It was probably the most anticipated initial public offering ever. For months, the financial market was abuzz with questions of how much this icon of social media would be worth when the bankers finally brought it to market.
But in what is turning out to be a more common event, the bankers got the valuation of this financial asset wrong. The Facebook IPO was overpriced by at least 20 percent.
The United States investment banking history has a long and storied history of bringing companies public. All the big company names of today, including Apple, Google and Wal-Mart, were at one time private companies. They have grown dramatically under public ownership.
When a developing business is going well, the time comes when original investors and the company founder want to cash in on their success by selling stock to the public. But most often the company needs help with this sale. The company selects what is called an underwriter.
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Investment banks operate as underwriters for a new issue and perform three important functions. They fulfill all legal requirements, buy the newly issued shares from the company and then sell these shares to the investor public.
The Facebook offering was made under what is called a firm commitment, where the underwriter pays a fixed price to the firm for the stock then sells the stock to the public for, hopefully, a higher amount. The difference is called the spread, which in this instance amounted to 1.1 percent or about $176 million.
Facebook became a public company when 421 million shares were issued and sold to the public at $38 a share. The underwriters, led by Morgan Stanley, got excited with all the hype about the company and sold 84 million more shares than originally planned at a price $7 higher.
It usually works the other way around. Most IPOs are underpriced.
Recall that the underwriter first buys all the shares from the company. In order to sell these shares quickly, underpricing or selling below the asset’s true value is widely practiced.
Historically, U.S. IPOs are underpriced by about 6 percent. This amounts to a significant cost to the company. Adding this to the spread, the company usually gets 7 percent less for the new stock below what it is really worth.
This time, Mark Zuckerberg and his initial investors netted the $38 per share, the underwriters got $176 million and new shareholders who didn’t sell right away are left holding a $30 stock — a loss of more than $3 billion.
Underwriters usually step in to buy a poorly performing IPO, and many did on the first day of trading. But the large size of this offering will prevent them from helping much.
Further, under their contract with Facebook, the underwriters have 30 days to exercise what is called an overallotment option. Morgan Stanley and other firms can purchase another 63 million shares from the company at the original offer price of $38 less the spread. This is not looking like a profitable trade these days.
PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa