Coverage in the press of the Facebook IPO has been sensational, with headlines about Facebook’s “stumble” at the IPO. In this post I’ll suggest a way to think about what happened, who won, who lost, and whether we should care about the decline in Facebook’s share price at the IPO. My answer: No, we shouldn’t care.
During an IPO, a firm and its shareholders wish to sell shares. Generally they want the highest possible price for these shares. Investors, on the other hand, want to pay a low price. The underwriter’s job is to strike a balance. To understand what happened with Facebook, you need to appreciate the difficulty in striking this balance.
The investors who buy in an IPO offer to buy up to a particular number of shares. Suppose Joe Average subscribes to the IPO, offering to buy 1000 shares for the offering price ($38 in the case of Facebook). If demand for Facebook is weak, that is, if there are not many subscribers, then Joe will get the full 1000 shares. However, if demand is strong, there will not be enough shares to go around and Joe will get fewer than 1000 shares. This asymmetry is the key to understanding IPO pricing. Joe thinks: When I get the full 1000 shares, the price will go down, but when I get fewer shares the price will go up. In order for Joe to willingly participate, he must expect that on average, the price will go up at the offering. This positive average return compensates him for getting fewer than 1000 shares in good times. Although the price goes up on average, sometimes it will go down. You can understand why this occurs by thinking about the strategy of those investors who actually have information. They will bid for many shares when the offering is valuable, and for few shares when it is not. This is the flip side of Joe getting all his shares in bad times and fewer in good times.
So investors lost money in the Facebook offering and we understand that sometimes this is going to happen. Did Facebook do anything obviously wrong? Surely Facebook management should have pushed for a high price and that’s apparently what they did. Does the IPO bode ill for Facebook? Why should it? Facebook is one of the most recognized names in the world. In the future, investors will judge Facebook by its financial success or lack thereof. Do you think that Facebook users will switch to Google+ because the stock fell at the IPO? If the offering price had been $32, Zuckerberg would have earned almost $200 million less in the offering. He looks to me like a smart guy.
The party on the hot seat is Morgan Stanley, the lead underwriter. Their institutional investors will want to know why Morgan Stanley agreed to a $38 price. These things happen: Morgan Stanley will make its mea culpas and be back the next time around.
Finally, what about the retail investors who participated? Were they treated fairly? Press reports made it sound like it should have been a sure thing: buy Facebook at $38 and flip the shares a few hours later at a higher price. Of course it could have happened that way. But anyone sure it was going to happen was expecting Mark Zuckerberg and Morgan Stanley to hand them free money. Here’s an Insider Tip: Zuckerberg and Morgan Stanley are not in business to give money to you. They make money from you.
Brokers and banks love to deal with investors who think otherwise.