Who Says Facebook's IPO Wasn't a Smashing Success?

Forgive me for not sympathizing with the gentle whining coming from hedge funds, institutional investors, and traders around the world about Facebook's (Nasdaq: FB  ) "disastrous" IPO. Articles from Bloomberg, The Wall Street Journal, MarketWatch, and even The Motley Fool are calling the IPO a flop on many levels, and most people believe it.

Now reports are surfacing that Morgan Stanley (NYSE: MS  ) and Nasdaq OMX Group (Nasdaq: NDAQ  ) are being scrutinized by the SEC and FINRA over issues relating to the IPO. When a stock like this tumbles in its opening days, everyone wants to point fingers and place the blame over the IPO's flop.

But the success of an IPO is in the eye of the beholder, and in my eyes the IPO was a smashing success for Facebook. Let me outline why I think the reports have it wrong.

You scratch my back, I'll scratch yours
What an underwriter like Morgan Stanley normally wants to do is price an IPO just low enough that demand will push the stock higher on the opening hours and days of trading. It wants to do this to make a quick buck for investors who participated in the IPO (usually hedge funds and institutional investors, not you and me) and make it look good for the media. Since the hedge funds and institutional investors the underwriter sold the stock to are clients, it's a case of I'll scratch your back (by participating in the IPO) if you scratch mine (by making me a quick buck in early trading).

It's the dirty little IPO secret that it's the initial buyers of the IPO, the ones who actually paid the advertised $38 price, whom the underwriters want to please more than the company they're selling. If it makes those investors happy, the next time an IPO comes around the underwriter can call on them to participate again, giving the underwriter bargaining power with potential IPO clients.

But underpricing an offering like this doesn't serve the IPO company very well, so when a stock pops on its opening day, it probably shouldn't be viewed as a success at all. Groupon (Nasdaq: GRPN  ) and LinkedIn (Nasdaq: LNKD  ) both exploded higher on their opening day, prompting cheers from the media, but the losers were really Groupon and LinkedIn, because they left money on the table.

But the protocol is to stack the deck in favor of preferred clients buying shares in the IPO, no matter who is really paying the bill.

Who is the client, after all?
What people usually fail to realize is that it's the company being sold to the market that's actually paying the underwriter. In the case of Facebook, Morgan Stanley was the lead on IPO and got a $67 million fee for its efforts (about 38% of the total) to sell shares to the public.

From Facebook's perspective, and it is the client, it would be a best-case scenario to see the stock fall in the first few days of trading, because it would indicate that the company got more from the market than it should have. If I were Mark Zuckerberg, I would be tweeting about what a great job Morgan Stanley and the other underwriters did in selling the IPO.

How bankers make a fortune from IPO deals
If you want to see another clear example about why an investment bank wants to underprice an IPO, just look at the typical overallotment, a pot sweetener for any share offering. In Facebook's case, the filing said:

"In addition, Facebook and the selling stockholders have granted the underwriters a 30-day option to purchase up to 63,185,042 additional shares of Class A common stock to cover over-allotments, if any."

What this means in reality is that if the stock goes up after the offering, the underwriter can sell additional shares at the higher price, turn around and buy them from Facebook, and pocket the difference. In the case of Groupon and LinkedIn, I'm sure the underwriters made off like bandits.

No sympathy from this Fool
When an IPO declines soon after reaching market, the media likes to call it a failure or a flop -- but that's true only for the investors who bought shares at the IPO price or early in trading. Maybe what we should be doing is cheering the IPO for taking money out of the pockets of hedge funds, institutional investors, and other preferred Morgan Stanley clients and giving it to Facebook. I would much rather see a company get too much from an IPO than watch a preferred group of investors make a quick buck.

As with anything, success is in the eye of the beholder. If you don't yet own shares of Facebook, if you will in the future, or if you're just hoping Facebook does well as a company, you should see the IPO as a smashing success. Forgive me for not feeling bad for those who lost out when they thought the game was stacked in their favor. I'm sure you'll have better luck next time.

If you're over Facebook, like I am, check out the IPO our analysts think you should really be buying. In our free report titled "Forget Facebook -- Here's the Tech IPO You Should Be Buying," we highlight a company that may outperform Facebook's IPO long-term.

Fool contributor Travis Hoium has no position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings, or follow his CAPS picks at TMFFlushDraw.

The Motley Fool owns shares of LinkedIn. Motley Fool newsletter services have recommended buying shares of LinkedIn. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On May 23, 2012, at 10:05 PM, TheCommonTulip wrote:

    I think the real travesty has less to do with the falling stock price and more to do with the non-disclosure of earnings estimates by MS bankers. How can the public feel comfortable spending any money on Wall Street with the possibility of analysts essentially being "bribed" to provide fake estimates? Shame, big time on both Facebook and MS.

