NEW YORK – The botched offering of Facebook stock has raised several troubling questions, but at least we don't have to worry about the one that plagues many IPOs: How are a few select investors able to buy in early at lower prices and then pocket huge profits when the trading frenzy begins?
Among the many apparent missteps in its public debut, Facebook is accused of setting an opening price that was too high. Instead of spiking on the first day, shares inched up just 23 cents, to $38.23. The stock has mostly fallen since.
But some IPO experts don't think this was problem at all.
"The debacle was not the IPO but all the whining by speculators who didn't make money," says Lise Buyer, who helps companies plan initial offerings. Says Jay Ritter, a finance professor at the University of Florida, "Selling something for what it's worth is the way most people think a market should work."
For all its flaws, the Facebook debut did fulfill the chief purpose of a stock offering — to raise money for a company to pay bills, buy rivals, invest and expand. That aim is often lost amid the inflated expectations accompanying high-profile debuts.
In an initial public offering, a company sells shares to investment banks at what's called an IPO price. Those investment banks, called underwriters, then turn around and sell the shares to big investors who've signaled they are willing to buy at the same price. The higher this initial price, the better because it means the company can raise more money. The much-anticipated pops on the first day of trading are mostly relevant to the big investors, not the company, since it has already pocketed the cash.
In fact, a big opening-day pop can suggest the company got rooked and could have set the IPO price higher and raked in more money.
Last year, several Internet IPOs soared 50 percent or more on their first days, recalling the Main Street excitement of dot-com offerings more than a decade ago. Shares of the online professional network LinkedIn, for instance, doubled in value on the first day.
"Some of the pops were excessive," says Ann Sherman, a DePaul University finance professor who feared another "IPO bubble" was brewing. Though disappointing to many, the flat Facebook debut came as a relief to her.
Whether Facebook blew it by committing the opposite sin — overpricing — is another issue. The stock closed Friday at $31.91, down 16 percent from its IPO price last week.
There are good reasons for pricing an IPO stock so it's almost assured a small first-day rise of, say, 10 percent or 15 percent. Companies going public tend to be young, small and risky. A "guaranteed" profit helps entice big mutual funds, hedge funds and other big traders to take a chance. Walloping those big first investors with losses on the first day can make them less likely to buy when a company needs to raise cash by selling stock again in a secondary offering.
But for the pop, these funds might not bother to even study newly public companies, much less show up at their roadshows where they talk-up their prospects to potential investors.
Ritter, the University of Florida professor, says "conflicts of interest" by investment bankers play a role, too. The bankers talk to potential IPO buyers to gauge demand for the stock, and then help the company set that all-important IPO price. Lowballing the price allows the investment banks to reward big funds. Those funds often are big customers of the banks, using them to help trade stock, design custom-made derivatives bets and provide other services.
The quid pro quo from the investment banks to the funds is this: We offer you a hot IPO stock on the cheap, you sell it after the pop for instant profits — and you do more business with us.
How this benefits the companies selling the stock in the first place is unclear.
Ritter, who probed the issue a decade ago in a paper titled "Why Don't Issuers Get Upset?," attributes it partly to the psychological thrill that CEOs with big shareholdings feel if their stock surges on the first day. "If you thought you were worth $18 million, and you turn out to be worth $21 million, you're happy," he says.
There also are positive headlines after a big jump on debut day, which can burnish a company's image with customers and, perhaps, help it sell more goods and services to them. However, some have concluded that the benefit was minimal given the extra cash that the company passed up.
Or as Buyer, a consultant at IPO Class V Group, put it, "You can purchase advertising for a lot less."
For our continuing fascination with outsize gains on the first day, you can blame the dot-com bubble. In 1999, the height of dot-com frenzy, stocks rose an average 72 percent on their first days of trading, according to IPO research firm Renaissance Capital.
"A lot of people fondly remember those days, even if they don't remember what happened next," Buyer says.
Dot-com stocks collapsed causing billions of dollars in losses. Banks were sued for allegedly staging IPOs to line insiders' pockets and lead to more business for themselves. In 2003, 10 large banks agreed to pay $1.4 billion and change their practices in order to settle regulatory charges that they rigged IPOs.
In the ensuing years, IPO pops became passe. Between 2007 and 2010, IPO stocks rose by an average 6.6 percent on their debut days. But then came a raft of Internet IPOs last year.
In April 2011, Zipcar Inc., an online car rental firm, rose by more than half on its first day. In July, Zillow Inc., a real estate website, rose 79 percent. And, in December, Angie's List Inc. climbed 25 percent, though the consumer review site had yet to turn a profit.
The madness just might have lasted, but for Facebook.
The downside of the Facebook faceplant is that it could discourage other companies from pursuing IPOs. Companies planning initial public offerings now number just 63, according Ipreo, a research firm. A year ago, there were 108 with debuts in the works.
A successful Facebook debut "would have brought back confidence in the market," says Reena Aggarwal, a finance professor at Georgetown University. Now "companies might say, 'Forget it, I'm not going public."