The Facebook IPO in May was a disaster.
Hyped up as the must-buy of the decade, the stock faltered as soon as it opened, and the shares then crashed more than 50% over the next few months.
IPO buyers got demolished. Facebook’s reputation took a dive. Lawsuits and recriminations commenced.
The main problem with the IPO was that investors paid way too much for the stock.
Most of the responsibility for this decision, unfortunately, lies with the investors themselves. No one made anyone pay $38 a share for Facebook.
But some of the fault lies with Facebook, Facebook’s bankers, and some idiotic IPO information-disclosure rules.
During the IPO roadshow, sophisticated institutional investors got important negative information about Facebook that small investors didn’t get. This made the institutions less enthusiastic about Facebook than some less-informed small investors were.
I wrote about the unfairness of this in the wake of the IPO disaster last spring. But now, thanks to an investigation by Massachusetts securities regulators, we have the blow-by-blow details on how small Facebook IPO buyers got screwed.
The Massachusetts “consent decree” tells the behind-the-scenes story of how the negative information about Facebook was shared with some investors and not others. It also shines a light on many aspects of the IPO process that aren’t well understood:
- The story emphasises just how big an information advantage sophisticated investors have over small investors.
- It makes a mockery of the fiction that investing is “a level playing field.”
The investigation also reveals that some IPO rules should be changed immediately: All investors should get all relevant information at the same time.
But first, the full story about how Facebook IPO buyers got screwed.
CFO Ebersman gave the analysts a very specific forecast for Facebook's performance. This forecast was never shared with small investors.
No small public-market investors ever saw (or even knew about) these estimates or Facebook's guidance. All the public got was vague language in the prospectus about risk factors.
Buried in the prospectus was a risk factor that discussed the growth of Facebook's mobile usage and how this might affect revenue.
Meanwhile, the analysts gave presentations to the banks' salespeople about Facebook. In these presentations, the analysts VERBALLY shared their estimates. These estimates were also given VERBALLY to big institutional investors. No smaller investors ever got them.
That night, the trouble started. Facebook's financial performance had deteriorated. CFO Ebersman realised that the company might not achieve the guidance he had verbally given the analysts.
Ebersman reached out to the head banker at IPO underwriter Morgan Stanley, Michael Grimes. He told Grimes that Facebook's performance had deteriorated.
Then Grimes called others at Morgan Stanley to warn them that Facebook's performance had deteriorated.
Meanwhile, Facebook's Treasurer, Cipora Herman, emailed the finance team to request the financial models that the analysts had submitted a couple of weeks earlier. She wanted to see exactly what their estimates were.
Grimes later testified about the purpose of the call: To avoid the appearance of sharing negative information with only a select group of investors. Ironically, that's exactly what ended up happening.
The lawyers' recommendation, apparently, was for Facebook to update the vague language in the prospectus to include a clearer warning about the possible impact of Facebook's mobile growth on revenue.
Then it was time to tell the research analysts about Facebook's deteriorating performance--and, through them, big institutional investors. This would be done verbally, by telephone. Banker Michael Grimes and Treasurer Cipora holed up in a hotel in Philadelphia to make the calls.
Under sub-poena, Facebook would later produce the script. It had been handwritten by... Michael Grimes.
Herman made a call every 15 minutes, talking with 7 analysts that evening. Then she called the other 8 underwriter analysts the following morning.
These estimate cuts were then shared VERBALLY with big institutional investors. The public didn't find out about them until after the IPO had priced.
A week later, as a result of intense demand for shares, Facebook raised its IPO price and increased the size of the deal. More Facebook insiders decided to sell.
And, not surprisingly, because the business was deteriorating, the stock quickly crashed, dropping by half over the following three months.
So, that's the story. Facebook's financial performance deteriorated during the marketing of the IPO. Big institutional investors were told about that (verbally). Small investors were not.
Facebook and Morgan Stanley believe that they followed the IPO rules in place at the time--and they may well have. (Massachusetts fined Morgan Stanley but didn't say what the firm did wrong). But it should now be clear that those rules are absurd.
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