On the morning of May 18, investors snapped up Facebook shares at prices ranging from the initial public offering of $38 all the way to $45, despite technical problems that made it difficult to know how many shares they had purchased, and at what price.
Then the selling started. By last week, Facebook shares were trading below $27. About $30 billion had been trimmed from the company’s market value, which stood at $105 billion on IPO day. The same investors who had been so eager to buy less than two weeks earlier were, for the most part, either selling or asking themselves whether they should sell.
Word did emerge after the IPO that Facebook’s investment bankers had told favoured clients – but not the general public – that the company’s prospects in certain markets, notably mobile advertising, did not look so good. This selective disclosure would be a crime in almost any other securities context but, oddly, is permitted in connection with an initial offering. (We can safely assume that someone in Washington is working feverishly to close this particular barn door.) Still, the news hardly seems to justify the turnaround in Facebook sentiment. People who liked Facebook at $38 ought to be deliriously smitten at $27 – but they aren’t.
It so happens that there are good reasons for this change, reasons rooted in principles of economics, business valuation and corporate governance. Those principles apply, of course, to IPOs – except that, very often, the hype and gamesmanship surrounding initial offerings seem to temporarily sweep such considerations aside.
In some ways, the rules of investing mirror the rules of dating. You may salivate at the thought of connecting with that gorgeous, mysterious newcomer, and you might feel a rush at the first contact. But when it turns out that the new flame is pretty much like your previous partners, chances are good that the romance won’t last.
In theory, the first day a stock is traded should look a lot like the second day, or the 10th, or the 30th. A company’s prospects almost never change radically over such a short time period, especially one in which managers are subject to a “quiet period,” in which they do not announce major news. One such quiet period is the weeks following an IPO.
Therefore, if a company’s stock has been priced fairly – neither too high nor too low – at the IPO, the stock should exhibit only fairly small fluctuations over subsequent days and weeks, some of which will mirror the movements in the general stock market or in the company’s industry.
This, however, is not how IPOs usually work. Investors don’t even expect IPOs to behave in such a boring way. They expect, or at least hope, for an underpriced IPO, which will shortchange the company that is going public, but will allow investors to experience a short-term “pop” that makes them feel good. Aggressive traders seek out IPOs just to exploit this pop, with no long-term interest in owning the company in question.
Unsurprisingly, companies do not like being shortchanged when they go public, and they don’t like having their stock end up in the hands of speculators and traders, either. Very few companies manage to avoid these results as well as Facebook did, however. As the most eagerly awaited IPO in nearly a decade, and under the leadership of a founder who was never that keen on going public in the first place, Facebook was perfectly positioned to hold out for the absolute top dollar at its IPO. It got the investors who bought its shares on May 18 to pay the full value of the company – and then some.
Let’s explore “and then some.” Only about 15 per cent of Facebook’s stock, or $16 billion, was sold to the public on May 18. Most of the stock remains firmly in the hands of the company’s insiders and early backers.
Suppose someone else with very deep pockets – maybe Google, or IBM, or Microsoft – decided on May 19 that Facebook would make a wonderful addition to the corporate portfolio and therefore proposed a merger. How much would they have paid?
Usually, when someone proposes to take over a public company, the offer includes a substantial premium over the recent trading price of the target’s stock. This makes sense, because the shares that routinely trade every day on the market represent just a minority interest that has no control over the company’s operations. The acquiring company is willing to pay a premium for control. Seen from the opposite direction, the daily stock market price reflects a built-in discount that applies to a minority, non-controlling interest.
Facebook’s investment bankers touted the fact that the IPO price valued the entire company at $105 billion. But if the entire company was worth $105 billion, then the buyers of IPO shares must have overpaid, because they did not receive a minority interest discount. On the other hand, if the IPO price was reasonable at $38, then a hypothetical acquirer would have had to be willing to pay a significant premium – maybe 20 or 30 per cent – above that price to obtain control.
In hindsight, it seems that the $105 billion valuation included a healthy control premium, so the IPO investors probably overpaid. But we cannot know for sure, in the absence of a genuine and serious takeover offer, which is nowhere in sight.
These issues are not unique to Facebook. Sellers who hold controlling stakes in companies typically do not want to take the haircut that a minority interest discount requires in order to go public. Most sellers, however, do not have the leverage that Facebook had in order to avoid it.
Facebook may yet prove to be a profitable investment for those who bought at $38 or more, if they hold their shares long enough, and if Mark Zuckerberg and his team can continue to build a profitable business on the “likes” of 900 million people or more. The profits would be better, of course, for someone who pays $27. Or maybe the whole thing will blow up when 900 million people find another way to spend their spare time.
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