Buyer beware: the Facebook debacle

In too many IPOs, ‘smart money’ gets rich and ordinary investors often get burned

Buyer beware

Richard Drew/AP

A beaming Mark Zuckerberg stood before a wobbly makeshift podium on Friday, May 18, and “rang” the electronic NASDAQ Stock Market’s opening bell. He was flanked by key executives and surrounded by giddy employees who had gathered for the made-for-TV event, held outdoors at the social networking giant’s campus in Menlo Park, Calif. The crowd erupted in cheers, as well they should have. Many were about to realize huge fortunes as Facebook, the hottest property in Silicon Valley, was finally about to list its shares on a public stock exchange through one of the most-hyped initial public offerings (IPO) of the last decade. But while insiders had much to celebrate—Zuckerberg, 28, pocketed US$1.15 billion and still holds a nearly $20-billion stake in the company he co-founded in 2004—just about everyone else got taken for a ride.

The trouble began almost immediately. The shares, priced at $38 apiece, were supposed to begin changing hands at 11 a.m., but massive demand—some of it by high frequency traders using sophisticated computer systems—overwhelmed the NASDAQ’s automated trading system, causing a half-hour delay. It would prove to be an ominous sign. Once things were back up and running, the stock shot up but almost immediately began to falter. Panicked investors tried to sell only to learn the technical glitches meant their brokers had no way of knowing if orders had been processed (many weren’t).

By the time the dust settled at the closing bell, Facebook’s stock sat at $38.23—a false floor maintained by lead underwriter Morgan Stanley’s frantic efforts behind the scenes to buy up shares at the offer price. The respite proved short-lived. As soon as the markets opened the following Monday, Facebook’s stock fell another 11 per cent. Two weeks later, it is trading 20 per cent below the offer price, with some speculating more losses are inevitable.

It wasn’t supposed to happen this way. The dot-com boom taught everyone that tech IPOs made people rich. More recently, Google sold its shares for $85 each and they immediately jumped 18 per cent, handing investors an overnight windfall. They went on to triple in value over the next year.

Not so with Facebook, and it didn’t take long for the finger pointing to begin. Critics took aim at Morgan Stanley for pricing the offering too high, and at Facebook for increasing the size of the offering by 25 per cent at the last minute as insiders rushed to cash in on the IPO’s buzz. Those extra shares put downward pressure on the price. More troubling are allegations the underwriters tipped off some blue-chip clients, or the “smart money,” about dimming advertising prospects for Facebook prior to the IPO—information that wasn’t easily available to those who bought in at prices as high as $45 a share.

Critics have also blamed pre-IPO trading of Facebook’s private stock. Sites like Secondmarket allow company insiders and employees to sell their shares to wealthy investors eager to get a piece of a hot, up-and-coming company before everyone else. That, in turn, may have created unnecessarily lofty valuations for Facebook, leading many to believe the company was worth more than it actually was and setting the IPO up for failure.

Several investor lawsuits have already been launched, while the Financial Industry Regulatory Authority, an industry-funded brokerage watchdog, and the U.S. Securities and Exchange Commission are looking into the way the underwriters handled the deal. “The underwriters made money, the large institutional investors made money and Facebook made money,” says Andrew Stoltmann, a Chicago attorney and investor advocate who is considering legal action on behalf of clients who lost as much as $200,000. “But it’s the small investor who was left holding the bag.”

The debacle couldn’t have come at a worse time for the market. The initial public offering was billed as a once-in-lifetime event, a chance to get in on the ground floor of the next Apple or Google. It also promised to inject some badly needed life into the stock market after investors fled in the wake of the 2008 crash, a painful event that single-handedly erased a decade’s worth of gains. Instead, it raised more troubling questions about Wall Street greed and the inherent unfairness of a financial system that favours big, professional investors at the expense of the little guy. “If anything was learned from the financial crisis, it seems to have all been put aside and forgotten,” says Richard Powers, a business law professor at the University of Toronto’s Rotman School of Management. “It calls into question the integrity of the whole public market system.”

The stock market is supposed be a simple, rational system connecting companies in need of money with people willing to invest. It also evolved into a place where average folks could generate savings, plan for retirement and ultimately pitch in to help the economy grow. But while that may have been true decades ago, it increasingly appears more an insiders’ game where ordinary people are easily separated from their money. And the Facebook IPO demonstrated just how badly those not in the know can get taken advantage of when there is billions at stake.

