Why a drop in Snap's share price on its opening day is great for the company -- but not so good for its bankers

This is an excerpt from the book “Chaos Monkeys” by Antonio Garcia Martinez. The book describes how Garcia got funding for his tech startup from Y Combinator and Chris Sacca, sold that startup to Twitter for millions, and then bailed on the deal to go work at Facebook. He eventually left Facebook after losing a showdown with COO Sheryl Sandberg and VPs Andrew “Boz” Bosworth and Brian Boland, over Facebook’s advertising strategy.

Martinez was working at Facebook at the time of its IPO in 2012. Facebook’s stock opened at $US42 and closed its opening day at $US38.37 , which led to many observers to declaring its public debut a disaster for the company. Here, Martinez describes why the opposite was the case for Facebook’s executives.

Snapchat parent company Snap lists its shares on the New York Stock Exchange on Thursday and is set to price its stock at either $US17 or $US18. Whichever way the stock goes on opening day, parallels will no doubt be drawn with Facebook’s stock market debut — here’s one way of assessing who the real winners of Snap’s IPO will be.

May 18, 2012

The news coverage surrounding the IPO, even from the supposedly savvy tech and financial press, was a reminder of that harsh lesson of life: there are those who write headlines about money for a living, and then there are those who make money.

“Facebook IPO Blunder,” announced Fortune; “Mark Zuckerberg’s Big Facebook Mistake,” thundered Forbes; “Facebook Disappoints on Its Opening Day,” intoned VentureBeat, a Valley insider rag that should have known better.

Despite such headlines, Facebook’s IPO was not a fiasco; it was without question the most successful IPO in financial history. If you don’t understand why, then you don’t understand how IPOs work, and you should read on.

What an IPO is

What’s an IPO, exactly? A company decides it wants to “float” part of its equity on the public markets, allowing employees and founders to sell private shares to pay them off for years of service, as well as sell shares out of the corporate treasury to have some money in the bank.

Large investment banks (such as my former employer, Goldman Sachs) form what’s called a “syndicate” (“mafia” might be a better term) wherein they offer to effectively buy those shares from Facebook, and then sell them into the capital markets, usually by pushing it via their sales force onto wealthy clients or institutional investors.

That syndicate either guarantees a price (“firm commitment”) or promises to get the best price it can (“best effort). In the former case, the bank is taking a real execution risk, and stands to lose money if it doesn’t engineer a “pop” in the stock on opening day.

Snap new york stock exchangeAlex Heath/Business InsiderSnap Inc. makes its debut on the New York Stock Exchange on Thursday, March 2.

To mitigate the risk, the bank convinces the offering company to expect a lower price, while simultaneously jacking up what real price the market will bear with a zealous sales pitch to the market’s deepest pockets. Thus, it is absolutely jejune to think that a stock’s rise on opening day is due to clamoring and unexpected interest. Similar to Captain Renault in “Casablanca,” Wall Street bankers are shocked —
shocked — that there should be such a large and positive price dislocation in the market they just rigged.

As proof of the complete charlatanism at work in most IPOs, let’s ask ourselves a question: Are there other situations in the financial world in which the banks are responsible for setting, ab initio so to speak, a fair market price, and in which that routinely works out?

Why, yes, in fact. It happens every morning when thousands of stocks start trading on the public exchanges. How does the first price of the day in IBM get set? Back in the days of floor traders, the “specialists” responsible for trading that stock weighed the amount of buying versus selling interest, and calculated a reasonable “midmarket” price.

Then they offered to buy at slightly less, and sell at slightly more, than that price when the market opened, supplying the liquidity they’re paid to provide via the narrow bid-ask spread they pocket on every trade. Modern electronic exchanges have replaced the manual process with an algorithmic one, but it’s essentially the same.

On opening, trading initiates smoothly from a stew of overnight speculation and imaginary price movements into real trades and shares changing hands. How often does one see 20% to 30% price changes on opening in US exchanges? Never, basically, other than after catastrophic events like market meltdowns or 9/11.

Given Wall Street banks’ consummate skill in (usually) running orderly markets when their money and reputations are on the line, isn’t it a wonder that they should suddenly find it impossible to engineer an IPO in which the price doesn’t pop 20% on open? Even assuming there were some ever-present estimation error, isn’t it striking too how they always manage to underestimate the price on the first day, making themselves a fortune, rather than overestimating and causing themselves a loss?

Whenever you see the headline ‘Stock X Pops on First Day of Trading and Declared a Success,’ instead think ‘Founders and employees just got completely screwed, and the bankers and their wealthy clients made fortunes.’

Facebook shredded the usual IPO script.

The stock opened at $US42, and closed at $US38.37, which put the financial press in a howling tizzy of complaint, and which nicely screwed the bankers.

Chaos monkeysPenguin Random HouseAntonio Garcia Martinez’s ‘Chaos Monkeys’ gives the inside account of building out Facebook’s early ad business.

The negotiations were way, way, way above my pay grade, so I have no idea how David Ebersman, Facebook’s then CFO, managed to coerce or cajole the bankers into offering a high and fair price, essentially screwing themselves in the process. But he and whoever else on the Facebook side deserve the Nobel Prize in economics for doing so.

They even squeezed the bankers on fees. Oh, yes: in addition to fleecing you with overt price manipulation, bankers are paid a flat fee for their exertions. Facebook’s syndicate accepted a modest fee of just over 1%, rather than a more typical fee that sometimes runs as high as 7%.

While the press jeered about the “disastrous IPO,” the feeling inside the company was one of utter triumph. Facebook had gone public without getting skinned alive, and it now had a mountain of money to recruit the best engineers, acquire budding competitors, and outspend rivals on product development, all with minimal dilution of the shareholders (i.e., of us, the employees).

Here is your lesson from the Facebook IPO: whenever you see the headline “Stock X Pops on First Day of Trading and Declared a Success,” instead think “Founders and employees just got completely screwed, and the bankers and their wealthy clients made fortunes.”

Because that’s what happened, and didn’t happen, in the case of Facebook.

From “Chaos Monkeys” by Antonio Garcia Martinez, Copyright © 2016 by Antonio Garcia Martinez. Reprinted courtesy of Penguin Random House.

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