had set up this astounding level of control intentionally. Mark Zuckerberg knew all about how impatient public-market shareholders are. And he set up the whole company so he would never have to pay attention to their whining.
In the 9 months following the IPO, insiders would be free to sell more than 2 billion shares of Facebook that they had been holding for years.
Facebook was going public at an astoundingly high price for a company with these characteristics—about 60-times the following year's projected earnings, in a market in which other hot tech companies like Apple and Google were trading at less than 15-times.
Even more importantly, if anyone had read the IPO prospectus, they also would have learned the following, all of which was expressed in a letter written directly to prospective shareholders by CEO Mark Zuckerberg:
Facebook's social mission is more important to Mark Zuckerberg than Facebook's business.
Facebook's business exists to support Facebook's product development, not the other way around.
Facebook's CEO is an extremely patient man who does not flinch under criticism.
Facebook will never care as much about clients and shareholders as it does about its service and users.
Facebook cares about the long term, not the short term (read: decades, not months).
Facebook shareholders may be annoyed by those facts, especially now that the value of their stakes are getting demolished.
But they can't say that they weren't warned.

you REALLY should read the whole thing.

September 5, 2012 9:02 PM
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