Tuesday, June 19, 2012
A Contrarian's Viewpoint on the Facebook IPO
I’ve been reading the recent press on the Facebook IPO with an increasingly unsatisfied feeling of unease. Yes, NASDAQ botched initial trading, Morgan Stanley got aggressive on pricing and deal size and the company management was perhaps arrogant. But none of these issues, or the other commonly discussed ones, addresses the real issue: that of how hard it is for even successful companies to go public after Sarbanes Oxley passed in 2002.
Facebook has been accused of “closing the IPO” market; it’s also facing a number of lawsuits tied to the IPO (as if the company owed flippers a pop on their short term investment). While a company can open or close the IPO market, a temperamental animal at best, I don’t think Facebook deserves the blame for this one.
Greece is a disaster as is much of Europe, with the European Union itself being threatened, growth in the BRIC economies and indeed much of the world continues to stagnate (or fall of the proverbial cliff), the Middle East is unstable (more so than usual) and the US is facing a presidential election in the midst of high unemployment, spiraling debt and political gridlock. Facebook was a delicate toe in the water of hoping for some normalcy which unfortunately didn’t work out as planned.
Were the company and investment bankers to blame as well? Probably, but they were also massively successful from an investment banking perspective in that they closed a deal raising almost $20 billion in a weak market. Yes, I can hear the cries of complaint on that statement but realize that no investment banker can anticipate all future market realities so at the minimum has to raise the money its client needs. The prospectus does list the risks involved; again, groan all you want and then tell me what better alternative exists?
What does that successful close mean for the company? They now have cash to expand their business and can buy other promising companies in what might end up being a fundraising winter. They rewarded early investors, management and employees, flooding northern California with liquid stock (read exchangeable for cash to shop, pay taxes and fund new innovative companies). The company also has a war chest to compete with more established concerns such as Google.
Having taken a number of high growth companies public as an investment banker before the above mentioned legislation I mostly did mergers and acquisitions work after SOX (had I stayed in Silicon Valley and not moved south to Los Angeles that reality would actually not be true). Companies face a different reality then when I started as a young, eager banker. To go public today is more expensive out of the gate and requires vastly more regulatory obligations and ongoing expenses. Liability for directors and management only continues to grow, especially in our current anti-business environment. Criminal liability has extended, and sometimes retroactively, to issues such as stock option backdating and whatever else Washington decides. Having worked in the securities industry for years and being a lawyer I still don’t fully understand the insider trading laws so never did any even possibly questionable trades without written clearance from my compliance department (which, by the way, would never have fully protected me from possible criminal liability even with full disclosure of related knowledge and relationships on my end).
Since Sarbanes Oxley most venture funds began pricing investments based on the likelihood of a company sale as an exit not the generally higher IPO valuations – to reflect the dramatic decline in IPOs. And, to be clear, venture funds need liquidity at some point as their investment pool must eventually be returned to investors, the timeline depending on the terms of each fund. I’ve written in the past at my shock of this change as early in my career an M&A exit was considered very second rate, with an IPO expected (or at least the goal).
Facebook management is now going to be dealing with some of those concerns as they deal with the legal fallout from their initially dropping share price post IPO, which is still about 20 percent off its initial trading price. Litigation is expensive and draining on management time even if the company wins.
Arrogance getting its comeuppance? No. Very few successful start-up company management teams aren’t arrogant. It takes a huge level of confidence or a dash of insanity to work like a demon to create a vision of reality from nothing. Any overnight success took brutal concentration and getting knocked down over and over again. It took a thick skin and confidence to proceed no matter how many people told you that you were wrong. It took long hours and late nights. No one without a strong sense of self and vision makes it to a billion dollar IPO.
But the repercussions expand further than just Facebook, the IPO market and venture funding going forward.
The IPO was also the first real test of how effectively private markets like Second Market are pricing what would otherwise be un-tradable company shares pre-IPO. The private market valuation did not hold up in the public markets, which provides a new metric.
I’ve read that this IPO also raises a number of questions about the viability of social networks and even new media companies. But really? Generally, the reality is that only a few strong players emerge from any high-growth innovative industry, swallowing up the smaller ones with good ideas or brilliant employees. Everyone else goes bankrupt. How many Facebooks do we really need?
The Facebook crew has created a lot of wealth and changed how people communicate. I’ll defend their arrogance and assert that we need them to teach others how to have such courage in their own innovations such that they can build a billion dollar (or hundred billion-ish) company. If we learn one lesson from their experience it’s that as a society we need to encourage innovation. If we learn two, the second is that we should make accessing the public markets easier so that high growth companies can more easily raise capital and provide liquidity to their investors.
IPO post market performance can be (loosely) correlated to long term success but more often a company that grows over time likewise increases shareholder performance regardless. Turns out that a quality company always returns more long term than does a failing one.
The grumblings that you’ve heard about financing possibly drying up? I’ve heard them too and they are absolutely true. Making money is getting harder and so a lot of investors are likely to hoard their cash and stay conservative until global economics and market conditions improve. Volume has been light in the public markets, if anyone missed that footnote.