I have read a couple of articles regarding problems, lawsuits, etc., regarding Facebook’s recent IPO. Here is one example, from CNN. Maybe it’s just the lateness of the hour; maybe it’s just my ignorance of how IPOs work, but I just don’t get it. I’m not seeking opinions regarding the validity of any of the claims of wrongdoing or the merits of any lawsuit. I’m just curious what the problem here is.
As I understand it, an Initial Public Offering is when a privately-held company sells shares of itself. In effect, the company sells the company to a bunch of investors. This raises quick cash for the company, allowing it to invest in the business and perhaps grow and reap great profits for its investors. Of course, the company could fail or lose money. In order to mount the IPO, the company must prepare information describing its financial health, it’s expected future earnings, plans for making those earnings that justify the expected earnings. I assume that Facebook did all of this. Is there an independent organization that inspects these statements for accuracy and reasonableness?
So, what is the role of the underwriter, in this case, Morgan Stanley?
How did Zuckerberg lose $2 billion in wealth?
Why is this thing being called a “fiasco”? Should members of the general public care about all of this? Should Facebook users care? Have people or organizations who invested in the IPO forever lost their money? Where did the money go, or did it not really exist in the first place?
Disclosure: I am not a Facebook investor, but I am a Facebook user.
When a company does an IPO, the way it typically works is that a group of underwriters (big investment banks) buy the newly created shares from the company, then turn around and sell these shares on the public stock exchange. From then on, the public can trade the shares. Investment banks provide this service because the issuing company agrees to sell the shares at a small discount, so the bank can then resell them at a slightly higher price to the public market, making a quick profit. This is what happened when Facebook did their IPO last week.
So this raises a question: how do you determine the price at which the underwriters will buy the shares from Facebook? The underwriters are supposed to look at all of Facebook’s financials and figure out how much capital they need, then come up with a valuation. Then they calculate the price, and negotiate with Facebook about how much they’re willing to pay for the shares.
When the stock hit the market, the movement in price in subsequent trading was fairly minimal, and then it started to go down. This meas that the underwriters seem to have overestimated Facebook’s actual value; the market is saying they are less confident in Facebook’s potential future earnings than the big banks who were supposed to figure that out.
The other big problem is that, it is alleged that Morgan and perhaps other underwriters had negative information about Facebook which they chose not to release to early secondary-market investors. This is the controversy at question in the shareholder lawsuits: the underwriters are supposed to include all relevant information in the IPO prospectus.
Additionally, now that Facebook is a publicly-traded company, they come under the regulation of the SEC. The SEC has now opened an investigation into these same allegations of bad behavior by the underwriters.
Zuckerberg’s wealth is almost entirely in Facebook stock. As a privately-held company, it’s difficult to put a value on that stock since people are not trading it regularly, but when Facebook went public, you could say that Zuckerberg was worth however many shares he still owns multiplied by the share price. Since the shares have decreased in value, his wealth has gone down. Of course, that’s a bit misleading, since his shares are not very liquid; if he tried to sell them all at once, the price would crash.
friedo basically got it in one. Basically when you’re an underwriter you can’t use information that you have due to your position as underwriter to get a leg up on the market as a whole, if you information suggesting facebook earnings aren’t as good as expected you have to pass that on to the public. The benefit of being an underwriter is getting to buy the shares at a discount and sell them, you are not legally supposed to benefit by having access to privileged information (in theory.)
The second fiasco relates to NASDAQ. NASDAQ had a technical problem during facebook IPO day relating to facebook stock. They started trading 30 minutes late and then had to stop trading facebook stock for awhile later in the day. A lot of investors may have ended up having orders fulfilled at a higher price than they otherwise would have seen if the exchange’s software had been working correctly. Some of the brokerage services (Morgan Stanley notably) have agreed to make adjustments to their customer’s purchase price to “make them whole” and mitigate the damage caused by the exchange’s technical glitch. (Morgan Stanley is talking about making in total $13m in adjustments, so the problem wasn’t that big in the context of the stock market.)
I don’t know if it’s true, but I’ve heard Zuckerburg sold $5bn worth of shares so that he basically has a permanent nest egg that he’ll use to fund his life in perpetuity (with a pile of cash like that you can fund a life style in a lot of ways, including borrowing money and such in ways that avoid income taxes.) For the rest of Z’s life most likely his book net worth will be of little relevance to him, he’s going to be living off a pile of cash he took out.
I don’t think it can happen that way. As far as I’m aware, all IPOs are with newly issued shares. However, going public means that the existing shareholders will now be able to sell their shares on the public stock exchange, which makes cashing out a lot easier. (You don’t have to find a buyer for your shares; just let your broker do it for you.)
If I remember correctly, there is a rule that principal shareholders (like Zuckerberg) can not sell their shares immediately after the IPO. They have to wait 30 days or something.
As I understand it, it may be worse than that. I think there are at least some allegations that MS released the negative information to some large investors but not others.
Actually, some of the stock offered was shares owned by the private shareholders. Zuckerberg, according to one report, sold $1B in shares - most of which will go to pay taxes.
