Inside Job: Facebook I.P.O. Shows System Is Broken
Monday morning’s big fall in Facebook’s stock hardly came as a shocker. It was clear on Friday that, at the offering price of $38 a share, there were more sellers than buyers. The only reason the stock held up was that Morgan Stanley, the lead underwriter on the initial public offering, stepped in and supported it. At the opening of trading this morning, the stock fell $5, to $33, before rebounding a bit. (At 2:30P.M., it was at $34.75.)
That’s bad news for investors who thought their luck was in when they were allocated some Facebook stock. It’s also worrying news for I.P.O.s and the capital markets in general. In fact, a strong argument can be made that Facebook’s shaky start as a public company demonstrates that the entire I.P.O. process, which is supposed to spread the rewards to innovation, is broken. By the time Facebook’s stock started trading on the public market, insiders—the company’s founders, employees, and venture-capitalist backers—had bagged most, if not all, of the company’s value for themselves.
That’s fair enough, you may say. Mark Zuckerberg and some Harvard pals created the company. It was Facebook’s professional managers, such as Sheryl Sandberg, the chief operating officer, and David Ebersman, the chief financial officer, who turned it into a real business. And it was some savvy venture capitalists, such as Jim Breyer of Accel Partners, and David Sze of Greylock Partners, who first spotted its potential. Surely, these are the folks who should be rewarded. (Bono’s investment, which my colleague Virginia Cannon wrote about, also falls into the reasonably early category. In April, 2010, Elevation Partners, a venture-capital firm in which Bono is a partner, paid ninety million dollars for one per cent of Facebook.)
Up to a point, I would agree with you. But the I.P.O. system only works if it preserves a balance between public and private investors. If this balance is upended, and virtually all of the rewards are reserved for insiders, ordinary investors will refuse to play the game. A dearth of I.P.O.s would hurt insiders along with everybody else. More important, a time-tested system of financing companies, which rewards innovation and makes Silicon Valley the envy of the world, would be destroyed.
Traditionally, I.P.O.s provided early-stage technology companies with cash to finance their expansion. They also allowed early investors, the founders included, to extract some cash. Public investors, in return for bearing considerable risk, got the opportunity to share some of the wealth these companies created. Investors who bought into companies such as Amazon.com, Apple, and Google at the beginning and stuck with them saw their investments double many times over. In the case of Facebook deal, and in several I.P.O.s that preceded it, such as those involving Zynga and Groupon, ordinary investors were largely cut out of the wealth-creation process, and well-connected investment firms took their place.
The fact is, Facebook’s I.P.O. wasn’t really an “initial” stock offering. In December, 2010, Goldman Sachs raised $500 million for the company in a deal that, following objections from the Securities and Exchange Commission, was limited to overseas investors. In the I.P.O. world, these late-stage quasi-public offerings are called “D-rounds,” and they are becoming increasingly common. Zynga did one before its I.P.O., and so did Groupon. They provide a cashing-out opportunity for insiders who would rather not wait until the I.P.O. More to the point, they allow “hot” companies to bid up the price of their stocks well before the investing public gets a sniff.
Groupon’s D-round, which raised $950 million in January, 2011, valued the company at close to $5 billion. (It is now valued at $8 billion.) The Goldman offering for Facebook valued the company at $50 billion. (It is now valued at about $95 billion.) The valuations put on the companies in these deals were quickly reflected in the so-called “gray market,” where investors in the know could buy and sell the firms’ stocks well before they started trading on the open markets. Now that Facebook’s stock is trading publicly, many of the early players have already sold out, taking a handsome profit.
How will the public investors fare? So far, they aren’t doing well, but it is still early. I said the other day that Facebook isn’t necessarily a bubble stock, but it is undoubtedly a very expensive one. Buyers are bearing a lot of risk, and it is hard to see them ever reaping the sort of returns that investors in companies like Amazon and Google enjoyed. At twenty-five times trailing revenues and a hundred times trailing earnings, the $38 I.P.O. is already discounting an awful lot of expansion—and this at a time when Facebook’s growth rate has already slowed.
Maybe I am a grouch. But it all sounds suspiciously like an inside job, in which the last ones in, the ordinary investors, are the saps. (In this week’s magazine, James Surowiecki highlights another way in which the I.P.O. favored insiders.) At the very least, this entire issue is something that the authorities—the S.E.C., but also the Nasdaq and other stock exchanges—should be looking at closely.