American Business Goes Galt 3

There's an old song that goes, "The streets are bare, after the parade, after the parade is over."  Now that the Facebook IPO has finally launched, however, the streets aren't bare - what was supposed to be a triumphant parade has instead become a rampaging mob of angry rioters.  The Wall Street Journal published "Facebook Among the Worst Big U.S. IPO Starts in 5 Years" which said:

The stock has recovered somewhat, recently down 3% to $33. That also marks a 13% decline from its IPO price, equal to the worst three-day start for an IPO that raised over $1 billion since 2007, according to Dealogic.

The New York Times put it a bit more plainly.  The teaser for their article said:

Rival bankers and big investors have complained that Morgan Stanley botched the debut by setting the price too high and selling too many shares to the public.  [emphasis added]

Not only did Morgan Stanley raise the price just before the offer, Facebook insiders sold more of their own stock than originally planned.  When founders' stock is sold, the money goes to the founder as a capital gain instead of going to the company to be used for growth.

Rival bankers also complained that Morgan Stanley, the lead underwriter, was trying to sell as much as 25% of the stock to individuals.  That's an unusually high percentage since most IPO stock is sold to institutions and pension funds.  The Times also pointed out that Morgan Stanley will receive something like $100 million in fees.

More Money for Lawyers

Other voices are claiming that Facebook knew about problems with its revenue model before the IPO and didn't share the information in the manner required by law.  That's led to lawsuits by people who expected the stock to go up immediately after they bought it.  CNET reports:

The lawsuit charges the defendants with failing to disclose "a severe and pronounced reduction" in forecasts for Facebook's revenue growth in the run-up to Friday's IPO.

The complaint seems to be that Facebook realized that it wasn't going to have as much income as they'd claimed in the prospectus that they'd mailed out to everyone in the world who might possibly buy their stock.  When they realized that their guess was wrong, they didn't tell everyone as required by law.  The Times observed:

The steps a company takes to go public are highly choreographed and regulated by securities law. A company cannot comment or disclose new information about its business or prospects unless it does so publicly by amending its prospectus. Otherwise, it risks running afoul of regulators. The company could also be vulnerable to securities lawsuits, as investors would have to prove only that it made “material misstatements” ahead of an offering, rather than a high threshold of securities fraud.  [emphasis added]

“Morgan Stanley followed the same procedures for the Facebook offering that it follows for all I.P.O.’s,” a bank spokesman said in a statement. “These procedures are in compliance with all applicable regulations.”

The Sins of Morgan Stanley

Let's divide the complaints into two categories:

1. Facebook and Morgan Stanley are accused of setting the offering price too high and selling too many shares.
2. Morgan Stanley, Facebook, and Mark Zuckereberg are being sued for failing to tell investors everything that the law requires.

The second item is, unfortunately, a matter for courts and lawyers.  As the Times pointed out, the laws governing IPOs are "highly choreographed."  The resulting morass of insanely-complicated regulations has chopped America's share of IPOs from 67% in 2002 to 16% last year.  American companies are going public overseas in preference to drowning in our legal system.

The complexity not only raises the cost of managing the IPO, it reduces the number of firms who're willing to take the risks of being sued after underwriting an IPO.  The fewer entities who're willing to underwrite an IPO, the higher the price goes.  The more it costs to manage an IPO, the less money the company has for investment and job creation.

Item 2 will grind its way through the courts.  What's spent on lawyers won't be used to grow Facebook or create jobs.  There's not much anyone outside the charmed circle of securities lawyers can say about it - how would you like the job of proving that every single line of your tax return was not only correct, it fully complied with every single one of our insanely complex tax laws?  We'll have to let the courts handle that one, so let's look at the other charge.

Too Many Shares at Too High A Price?

The New York Times complains that Morgan Stanley set the price too high and sold too many shares to the public.  Bloomberg says that the 13% post-IPO drop means that Facebook is the worst IPO of the decade.

Think about that for a moment.  Set the price too high?  Sold too much stock at too high a price?  Who's Morgan Stanley working for?  Facebook.  Who pays their fees?  Facebook.  Who wants the price to be as high as possible?  Facebook.

The basis of the complaint is that Facebook shares went down after the initial sale instead of going up as earlier IPOs had done.