(Which brings up another issue - what is your tax liability if you own but do not sell shares, but the stock goes public with an IPO? Is there an initial valuation you are taxed on? )
The calculation of initial value is more “pie in the sky” with wild ass guesses as to what the company will be worth down the road. Part of this calculation was based on “look, revenue has been going up by leaps and bounds, X percent more each year!” However, the new secret data was that the revenue in the last few months had started slowing down. A stock whose revenue quadruples every year will be making 64 times as much in 3 years. If it only doubles, that will be only 8 times. Both are better than Kodak, but the amount it’s worth is nowhere near the same.
So if your broker told you “this $38 stock will probably be worth $70 next year” I think you’d be ticked off and ready to sue if the new calculation said “oops, your $38 stock will be worth $10.” And they knew this before they sold it. And they told a few special clients, but not you.
At the risk of dragging this into GD territory, Congress is launching investigations into the IPO in large part because provisions of the recently-passed JOBS act removed some oversight of IPOs:
ETA: I’m not saying Facebook will be taking advantage of the JOBS act to avoid lawsuits–it’s likely they had to abide by older rules–just that Congress will want to revisit the decision to weaken IPO rules given what happened here.
It is worth noting that while the post IPO drop in share price hurts the early investors, it could be considered a good thing for existing Facebook shareholders. Essentially the market response means that the company received the maximum possible capital in return for the dilution of the shares of existing stockholders. The company could, in theory, turn around and buy back all those shares at the current market price, and still show 15% or so net profit on the transactions. Wouldn’t work in practice, though, as trying to buy back all the shares would quickly drive the market price upward, and the fact that Facebook, no doubt, spent a hefty chunk of change preparing for the IPO which you’d need to count against any trading profit. When the share price skyrockets immediately after an IPO, it means the company’s existing ownership got screwed by the investment bank.
Private companies conceivably could sell shares of their company (“go public”) directly to the public without an underwriter. For a company like Facebook that’s trying to raise billions of dollars, this is not a realistic route.
The underwriter (investment banks such as Morgan Stanley) already has a client list of investors to sell to. Facebook does not. Morgan Stanley would have contacts of big wheeling investors such as California Pensions and their billions, Harvard Trust fund and their billions, Europe & Asian investors, etc. A company like Facebook isn’t going to have the deep network of financial relationships to issue $16 billion in stock on the open market all by themselves.
It’s the underwriter that buys the first shares and then “issues” them to multiple parties. That’s one transaction between Facebook and Morgan Stanley. If Facebook went on their own, they’d have to create a big team of people dedicated to directly issue shares numbering thousands of transactions. Facebook would rather concentrate on building their social networking website instead of worrying about mailing Grandma Jones her stock certificate of 100 shares. Morgan Stanley isn’t going to deal with Grandma Jones directly either but Morgan has the deep network of brokers. Facebook doesn’t have that.
The underwriter has the long history of doing the financial analysis to price and issue stock. Investors would trust the due diligence of Morgan Stanley rather than Facebook’s naked self-assessments of financial health. Therefore, it’s also the credibility factor of a 3rd-party bank risking their reputation on buying & issuing a company’s stock.
There’s a bunch of other reasons I can’t think of at the moment.
Even if we got to some future internet scenario where information is fluid enough that a company like Facebook could just auction a “a million shares on ebay”, there would probably always be some big 3rd-party as a mediator. Issuing shares directly to the public would be an administrative nightmare that most companies would not want to hassle with.
I don’t think so. When you sell the shares, you’ll pay capital gains tax on the difference between the sale price and the value the shares had at the time you acquired them. In Zuck’s case, I believe that the shares were worth very little when he acquired them. Facebook when it was incorporated wasn’t worth much.
I generally agree with this; plain vanilla unrealized gains are not taxable events. I do not know if it applies if shares are converted from one type to another or some other transaction that could have occurred with Zuckerberg’s shares.
(The rule is a little different if you exercise nonstatutory stock options, however; the exercise of the option is considered a taxable event to the extent of the difference in the market value on the date you exercise vs. your acquisition price. None of this applies to Zuckerberg or the Facebook IPO–I just wanted to make it clear that this is not a blanket rule.)
My understanding is that Morgan Stanley, as market maker for the stock, had to buy shares to keep the price from going below $38 the first day of trading. I didn’t get if this was a legal requirement, a requirement of their underwriting duties, or just necessary to keep them from looking like total bozos.
There was an additional problem. Shares get allocated in an IPO, and for non-institutional investors there was more demand than shares, despite the fact that a greater percentage of the offering was targeted to this category. Now, for some reason, investors were getting more shares than initially promised. If the stock was soaring this would be a good thing, but it appears that this gave them an impression that there was less demand than expected, which made them nervous, and which caused some to dump their shares. The Times reported that some institutions dumped all their shares at 42.
BTW the Times yesterday said, buried in the article on this, that FB was talking about moving to the New York Exchange, which would indicate that they are very unhappy with NASDAQ.