Facebook IPO Gave the Market Just What It Doesn't Need

The biggest problem with Facebook
Inc. (FB)’s botched IPO isn’t that there was no first-day “pop.” Or
that the shares went into free fall over the next few days. It’s
what it might do to investor confidence.

Facebook’s initial public offering shows how broken the
process has become, and we don’t say that just because technical
glitches plagued it from the very start on May 18. There were
flaws in building the order book, distributing information to
potential investors, pricing the shares and setting the size of
the float. It’s too soon to tell whether laws or rules were
violated. But it’s not too soon to review some basic principles:

-- Follow the Law. This is obvious, but it bears repeating:
Securities laws are clear about the do’s and don’ts of IPOs.
Important information must be in the prospectus, and shouldn’t
be revealed during roadshows. The Securities and Exchange
Commission rightly considers the prospectus almost like a sacred
document. It must be on file with the agency and updated
regularly -- no excuses allowed.

The SEC’s Regulation Fair Disclosure, aka Reg FD, requires
that company guidance be made available to all, not just to
selected analysts who can then pass it on to major investors. It
certainly shouldn’t be whispered to analysts working for the
banks running the order book.

Reg FD

News reports allege that Morgan Stanley (MS), the chief
underwriter, did just that. (The company denies it.) But if its
analysts independently scoured the prospectus, crunched the
numbers and decided Facebook’s stock was overpriced, that’s not
only legal, it’s encouraged by Reg FD. Facebook, did, in fact,
file a revision to its prospectus on May 9 that said the
company’s ad-sales growth wasn’t keeping up with its user-base
expansion. That disclosure was public, if not exactly prominent.
(It can be found on Page 57 of the company’s S-1.)

If, however, Facebook urged analysts to lower their revenue
and earnings forecasts, and the information was relayed only to
a select group of clients, that would raise legal issues. When
an investment bank has material information not in the
prospectus, and tips off analysts, knowing they will tell
clients, that’s a misuse of information and could even be
criminal insider trading.

-- Underwriter, Earn Your Fee. The job of the underwriter
is to know the company and know the market for its shares. That
means drumming up commitments from pension plans, mutual funds,
hedge funds and other institutional investors, while also making
sure the little guy has a chance to get some shares.

It means testing various prices and share allotments to see
what the market will bear. It also requires some skepticism
about your own hype, so you can hear what short-sellers are
saying; their analysis can drive down the price.

A successful IPO should adhere to the Goldilocks ideal: not
too hot, not too cold. A big first-day pop is a sign of poor
underwriting, as is a post-IPO price plummet. Valuations are
never perfect, but Morgan Stanley surely got this one wrong. A
company’s value must be based on a demonstrated ability to
generate sales and profits. It can’t be faith-based.

After first saying they would set the price between $28 and
$35 a share, Morgan Stanley and Facebook executives decided the
stock was worth $38 a share, which amounted to a $105 billion
valuation. They also added 25 percent more shares to the float
at the last minute, possibly flooding the market. It was the job
of the underwriters to warn Facebook if demand for the shares
couldn’t support such a large float.

Unconvinced Investors

When the share price dropped as soon as it began trading,
it was evidence that investors didn’t believe Facebook is a $105
billion company. Morgan Stanley should have sussed that out
beforehand.

-- Buyer Beware. Investors caught in the backwash of the
Facebook IPO must share some of the blame, especially if they
thought they could make a fast buck by flipping the shares. Many
IPO investors are left with paper losses now that the shares are
trading well below the $38 price. The lesson: Read the
prospectus, financial statements and, yes, press clips about the
company. When the price and size of an IPO are increased, but
the company’s rate of revenue growth is slipping, that’s a bad
sign.

A simple price-to-earnings calculation would also have
raised a bright red flag. At $38 a share, Facebook has a P/E (a
measure of how much profit a share buys) of almost 100 times
projected earnings for the next 12 months. By comparison, Google
Inc. trades at 13 times earnings.

-- Stock Exchange, Heal Thyself. Nasdaq, the exchange where
Facebook’s stock is listed, wasn’t prepared for the high volume
of trades. Technical problems prevented some investors from
getting confirmations that their trades went through or were
canceled. There was a five-minute delay, then a 25-minute delay
as Nasdaq switched to a backup computer system. A technology
upgrade seems in order. The exchange also may have been
overtaken by a flood of orders from high-frequency traders. If
so, it may be time for the SEC to control the trade-bots.

Friday was a good day for Facebook insiders, who managed to
sell $16 billion worth of shares at a very high price. But the
days that followed haven’t been good ones for the market’s
reputation. Individual investors haven’t returned to the stock
market since the 2008 financial crisis; the Facebook fiasco
gives them another reason to keep their distance.

An IPO ought to leave investors confident that the system
of share allocation is fair, the price is right, and the company
is forthright. The Facebook IPO achieved none of these goals.
The good news is that individual investors who were denied a
piece of the IPO can now buy Facebook shares for about $32. For
once, they were the smart money.

Read more opinion online from Bloomberg View. Subscribe to
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and op-ed articles.

Today’s highlights: the View editors on how Germany gained from
the euro; Clive Crook on Europe at the brink; Jonathan Alter on
political substance and slander; Ezra Klein on the fight over
Bain; Caroline Baum on overregulating banks; Tobias Moskowitz on
data-driven policy; Panagis Vourloumis on Greek shock therapy;
Junheng Li on China’s economic misinformation.

To contact the Bloomberg View editorial board:
view@bloomberg.net.

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