Photo: Scott Olson / Getty Images
Last Friday, after Facebook stock started trading at $42, most observers immediately pronounced the IPO a flop.Why?
Because the IPO had been priced at $38, which meant that the IPO “pop” was only about 10% above the IPO price.
Facebook stockholders who had bought the IPO the night before had instantly made 10% overnight–a spectacular return. String together a few months of daily returns like that, and you would quickly be one of the most successful investors in history.
But some Facebook speculators had expected to make much more free money overnight–perhaps as much as speculators in LinkedIn and other hot IPOs had made.
So they felt disappointed and ripped off.
And the media, who have been carefully trained by Wall Street and short-term speculators to view IPOs with big pops as “successful” and IPOs with small or no pops as “flops” immediately dissed Facebook as a flop.
Now, there were two serious issues with the Facebook IPO that complicate any discussion focused on this IPO in particular: The NASDAQ screwup that borked at least a day’s worth of trading, and the “selective disclosure” scandal, in which the underwriters told their big clients that Facebook’s second quarter was weak but did not tell their small clients this.
Both of those issues may well have affected Facebook’s first day of trading and contributed to the subsequent price decline. And both of those issues are legitimate sources of frustration, for investors and the company alike. (So please don’t bother raising these issues in the comments below: They’re separate and apart from the point of this discussion, which is about first-day “pops.”)
According to a source very close to the situation, all other issues aside, Facebook was aiming for a 10% pop. Not a 25% pop. Not a 50% pop. A 10% pop. And for most of the first day of trading, that’s exactly what Facebook got. In other words, Facebook did exactly what it was hoping to do.
Facebook knew well how this 10% pop would be perceived by the media: As a disappointment.
But Facebook understood what most companies that go public don’t:
- Any press grumbling about “disappointments” and “small pops” will be quickly forgotten.
- The only investors who benefit from “pops” are short-term flippers who won’t help the company long term and don’t deserve free money
- “Pops” cost the company and its existing shareholders hundreds of milions of dollars (in Facebook’s case, billions)
- “Pops provide no advantage to the company other than a bit of extremely expensive and ephemeral excitement and PR
- Pricing the IPO high enough to have only a small pop meant raising millions or billions more dollars that would subsequently be worth milions or billions of dollars to the company
Specifically, in Facebook’s case, if Facebook had priced the IPO at, say, $30, instead of $38, it would have raised ~$12.5 billion in the IPO instead of $16 billion.
In exchange for a bigger “pop,” happier speculators, and a more enthusiastic press reception, in other words, Facebook and its selling shareholders would have sacrificed $3.5 billion that they can now use to create real value for the company and its shareholders (including its new shareholders).
$3.5 billion is real money.
Photo: AP/Android Police
Blowing $3.5 billion on making speculators and financial reporters happier would have been the height of short-term thinking. And, like other great companies, Facebook doesn’t make decisions aimed at creating short-term value. It makes decisions designed to create long-term value.The extra $3.5 billion Facebook raised by aiming for 10% pop will create at least $3.45 billion more value for Facebook over the long term than a bigger “pop” would have. (The short-term press hyperventilation and speculator euphoria may create some value for a company, but not much. And it may even be harmful to the company by making everything after the IPO seem like an anti-climax.)
But, but, but!
What about the IPO investors?
Shouldn’t Facebook and other IPO companies want to make investors happy?
Shouldn’t they be less greedy and give investors a reward for taking a chance on them?
IPOs should not be priced “at market value.” They should be priced just below market value This rewards initial investors for taking the chance on the IPO pricing (which is always risky–no one knows exactly what “market value” will be). And it gives the investors an incentive necessary to do the research on the company before it goes public. Without that, the investors might just wait to see where the stock traded and do the research then.
But any investor who thinks they need more than a 5%-10% overnight return as a reward for placing an order on the IPO is unbelievably greedy.
Again, a 10% return overnight is a spectacular return.
A 10%-20% return, which is what early-stage IPOs should aim for, is an even more spectacular return.
So any investor who thinks they deserve more than that is just greedy.
But What About “Broken IPOs” — They’re Terrible, Right? [No]
What if the “market value” for a company on the first day of trading is higher than a conservative market value that a conservative investor would place on it? What if the stock drops below the IPO price after the first couple days of trading? What if the company has a “broken IPO?”
Yes, what about that.
This is where Wall Street’s brainwashing of clients and the media about IPOs has been most insidious and effective.
So, really, what if a company has a “broken IPO?” Isn’t that a huge disaster?
In fact, it’s hardly worth mentioning.
What it means is that investors who placed orders for the IPO at certain prices and were intending to hold the stock for more than the first day of trading and were unwilling to tolerate a drop below the IPO price were too aggressive in their bids.
That’s the investors’ fault, not the company’s fault. And the resulting disappointment and disgruntlement is called “buyers’ remorse.” And it happens all the time, in almost every industry and type of transaction on the planet.Let’s use a real-estate analogy.
Let’s say a beautiful house is being put up for sale. The agent hired (and paid) to sell the house advertises it everywhere, so all potentially interested buyers know about it. Then the agent calls for bids. The agent explains that there will be only one round of bidding, so bidders need to submit their highest and best offers. Then the agent and the homeowner look at all the bids and pick one, probably the highest. And then the house is sold at that price.
The day after the deal, it is highly unlikely that the buyer would be able to resell the house for the price he or she just paid–because he or she offered the highest bid around. The true “market value” for the house, in other words–the average price paid by most buyers and sellers–might actually be below the price the buyer paid.
