The Facebook

Just for the record, I would not recommend an "All Peanut Butter Cup" diet. I am not saying that it was a terrible idea, but it also wasn't really a great one (and I did have a sandwich in addition to the hundred-odd peanut butter cups that I ate yesterday)...

Jumping back in time a bit, I promised last week to give you my (partially informed) opinion of the Facebook IPO brouhaha. I will warn you up front that it is kinda long, a little dry, and may not be all that satisfying...but here goes anyway. I will also acknowledge that I have a financial interest in shares in Facebook now, although I won't tell you exactly how, how much, when they were bought, or what the cost was. I don't think it actually matters here...

First, a little primer on what happens when a company goes public. Let's use Company XYZ as an example...XYZ is a private company that has 100 million shares, all owned by the founders, employees and early investors. XYZ decides to raise some money by selling 10 million new shares to the public. However, in addition to selling these brand new shares, the original shareholders want to sell some of their shares to the public as well.

To some, this seems a little bit shady...the cash raised in the IPO goes to the founders and investors and employees, and not to the company for the purpose of funding growth. However, this is pretty common and has some legitimate, non-nefarious reasons: those people may incur a huge tax bill when the company goes public, and need to cash to pay the Gub'ment. They may also have some basic asset allocation issues and have a desire to transfer some of their wealth to other assets.

So, that leaves us with an initial offering of, say 20 million shares...10 million new shares (the proceeds of which go to the company) and 10 million existing shares (the proceeds of which go to the original shareholders.) The company hires and investment bank (in FB's case, Morgan Stanley) to run the IPO and sell all of those shares.

The Bank puts together a series of investor presentations, takes the company to visit potential investors and recruits other banks to do the same to their big customers. The goal is to increase interest in the IPO and get as high a price as possible for the shares that it is selling (or at least it should be, more on that later). Shortly before the actual IPO date, the lead bank issues a potential range of IPO prices, and investors get the chance to subscribe to the IPO, with the final price to be set later.

Usually, these shares go to big institutional investors that are the Bank's "best customers". And here is where the process starts to get a little fishy in my book. Typically, the actual IPO price (which is set based on final demand for the shares) ends up being somewhere around 20% lower than the price at which the stock starts trading the next day.

Back to XYZ, let's say that the final IPO price is $10/share. XYZ then gets $100 million for its shares, the insiders get $100 million for their shares, and the company is valued at $1.1 billion (110 million shares at $10/shr.) The next day, the stock starts trading and anyone can buy shares on the open market. In a normal IPO, the stock would start trading at about $12 or so, valuing the company at $1.22 billion. Anyone who bought shares in the IPO now has 20% more money than they did the day before.

Here is where I start to call bullshit. The Bankers will tell you that the 20% bump is the reward that the buyers get for taking on the risk of the new issue. I say that reward is totally disproportionate to the actual risk, and that the first day bump is really a way that Banks reward their best clients using money that should belong to the company. In XYZ's case, $20 million ($2/shr on 10 million shares) has been transferred from each of the company and the original shareholders to the best customers of the Investment Bank.

So, first thought on Facebook...much of the "failure" of the Facebook IPO was that it didn't open higher than its offering price, and has in fact fallen below that price. Well, TOUGH SHIT!!! These are not riskless transactions, and all of that crowing about how the first day premium is in exchange for the risk of the issue means that sometimes you actually take a loss on these offerings. There are no promises that initial buyers make money on these deals...economic sense says that, if the markets are fair, they would often result in immediate losses.

There has been a lot of ink about "the little guy" getting screwed here, because small investors made up a larger than normal portion of the initial issue. Ignoring the insider information allegations (I will get to them later), that is just not an argument that holds economic water. They were all issued a prospectus, all got to review the published financials of the company and bought what everyone knows to be extremely risky shares. They then lost 20% or so of their money...well, again, tough cookies. These are supposed to be high risk transactions, and there is a reason that they are not considered to be appropriate for all investors. This was the most highly publicized, overhyped IPO that I ever remember...is it at all surprising that demand outstripped reality?

For another perspective, put yourself in the shoes of Facebook, Inc and its original shareholders...Morgan Stanley just sold your shares for $38 each, and the market is now telling you they were really only worth $32. So, the Bank did a great job for you! Morgan's other customers, who are used to being bought off with company money, may be pissed, but the issuing company should be ecstatic. As much as this is a disappointment for the original buyers, it is a huge victory for the seller...who probably could have expected under normal circumstances to be the sucker in this deal.

Which gets us to another interesting point...there was a higher-than-normal percentage of insider shares in this deal. And some of those insiders are really, really influential people who may be deciding on a Bank to handle other IPO's in the near future. Did Morgan reverse course and sell out its Institutional clients in exchange for buying the loyalty of new Banking clients? Hmm...interesting theory that I just thought of there...

One party that unquestionably failed...NASDAQ. For whatever reason, their systems were totally incapable of handling the first day open, and it was delayed longer than it should have been, and the handling of orders was atrocious. Investors went for days not knowing whether or not orders were executed, or at what price. If you compare that to NYSE's opening of the only two larger IPO's (Visa and GM), NASDAQ looks like a completely amateur operation. I find it hard to believe that the next mega-IPO ($10 billion or more) will spend more than a cursory minute considering its listing exchange.

One final note...there are some allegations that an analyst at Morgan knew about a forthcoming bad earnings report and passed the information out only to his best clients. This, of course, is the absolute dumbest kind of insider information dealing...and if it is true, then the guy belongs in jail both for violating securities law #1, and also for being so incredibly stupid. Whether the company should have released the information is actually a pretty sticky question that I can't really cover because it is a LONG answer and above my legal pay grade;-) (there is a "quiet period" issue that I am just not terribly familiar with the ins and outs of.)  I am not sure where this stands (and it would explain the large number of small investors as opposed to institutions...although the sheer popularity of Facebook could explain some of that as well), but that is what the various state AG's are investigating. If it is true, then it is a really easy conviction...

So, that is my long-winded take...the whole thing makes me say "Eh" and shrug my shoulders. The fact that the price fell is not bad for the company (in fact it implies they had a great IPO), and it is not at all a scandal. IPO buyers are not entitled to make a riskless day one profit!!! If there was insider information passed to key investors, then that indeed is a criminal activity, but that seems like it would have eroded the demand somewhat as well.

If you made it this far, then you probably need a more exciting day job;-)