Critics say there were two problems with the way the Facebook IPO was handled: how key information was distributed and, more generally, how the company was valued. The first sign something was amiss came on May 9, a little more than a week before the offering. That’s the day Facebook filed an amendment to its IPO filings, adding a warning that an increasing number of Facebook users are accessing the site through their mobile devices, where Facebook has a tough time selling and placing ads because of the small screen size. Several media outlets reported that Facebook executives later held a briefing with several bank analysts to discuss the new information, and that many analysts asked questions in a bid to get more clarification. It was a key piece of news since Facebook’s lofty IPO valuation was based on breakneck revenue growth, and any speed bumps could have a big impact on what investors would be willing to pay for Facebook’s soon-to-be-listed public shares. As a result, several analysts revised their earnings estimates. While Facebook’s disclosure was available to everyone who cared to read it, and was reported on by news media, it’s questionable whether average retail investors could be expected to grasp the importance of a few extra lines buried in an already lengthy document.

More concerning, there have also been reports that analysts at the firms involved in the underwriting tipped off key clients prior to the IPO about diminished revenue expectations. That immediately raised questions about whether the banks violated the traditional quiet period before and after an IPO, which puts certain restrictions on what insiders can publicly discuss. But there is a significant loophole: there’s nothing stopping analysts or sales staff working for the underwriters from picking up the phone and calling a big client—something that would normally be considered selective disclosure, and was dubbed by the Wall Street Journal one of the industry’s “best kept secrets.”

Not surprisingly, many view such practices as inherently unfair. “A lot of sophisticated investors knew exactly what was going on, but the unsophisticated investors were the ones who got burned because they didn’t understand the process,” says Powers. “Even if nothing done was illegal, it certainly went against the spirit of the marketplace.”

Morgan Stanley has so far defended its handling of the process, saying it followed established procedures. Similarly, some observers argue that just because some people lost money on the IPO, and weren’t afforded the same access as big, professional investors, doesn’t mean the system is broken. “If people want the coin toss to come up heads all the time, I don’t think the stock market is the place for them, let alone the IPO market,” says Anant Sundaram, a professor at the Tuck School of Business at Dartmouth College. He argues that IPOs, and the stock market in general, are not intended to be a level playing field. Deep-pocketed professionals buy and sell more shares and generally have the resources and expertise to value companies—and risk—more accurately. “To make it a free-for-all for every category of investor is dangerous,” Sundaram says.

Even so, Stoltmann says the underwriters should have known that retail investors would flock to Facebook, creating the potential for a bloodbath if the stock cratered. Some estimates peg the number of shares allotted to retail investors at 25 per cent, far higher than the 10 to 20 per cent customary in most IPOs. It has been speculated by some that the extra shares were made available because Zuckerberg wanted regular folks to have a chance to participate in the IPO. Unfortunately, it was a tactic that may have backfired in a big way by drawing in ever more unsophisticated investors who would soon be parted from their money. “The small investor participation was massive,” Stoltmann says. “And that’s what makes this experience particularly unfortunate.”

To make matters worse, many small investors also suffered at the hands of professional traders who use computer programs to perform high-frequency trades, which account for up to 70 per cent of all market activity, says Dennis Dick, a proprietary trader with Bright Trading LLC. That means buying and holding stocks for as little as a few seconds in an attempt to make a quick buck off movements. Investors jumping into a stock the pros were preparing to short—a process in which an investor borrows a stock from a broker at a certain price and, if the price drops, buys it and pockets the difference—would have been sitting ducks. That’s because short-selling can quickly drive down a stock’s price. “High-frequency trading is seeking out to trade against ‘dumb money’ so if you’re not that knowledgeable and you’re saying, ‘Oh, I like Facebook and I’ll come buy it,’ they’re probably going to try and make a few cents off you,” says Dick.

What’s more difficult to explain is how the deal’s architects so badly misjudged the appetite and price for Facebook shares in the first place. Despite a flurry of last-minute warnings about Facebook’s performance, the underwriters pushed ahead with plans to sell shares at $38 apiece, the very top of the $34 to $38 range that had been advertised (the initial price range presented to investors was even lower, between $28 to $35). Many argued the offer price, which valued Facebook at an eye-popping $104 billion, was far too rich for a company that generated just $3.7 billion in sales last year, and earned $1 billion in profit. By contrast, search giant Google is currently valued at less than two times that ($192 billion) despite having sales and earnings last year that were 10 times Facebook’s. “They had a range of prices and they came in at the very top,” Powers says. “But even at the bottom end, it was hard to support Facebook’s valuation.”

