What Facebook Should Have Done

I would like to expand on my Five Lessons from the Facebook Fiasco IPO.  Lesson 2 is there is a reason why IPOs have been done in a way which gets a 20% or so first day pop.  It is not banker greed nor giving a free benefit to the institutional buyers (who can flip part of their position during the pop).  It is to build a book of long-term holders and create momentum for the stock.  LinkedIn did this well, and has continued to out-perform each quarter, providing a strong base to its stock price and improving access to capital markets for future financing.

The primary rebuttal I hear is that a pop means the company is leaving money on the table, and wasn’t it smart for FB to get all they could in to the company?  Well, not in this offering.  Of the 420 million shares offered, the majority (240M) were for insiders not the company.  They got the windfall.  The company sold 180 million shares gaining close to $7B.  The greenshoe issued another 63M shares, but wouldn’t have added to the company’s coffers, for 243 million shares of dilution.

Let’s play alternative history.  A counter-factual scenario is FB first sells 100M shares with no selling shareholders at a lower-priced IPO, say $32. Likely the stock would have risen to the $44 range where it was selling in the private secondary markets prior to the IPO, and in the middle of the range at which it opened during its IPO.  The many fewer shares floated would have made a pop much more likely.  Then it would do a fast secondary offering at the higher price, say another 100M shares at $44.  The company would have floated 200M shares and pulled in more than $7B.  The secondary offering would have added selling shareholders. In the end, even with the ‘shoe, the dilution would have been less and the company proceeds higher.

Something Funky Happened at the Facebook IPO

Facebook: Fakebook, FailBook, FacePlant, pick your favorite euphemism for the epic fail tepid offering on Friday. It hasn’t failed, yet, although perception here seems to have become reality – no pop, fail. The first half an hour of trading was a mess, and some retail trades ordered right away didn’t get filled until after hours. Amazing.

Whatever plagued FB also impacted a plethora of other tech stocks, including ZNGA, AAPL, NTFX, and INTU. Zynga in particular had a wild drop followed by a trading halt before recovering a bit. ZeroHedge’s foresenic analysis concluded that software hammered the social software’s IPO – software errors in the exchange routing systems.

The NASDAQ head defended his software this morning in the NYT, claiming his system didn’t cause the stock to decline. He blamed order cancellations for the trading delays. I guess he doesn’t realize that the glitch led to trading confusion, which caused the brokers to back off selling to their retail investors, who then stood aside. So, does he believe that a slackening of buy orders didn’t contribute to the decline?

First lesson: FB would have been better off listing on the NYSE.

The expected first-day pop failed. Was this due to routing errors, or to gross over-pricing and other human mis-judgement?

A lot of the tech press blames the greed of insiders, who upped the amount of shares they could sell in this offering by a whopping 25% of the offering. Or the underwriters, who let it happen. Sy Harding has a more prosaic view, that Zuck’s desire for advantaging the retail investor screwed up the normal process. There is also the Goldilock’s view, that the offering ending flat means it was priced just right.

I think my partner Paul got it right, that the disproportionate insider selling signaled that the insiders thought it was fully-valued, meaning FB has little reason to rise for a while. The implication: if you buy it, you are the greater fool. In addition, these other factors had an impact. Some whisper numbers that have leaked suggested the institutions would have been happier at $36 not $38; and I suspect that when they got pushed aside for more retail investors, they had less incentive to play the first-day pop (where they sell off some of their position for a quick skim). Worse, letting the enthusiastic retail investor in early removes the piling-on that drives a first-day pop. For the savvy retail investor, if you can get a piece of a hot offering, the offering ain’t so hot.

Second lesson: there is a reason IPOs are done a certain way, and it isn’t all greedy bankers. Google tried to change it, and got a tepid offering. Perhaps the same occurred here. Stocks are not like normal commodities, in that they increase in perceived value as they rise, whereas as normal stuff sells more when it goes on sale. BTFD.

Thanks to the greenshoe, the underwriters most likely have avoided taking a bath. They came in to support the stock big-time at $38. This Reuters piece, widely linked, estimated the potential cost was $2B, well in excess of the potential profit on the offering – indeed, in the JP Morgan derivatives “London Whale fail” level of a huge loss – but this reflects a common misunderstanding of the mechanics of an IPO. (Take a gander at this ‘evil banker’ sort of post on the economics of an IPO that exaggerate the upside and overlook the potential downside.) The greenshoe allows them to float an additional 15% in a hot offering – a potential profit enhancer – but also allows them to buy back shares in a cold offering as this one turned out to be. In effect, the ‘shoe gives them a 15% short position which they can apply against buying back shares without cash by offsetting the shares in the shoe. (Amazingly, Reuters persisted with its misleading reporting even after the greenshoe was explained to them.)

Various investigations will sort out what went wrong. Fundamentally this is such a large float that a dramatic first-day pop should not have been expected – even though the people-in-the-know almost universally expected a pop. But is it a surprise that even the sharpest VCs are not immune from the enthusiasm that has gripped Silicon Valley about the social mobile web boom we are in?

Third lesson: Man is a herd animal. That is why we get booms and busts, bubbles and depressions.

I must confess, our group played the game of where the stock would go. Paul thought it would track like Zynga’s IPO, and he got it spot on; I thought it would open at $44, be driven down near $38 and then rise above $44 to end the day around $48. I got caught up in the same enthusiasm. It did open around $44 – some services have it at $42.99 (WSJ), others at $45 – yet that was such a momentary tick that I wonder if anyone even could sell into it, and of course it never climbed back above those levels.You can see the opening action in this chart.

The biggest fallout of this IPO may be that it will not take the place of Apple in 1980 and Netscape in 1995 – the IPOs that rang the bell on the subsequent tech booms. Instead, it is more of another Google, a seminal offering that did not spark an early Web 2.0 boomlet. You can see a comparison to AAPL, MSFT, GOOG and AMZN in this cute infographic.

My take: FB waited too long to go public.

Fourth lesson: It should have gone IPO in 2009, while it was still in the big growth stage. THAT would have been one glorious pop! And a lot of the value would have flowed to the retail investor, not just the insiders and institutional investors, as they would have caught the great 10x rise from then to now.

I do not expect the FB IPO to put a damper on the upcoming onslaught of other social mobile web IPOs. Think of the pop that didn’t happen as the proverbial dog that didn’t bark. It doesn’t mean the boom is over; quite the opposite. It got out at a huge valuation! It has spawned thousands of local millionaires, and after buying their plush houses in tony neighborhoods, they will become a new hoard of angel investors to increase the entrepreneurial fervor that has gripped SF and NY. The boom will continue without a FB pop. The IPO wave should also continue, as there are about the same number of $1B+ valued private social companies as public ones, and most will attempt to get public over the next 18 months. On top of this, Facebook now has a huge cash hoard to go roll-up the industry and solidify its tremendously advantaged position.

Final lesson: Don’t confuse buying a stock with buying a company. Facebook is stronger after their IPO, much stronger, even if the stock weakens.