Facebook’s initial public offering was supposed to be the investing event of the year, a signal that the Internet industry was once again producing powerhouse operations worthy of worldwide attention. As the 800-pound gorilla of the social networking revolution, Facebook was the Silicon Valley poster boy, with name recognition even Walmart would envy. Prices for Facebook shares valued the company at over $100 billion.
Yet three months later, things seem to have gone horribly wrong. First, Facebook’s IPO was hobbled by technical problems at NASDAQ that delayed the start of trading. In less than two weeks, the stock lost 40 percent of its on-paper value as investors jockeyed for position and re-assessed their strategies. Now, lockout periods that prevented early investors from immediately selling their shares are starting to expire, and Facebook has been trading as low as half its IPO price. Many Facebook employees now find their stock is worth less than its book value when it was granted.
How is this possible? Facebook continues to sign up new users around the world at a blistering pace. The company is expanding both its mobile presence and the revenue it generates from advertising. It’s still the closest thing to an arbiter of identity for the whole Internet: How many sites and apps are only usable by logging in with a Facebook ID?
Can Facebook really be in so much trouble that it’s worth half what it was just a few months ago? Or is something else going on?
The nature of IPOs
Initial public offers are a tricky business — particularly for companies like Facebook that command so much industry and media attention. The whole point of going public is to raise money to fuel future expansion and growth, without having to go hat-in-hand to private investors and banks to convince them to lend money. Once a company goes public, investors hand over their money willingly with no guarantee of return, because they believe the value of their shares will increase over time. Going public also means ceding some control over the company to shareholders, but it’s a far more public (and diverse) process than dealing with a handful of institutional or private investors.
So, setting up an IPO is a tricky balancing act. Offer too many shares for sale, and your company loses too much control over its own destiny, ceding it to a rabble of shareholders armchair-quarterbacking over what they believe the company ought to do. Price shares too high, and the company scares off potential investors and fails to raise the capital it needs. Consequently, the stock price drops as investors look to minimize their potential losses. Price the shares too low, and the company leaves money on the table. The stock price surges, making money for folks lucky enough to get in on the initial offering, but failing to benefit the company itself.
The “perfect” IPO needs to do two things. One: Offer enough shares to satisfy initial investor interest in the company without ceding significant control to new investors. Two: Offer a price high enough so the stock doesn’t have a significant upward rise once it starts trading.
How did Facebook do?
Like many companies, Facebook fudged with the numbers between the time it announced it was finally going public and that time that shares actually went on sale. Facebook announced plans to go public back in February, but not how many shares it planned to offer, or their price. It set those numbers in early May: 337 million shares up for grabs, priced at $28 to $35 per share. That price range meant Facebook valued itself at somewhere between $76 and $95 billion, with the IPO pulling in nearly $12 billion for the company. Of course, a portion of that money would go to the banks brokering the deal.
However, a couple things happened between Facebook’s IPO announcement and its initial pricing. In the second week of April, Facebook dropped a cool billion on Instagram, by far the company’s largest acquisition to date. Just a couple weeks later, Facebook revealed that its net income had dropped 12 percent during the first quarter of the year to $205 million, even as revenue had risen by 45 percent year-on-year. These developments made some investors question whether getting into Facebook was a good idea. The company appeared to be on the verge of spending money faster than it was bringing it in.
Facebook countered with a road show; it zipped execs around to different cities to explain why a company is a solid investment. Roughly a week later, Facebook increased its planned IPO pricing, moving to a range of $34 to $38 per share. At those prices, Facebook it was positioned to raise as much as $12.8 billion, putting the total value of the company over $100 billion. Immediately after increasing its IPO price, Facebook added another 84 million shares to the IPO to satisfy investor demand, for a total of 421 million.
Finally, Facebook went for the high end and set its price at $38 per share. Potentially, the company was lined up for the company up for the second-largest IPO in U.S. history: If everything sold, Facebook stood to net well over $18 billion.
The next day, Mark Zuckerberg rang the NASDAQ opening bell from Facebook’s headquarters in California — but didn’t begin selling until two hours later, due to technical problems with NASDAQ. Facebook opened at $42.05 per share.