The seller of the house, meanwhile, has gotten full market value for the house–just as he or she should.
No one complains that there wasn’t a “pop” in the house price.
No one thinks the buyer “got screwed.”
No one says the agent should have sold the house at 25% below market value just to give the buyer a “pop.”
In fact, if the buyer ever complains that he or she paid too much for the house, everyone will tell the buyer to grow up and look in the mirror if he or she wants to figure out who to blame.
And it’s exactly the same for IPOs.
Any “pop” in the stock price on the first day is the difference between the IPO price and the market value.
The market value is not, perhaps, a “conservative value that only a cautious prudent investor would pay,” but the market value–the average value that all investors, conservative and aggressive, are paying.
Any investor who chooses to pay market value for an IPO needs to accept that. And if he or she doesn’t want to accept that, then he or she just shouldn’t place a bid. (This is voluntary stock speculation, after all: We’re not talking about selling water and air.)
“But It’s Not Like Selling A House… It’s Like Selling Apartments!” [No, It Isn’t]
There’s one more argument that sophisticated “pop” defenders invoke. And that’s this:
Selling an IPO is not like selling a house. It’s like selling an apartment in a big apartment building with lots of apartments. What you’re trying to do with the first sale, the pop defenders say, is generate excitement for the stock, by showing how much money can be made if buyers start speculating on the apartments. If you give away a lot of free money to the first few buyers, this story goes, others will see how much money is being made and then they’ll pile in and start buying. And the value of all the apartments will go up!
That argument sounds sophisticated and intelligent, but it’s wrong.
Because the shares in an IPO are sold all at once, not one after the other.
And future sellers of shares in the company–existing shareholders–will not be selling any more shares for months after the deal, at which point the trading price of the stock will be determined by the first day “pop” on the IPO but by what has happened in the interim.
“No!” the IPO pop defenders shout.
“The first-day pop determines everything! Investors who don’t get a pop will storm off in disgust, and they’ll never come back! The company’s stock price will be lower forever, because burned investors will always want to punish the company!”
I hope no one seriously believes this.
The reality is that after a stock settles in the weeks and months after the IPO, what happened on the first day of trading is quickly forgotten. Potential buyers and sellers of the stock react to “news”–to what is happening in the market and industry and at the company–not because of some collective market memory about the IPO price. And, in any event, even in a huge deal like Facebook, the investors who played the IPO are only a tiny fraction of all available investors out there, so even if the investors who didn’t get their free-money pop remain disgruntled, plenty of other investors will rush in to fill the gap.
So, if IPOs pops are actually bad, why does everyone think they’re so good?
A few reasons:
- Everyone loves free money, so when a handful of speculators get lucky and make a lot of it (when an IPO is underpriced), they’re very loud in celebrating their brilliance and success
- Pops are exciting and controversial! Pops give the press an excuse to write breathless stories about the IPO, in which they can rave about the “instant overnight millionaires and billionaires” and the “popular madness and delusions of crowds” and other age-old stories that sell newspapers and cause viewers to tune in (and get clicks).
- Wall Street has brainwashed companies and the media into thinking that pops are good. Why? Because a healthy “pop” makes it easier for Wall Street to keep both kinds of clients happy–not just the issuer (company) client but the investor clients. Wall Street deals with issuer clients only every once in a while, when companies do IPOs or secondary offerings. But Wall Street deals with investor clients every day. So Wall Street loves to dole out favours to those investor clients at the expense of issuer clients. And those favours often come in the form of huge IPO pops.
What a small IPO pop like Facebook’s really means is that the underwriter has correctly assessed market value (often hard to do) and then priced the stock just below market value. In other words, they’ve done a great job for their issuer client and a fine job for their investor clients. Especially on a hot offering, this is extremely hard to do. That’s why I said last week that Morgan Stanley had priced Facebook perfectly.
Yes, in the week since its IPO, Facebook has traded down sharply. But a lot of that sell-off is due to the NASDAQ screwup and the now-widespread understanding that Facebook is having a weak second quarter (something that was only known by institutions). And a lot of it is also probably due to the fact that many, many players placed orders for Facebook only because they were hoping to get a huge IPO pop.These speculators–and that’s what they are, speculators–did get a nice modest pop. Again, on the first day of trading, unless they were burned by the NASDAQ screwup, they could have sold their stock for 5%-10% more than they bought it for the day before–a spectacular return. And if this was still disappointing to them, well, then, that’s because they were greedy.
Meanwhile, Facebook raised $16 billion at a good price, one that–at the time it priced the stock–was just below the market value.
The extra cash that Facebook raised by pricing its stock 10% below market instead of, say, 25%, will create value for the company for decades to come.
If the company executes well, meanwhile, memories of the “broken IPO” will quickly be forgotten.
And anyone who doesn’t believe this should just take a look at Amazon.
Back in 1997, when Amazon went public, the stock quickly “broke” the IPO price.
As it was for much of its early history, Amazon was shellacked in the press for this.
15 years later, Amazon is up about 75X from the IPO price.*
And the shellacking has long since been forgotten.
* No, I don’t think Facebook is going to go up 75X from the IPO price. This is in part because Facebook went public at a far more mature stage than Amazon. When Amazon went public, it was valued at $500 million. When Facebook went public, it was valued at $104 billion. It’s a lot harder to create oodles of future value from a $104 billion level than it is from a $500 million one.
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