Some critics, including business magnate and Dallas Mavericks owner Mark Cuban, have speculated about the role of secondary markets in Facebook’s flop. Investors eager to climb on board the Facebook bandwagon while it was still a private company were able to get a piece of action through sites like Secondmarket and SharesPost. Such secondary markets have done a brisk business in recent years as employees of tech firms look for a place to cash in their stock options (a form of compensation favoured by Silicon Valley) before their employer decides to go public—a process that’s taking longer than ever these days as companies balk at the ever-increasing level of public disclosure requirements and regulatory oversight. Though such trading is open to the public, investors generally must be accredited, which means either having a net worth of $1 million or having annual earnings of $200,000 in each of the past two years.

Goldman Sachs also raised eyebrows last year when it invested $500 million in Facebook through a private transaction in exchange for private market shares, and then set up a special fund that allowed wealthy clients to own a piece of the company for a minimum of $2 million each. (The transaction was designed to allow more wealthy private investors access to Facebook’s private shares without exceeding a 500-shareholder threshold set by regulators, after which Facebook would be required to begin disclosing details about its finances as though it were a public company). All of that behind-the-scenes trading in private shares, it’s argued, where demand far exceeded supply, may have set an unrealistic floor price for the IPO. In effect, the real gains were realized before the stock ever listed. “If insiders were able to sell stock on a [private] market at a valuation of $75 billion, that suggests a public market value for the company,” says Kevin Werbach, an associate professor at the University of Pennsylvania’s Wharton School. In fact, Facebook’s private market valuation exceeded $100 billion earlier this year on SharesPost.

Wall Street doesn’t have a great track record of getting it right when it comes to pricing social networking sites at the best of times, never mind when the hype machine is in full swing. Daily deal site Groupon went public at $20 last year and the stock has since fallen 40 per cent to about $12 a share. (Professional social network site LinkedIn, on the other hand, went the other direction, listing its shares at $45 each last year and seeing them jump 90 per cent on the first day of trading.)

Facebook, though, is in a league of its own when it comes to question marks. With a user base that accounts for nearly one-seventh of the world’s population, many investors are betting Facebook’s money-making potential is off the charts—providing it can figure out how to transform its giant user base into ad dollars. “The existing advertising [model], in a lot of people’s eyes, just doesn’t work,” says Stephen Rogers, a portfolio manager at Horizons Investment Management in Toronto, who didn’t attempt to buy any Facebook shares and still thinks they are priced too high.

To get an idea of just how much growth Facebook needs to experience to justify even its current share price, which was trading at $28 earlier this week, consider calculations done by Mark Hulbert at the finance site MarketWatch. Citing a recent study that found the average revenue growth of new public companies to be 212 per cent over the first five years, Hulbert estimates Facebook’s annual revenues should be about $11.58 billion by 2017 if it follows a similar trajectory. That would make it $63.8-billion company, assuming a value based on the same price-to-sales ratio as Google. That’s barely more than Facebook is worth today, even at the stock’s currently depressed prices.

Brandon Snow is a portfolio manager with Cambridge Advisors in Toronto and one of those professional investors who ended up in the black on May 18. His firm bought tens of thousands of Facebook shares from the underwriters and sold them while they were briefly above the offer price. However, he says he wasn’t acting on any special information, just a bet the hype surrounding the IPO was wildly out of hand. Among the red flags: “I was getting into a taxi, and the cabbie asked me how to get into the Facebook IPO,” Snow says.

The irony may be that the broad interest in the Facebook IPO only made it more risky for those same people who lacked the expertise to play the market. And many may decide to avoid the stock market altogether as a result—with potentially dire consequences. Like it or not, the stock market is an important tool of wealth creation for the average person trying to save for their children’s education or retirement. And investors aren’t likely to find the necessary returns to realize those goals by leaving their hard-earned cash in their savings accounts, where it earns less than one per cent interest—not even enough to offset inflation. Stoltman wonders “whether this is the final straw that’s going to cause small investors to stay on the sidelines and not partake in investing or the capital formation process. Many investors were following the Peter Lynch invest-in-what-you-know principle, and 900 million people know Facebook. And now those investors have been burned.” For now, those investors who got caught up in the Facebook hype are now left with one of two options: sell their stock and cut their losses, or hang on and wait to see if Facebook makes good on its business plan. “Personally, I think a few quarters from now, people will have forgotten the IPO imbroglio and the focus will be on whether Facebook can execute its strategy,” says Sundaram. Indeed, if Facebook follows the lead of high-flying firms like Google and Apple, $38 may look like a bargain in a few years. Of course, like all stock-market plays, it’s far from a sure thing. Which is why the smart money, those “friends” of Wall Street, have already cashed out.

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