Last weeks much anticipated Facebook IPO ( Initial Public Offering – otherwise known as the day Facebook sold part of the company to the public) ended up being a crushing disappointment. Or so it would seem to anyone reading the negative business media.
I’m of the opinion however, that the IPO was a huge success.
To understand why I thought the IPO was sucessful, you have to understand how IPOs work.
When an investor buys shares of a company which trade on a stock exchange, they buy them from another investor (not from the company).
When the owners of a company decide to go public, it means they will sell a certain percentage of the company to the public in the form of shares. If you can buy shares of an IPO, you essentially buy the shares right from the company (instead of from another investor).
Typically a company that wants to do an IPO will hire at least one investment bank to facilitate the deal. For a generous fee, this investment company will figure out the valuation of the company, gauge interest in the stock and will help determine the IPO share price and will line up buyers for the IPO shares.
To put this in a common analogy – imagine if you want to sell your house. You might hire a real estate agent, they will do some analysis on the house value and will work to sell the house for you. It’s possible they might even have some potential buyers lined up.
I’ve written too many articles about the huge conflicts of interest that real estate agents face, and investment banks that are handling an IPO have the exact same conflicts.
The seller of a business wants to get the highest price. That is typically their one and only concern. The problem with investment banks is that they play both ends of the field – they want to get the IPO business, but they also want to underprice it as much as possible so that they can sell it more easily and so their clients will make a guaranteed profit when the stock jumps up to the true market value. These clients will be lining up to participate in more IPOs and this works out really well for the investment banks and their favoured clients who can profit from the IPO shares.
But it doesn’t work for the company that is selling. There have been many examples in the past where a company was valued by the investment banks (and presumeably the company owners) at a certain price, but then the market has priced it higher. This means that the selling owners have left money on the table. It also means that most private investors who can’t get in on the favourable IPO price, miss out on the ‘great deal’ which was only available to richer investors.
As it turns out, the big short term winners of the Facebook IPO were the owners of the company who sold their shares for more than the market valued them and the small investors who now have the opportunity to buy the shares for a price lower than the IPO.
Investment returns aren’t supposed to be guaranteed, so in this case the IPO process worked just fine.