Sorting out Facebook's disappointing IPO

Here's a status update on Facebook's vaunted initial public offering: not as hot as your brother-in-law might have told you. But it remains to be seen whether the Wall Street banks orchestrating the $16 billion stock sale did anything wrong, or whether last week's investors have only themselves to blame if they feel burned.

Facebook shares closed Wednesday at $32 apiece, up a dollar for the day but down nearly 16 percent from the $38-a-share initial price set last Thursday.

Lawsuits are already alleging that investors were somehow duped by the high-flying social media company or its underwriters, led by Wall Street's Morgan Stanley. Federal and state investigators are reviewing whether reduced revenue projections may have reached some investors but not others, and if so, whether that violated market rules.

But before you poke your brother-in-law in the eye rather than on his Facebook page, some words of caution: Like any other new company, Facebook was always a risky bet for investors. And the performance of the stock in its early days - while partly a response to some clear-in-hindsight market signals - may not be a clear harbinger of what's to come.

"I think everyone had their high-tech, new-issue, 1999 goggles on," said Howard Trauger, president of Schuylkill Capital Management, who purchased about 2,000 shares for a half-dozen clients and said he reminds investors to take the long view.

"I convinced them that you really want to take a five-year horizon for this, not a three-day view," said Trauger, who manages about $50 million in assets for wealthy clients, trusts, and institutional investors. He told some to consider it "a legacy stock for their grandchildren."

Facebook, born at Harvard University just eight years ago, is a real company with large cash flows and significant profits: It earned $1 billion last year on $3.7 billion in revenue, according to its IPO prospectus.

By many measures, its reach seems phenomenal. Worldwide, Facebook counted 901 million "monthly active users" in March, meaning that they had visited or done something related to the site, such as clicking Facebook's iconic "Like" button. According to Nielsen, nearly 153 million Americans logged on during March - more than two of every three active U.S. Internet users.

But the question for investors wasn't about today's impressive reach. It was about what that reach will mean for revenue and profits in the months and years ahead. And that was always a much more complex question, according to investment managers and financial experts, many of whom questioned the $38 IPO price that briefly gave Facebook a market valuation of almost $105 billion - more than, say, Amazon's and more than half that of Google - and a price-earnings ratio of more than 100 to 1.

Facebook's prospectus, filed with the Securities and Exchange Commission in February and amended several times since, gave detailed warnings about some of the risks that could undermine the company's ambition "to make the world more open and connected" and to profit handsomely as a result.

For example, the prospectus warned repeatedly that Facebook was seeing a shift among users to mobile apps - 488 million of its monthly active users connected through mobile devices sometime in March, it said.

That was an obvious concern at a company that had so far steered clear of sending ads to its members' smartphones, and the company said it had begun in March "to include sponsored stories in users' mobile News Feeds."

Then it added: "However, we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven."

So how was that IPO share price determined? In theory, it was based on factors such as the company's so-called enterprise value, and complex models estimating the worth today of tomorrow's profits.

But experts say that a sizable part of the calculation - say, the difference between setting the IPO price at $25 vs. $38 - isn't about the supply and demand for company's services, but about the supply and demand for shares of a big-buzz IPO.

Based on financial models, Facebook estimated the fair value for its common stock at the close of each of the last five quarters. That estimate ranged from about $25 to $31, according to its amended prospectus.

But when investment bankers did the "road show" rounds and contacted potential investment managers to help gauge the right price to set for the IPO, they were involved in a delicate negotiation, according to David Wessels, who teaches venture capital and finance at the University of Pennsylvania's Wharton School.

"Because of securities laws, they can't actually say, 'Here's the price. How much do you want?' " Wessels said. "But they can say, 'OK, if the price was $30 to $35, what kind of interest would you have?' "

Wessels said that, ideally, that delicate dance is designed to discover the right price: high enough to generate a healthy chunk of capital for the company and to give early-stage investors a sizable return for their willingness to take a risk, but low enough to attract heavy demand for shares and to generate a substantial "pop" - an increase in value - in the early trading.

The idea of the pop is to err somewhat on the low side, partly so IPO subscribers can benefit - it's called "leaving something on the table" - if they want to sell quickly, and partly so the market as a whole is impressed. It also pleases first-day investors, which often includes people closed out of a heavily subscribed IPO.

Wessels said that the average pop for an IPO is about 15 percent. But on Friday, the first day they were publicly traded, Facebook shares spent most of the day below $42 and closed barely above $38. And the only reason they didn't dip below the IPO price was that Morgan Stanley, the lead underwriter, stepped in to support the price by buying millions of dollars worth of shares. Without the support, shares dipped Monday to about $34.

What went wrong? Wessels and other experts blame several factors.

One was Facebook's decision to allow early investors to contribute 241 million of their own shares to the 180 million new shares that Facebook was issuing.

"When you have insiders who increase their selling desires, that's a little scary," Wessels said.

Another last-minute red flag was that IPO participants got close to the numbers of shares they requested, said John C. Coffee, a securities-law expert at Columbia University law school. In a hot IPO, buyers are typically allocated only a fraction of what they seek. So by the time trading began Friday, it was clear that the hot IPO was very likely not so hot.

"What happened is everyone got greedy," Trauger said. "It looks like that when the IPO guys finished, they didn't leave anything on the table - except the bag."