Morgan Stanley used the hype to sell Facebook stock at the peak just as Chrysler was sold to Daimler at the peak.  What's wrong with that?

Suppose you hire a real estate agent to sell your house.  Your agent's job is to find a customer, help you follow all the laws that are making it harder and harder to sell houses, and get as much money as possible.  You and the seller are competitors in a zero-sum game - every dollar you get is a dollar the seller pays.  You want a high price, the seller wants a low price. 

After much negotiation, your real estate agent persuades you to accept a price that's lower than you wanted.  The sale goes through, you pay your agent.  A week later, the seller flips the house for 30% more than the price your agent persuaded you to accept and pays your agent another commission.

Are you going to be happy?  Or are you going to call a lawyer because your agent left so much money on the table?

That's what commentators are saying Morgan Stanley should have done - priced the IPO low so it would go up 30% in three days.  A Wall Street Journal article had a chart showing that when Visa went public on 3/18/2008, the price was up 36% three days later.  When VMWare went public on 8/13/2007, the price was up 97% in three days as opposed to the 13% drop Facebook experienced.

VMWare's experience is like your agent, whom you're paying, urging you to sell your house for $100,000.  You accept the deal and pay the fees.  Three days later, the buyer sells your house for $197,000 and pays your agent another commission.  If I were VMWare, I'd feel badly ripped off - my sales agent got me to accept a price which was about half what my company was worth and then helped flip it for twice as much.

Morgan Stanley did what they were paid to do.  They ably represented the interests of their client, Facebook.  The got the maximum possible value for the shares and sold the maximum possible number of shares.  That's what Facebook hired them to do - get the most money for the product just as your sales agent is supposed to get the most money for your house.  Anything less would be dishonest.

Conflict of Interest

The world of IPOs is different from real estate.  Not only are the laws more complex, it takes a lot of hype to sell shares to the public.  The Facebook IPO allocated an unusually high percentage of shares for public sale - 25%.  The rest had to be sold to institutions, pension funds, and the like.

This puts the lead underwriter in an impossible conflict of interest.  If you set the price high enough to realize value for your client who's going public, institutions who buy the shares won't get a quick pop.  That will make them less likely to buy the next IPO you underwrite.

If, on the other hand, you price it low so your pals get the pop, you've ripped off your client.

Facebook has profited from the fact that our laws are making it so expensive and so risky to go public that fewer firms are doing it.  Knowing that there wouldn't be another big IPO any time soon, Morgan Stanley was free to get value for their client as opposed to ripping off their client by letting their pals profit from the pop.

Unintended Consequences

Facebook put off going public as long as possible.  They didn't need the money - they have few employees relative to their sales and they can fund their server farms out of cash flow.  As the Economist explained:

Mark Zuckerberg, Facebook’s young founder, resisted going public for as long as he could, not least because so many heads of listed companies advised him to. He is taking the plunge only because American law requires any firm with more than a certain number of shareholders to publish quarterly accounts just as if it were listed.  [emphasis added]

More unintended consequences.  Mind-bending American regulations made it impossible to go public when Facebook was small.  Zuckerberg had to get money from well-connected wealthy individuals such as Russian oligarchs.  The regulations which claimed to protect the public locked ordinary individuals out of Facebook.  All the profit went to wealthy people who could get into Facebook before it went public; small investors took the losses.

Facebook went public only when it got so big that it had to follow the same regulations as if it were a public company.  This gives businesses a huge incentive not to let in lots of stockholders - whatever that "certain number" is, if they let in just one more, they'll have all the burdens of being public even if they aren't.  American regulations are not only driving IPOs offshore, they're locking the common man out of the most profitable parts of the market.

The switch from public companies to private companies has become an issue in the Presidential campaign as Mr. Obama accuses Mr. Romney of "vulture capitalism."  The secretive world of "private equity" is entirely a creation of government regulation - if companies could be publicly traded without jumping through too many hoops, they wouldn't go private.  If start-ups were able to raise money publicly instead of getting politically-connected loans, we'd have fewer Solyndras.

The next article explains just how completely our government is saying they're protecting investors while destroying public companies and stock markets, the two engines which grew our economy and offered small investors a path to riches.