Nonetheless, first-day trading was enormous: More than 500 million shares changed hands. And at the end of the day, Facebook seemed to have pulled off an IPO coup: Its share price was nearly unchanged, landing at $38.23. That meant the company left no money on the table, and investors and speculators didn’t walk off with a slice of Facebook’s pie. At first glance, Facebook had played the IPO game with ruthless efficiency.
Where is Facebook going?
Then the other shoe fell. By the next day of trading (a Monday) Facebook traded below it’s IPO price. Just an adjustment, right? But companies affected by technical issues at the start of trading began to sue NASDAQ. By the next week, Facebook stock was trading below $30. A week after that, NASDAQ announced plans to offer $40 million in cash and credit to firms that had their Facebook IPO plans foiled by the technical problems on the first day of trading. Facebook’s stock price gained back a little ground on the news. In a way, it implied that NASDAQ’s glitch caused the low sticker price, but that optimism didn’t last. A month later, the gains were erased when Facebook makes its first earnings report as a public company. It met expectations, but investors who were hoping for a blow-out quarter were not impressed. Facebook’s stock dropped further.
Some 90 days after Facebook stock began trading, blackout periods that prevented early investors and company insiders from selling additional shares began to expire. Facebook’s stock immediately started to fall, dropping as low as $19 per share — half of its IPO price. Yesterday, Facebook revealed in a regulatory filing that one of its board members and earliest investors, Peter Thiel, sold roughly 20 million shares through affiliates.
Facebook originally offered 421 million shares for sale; the expiration of initial lockout periods mean roughly another 270 million shares are now eligible to be sold on the open market — including the 20 million unloaded by Thiel. More lockout periods will expire for some of Facebook’s largest shareholders between now and November, with an additional 1.9 billion shares becoming available for potential sale.
Was Facebook priced too high?
Facebook’s quest to maximize the capital it raised from its IPO may have set a high bar the company will have trouble meeting — let alone exceeding — in the near future. So, it’s easy to argue that Facebook priced itself too highly, and is now being bitten as business realities set in.
There’s some truth to that assessment. As the number of Facebook shares being traded increases, the average price of those shares will continue to drop unless Facebook can convince investors there is a significant upside to owning (and holding) Facebook stock. Facebook’s first opportunity to do that will come in October, when it will deliver its second set of quarterly results as a public company.
Investors used to judge Facebook by the size of its user base; going forward, revenues are all that will matter. Now that Facebook has accumulated nearly a billion users around the world, the growth rate of its user base will slow. Some markets like India may still hold phenomenal growth for Facebook, but in developed economies like Europe and North America, it’s close to reaching saturation: Most people who want to be on Facebook already are.
To satisfy investors, Facebook has to successfully generate advertising revenue from all those eyeballs. On that front, it’s making progress. Facebook has finally started to insert advertisements into its mobile offerings, and the company pulled in more than a billion dollars in revenue last quarter. That’s up 30 percent from the previous quarter, and most of it came from advertising. But Facebook’s ad-centric strategy also threatens its existence. Facebook says it is about building services, not about making money, and that people will flock to those services because they find them interesting and useful — a model not unlike Google’s. But ads potentially reduce the value of Facebook’s services: If the company goes overboard with advertising, it will alienate users and inhibit its own revenue growth.
None of these Facebook business realities are new. Right now, Facebook is trading for more than 70 times its diluted earnings per share (leaving off one-time blips like buying Instagram). That compares to about 19 for Google and less than 16 for Apple. Very few companies can sustain a situation like that. By maximizing its IPO price, Facebook frustrated fly-by-night opportunists and put the most money it could into its own pockets. Will that warchest ensure Facebook’s long-term survival, or will core investors (like Thiel) wash their hands and cash out? If Facebook’s core shareholders can keep the faith — and keep their stock — Facebook could use its IPO to sustain years of operations and growth, making the long-term bet that the company’s savvy and strategy will pay off.
But investors who can’t look past the next quarter — and employees who find the paper value of their stock options less than when they were awarded — might find Facebook’s business plan very frustrating.