    AT

  • Report this Comment On May 23, 2012, at 10:21 PM, NOTvuffett wrote:

    As far as I know, FB warned of lowered revenue projections but they weren't given to any but the larger investors. FB seems blameless in this.

  • Report this Comment On May 23, 2012, at 11:16 PM, RockPress wrote:

    We were fool when Facbook got started. Now they use us and our information against us. Then they burned us with their IPO. I found this:

    http://www.cafepress.com/facebookiposucks

    Which says it all! First there was Disco, then there was Disco Sucks. Now there was Facebook, now it is Facebook Sucks!

    Rock

  • Report this Comment On May 24, 2012, at 5:52 PM, kjwes3 wrote:

    How can I possibly loan money to someone with no assets? Facebook has nothing to sell if it went under. Of course, it is now too big to fail...

  • Report this Comment On May 24, 2012, at 6:07 PM, CER4040 wrote:

    Most investors should know it is very risky to buy into an IPO. Most IPO's go up and by the end of the day the day traders are flipping their shares and the price usually takes hit.

    Even if it is a solid company the first 90 to 180 days can be very bumpy. And to that point is why I didn't and would not have bought FB. In my mind they still have to prove that they have a reliable business model built on something more than advertising, and that they are growing their business at a rate that justifies their valuation.

    Until I see that happen I'm not a buyer not only for FB but for any stock. But, I would not count out FB. They have the talent and drive I think to make something happen. In my opinion they will only become a fad if they stop innovating.

  • Report this Comment On May 24, 2012, at 6:07 PM, 102971 wrote:

    Although very few will admit it, you're right! The purpose of an IPO is to get the company going public as much money as possible. Underwriters consistently under price the offering company's shares to give a benefit to themselves and their close friends.

    Unfortunately, Morgan Stanley miscalculated as it is not good business for a stock to close at 10% or more BELOW it's offering price.

    I could see this coming and stayed well away from dealing in the FB stock for the first few days. In fact, I don't think I'll ever be a buyer as the fundamentals are still not there.

  • Report this Comment On May 24, 2012, at 6:07 PM, salmonnegro wrote:

    I like this view. I was disgusted by how hedge funds and institutions wanted to make money by buying all shares before retail investors could, create hype, and then sell them to retail investors at inflated prices. Let the Joes sustain the losses while they transfer money into their pockets. I like how the IPO played out. There are less stupid Joes out there than those institutions thought.

  • Report this Comment On May 24, 2012, at 6:10 PM, yishaika wrote:

    So the stock dropped 20% since the IPO? I don't remember any guarantees given that there will be a pop. All I remember are strident warnings in the press not to buy the stock, so nobody is buying it.

    The success or failure of the stock depends on Facebook. Look again when the market is not overly confident or depressed in a year or two. If you are a speculator, then too bad. You cannot win them all. Move to the next one. Just make sure you bet appropriately and keep a success ratio well above 50%.

  • Report this Comment On May 24, 2012, at 6:27 PM, mikecart1 wrote:

    Facebook was a success because it shows to the world - even casual or new investors - just how 'broken' or 'uncertain' the stock market really is. I have no doubt that lots of Facebook users that have no clue about stock investing decided to sign up with some online broker and put some money in, just for the chance to own Facebook. Many probably bought the first day it came out because they have this mental picture of other popular names in the stock market that make their way into homes like Apple or Microsoft. Knowing that these 2 companies are much higher than their IPO price, they get this idea that Facebook is this generation's Apple or Microsoft. So they put a bunch of money in - or at least all they can afford.

    Now it is 20% lower or whatever and all these new investors feel like they got suckered into the market and will probably not buy another stock again. Meanwhile, all the experienced investors and regular investors now have another example of how there are no guarantees in the market. They get have further support that the independent investor has no chance against the big guys and this now moves these investors out of the market.

    Facebook was a success in driving away future investors in a market where most casual/independent investors were already gone.

    Congratulations Facebook. I am not the guy in Good Will Hunting btw hehe.

    :)

  • Report this Comment On May 24, 2012, at 6:38 PM, BentMike wrote:

    Travis, I have been watching IPOs for a long time, but only began to understand them in the last year or so. I knew when an IPO went high that it was not a good deal for the issuer, and it seemed like the parochial nature of the initial buying was a set up that favored the insiders. I couldn't figure out why the issuers would like this. Thanks for elaborating on this and confirming that I have learned well. Of course I had to rec this because I agree.

  • Report this Comment On May 24, 2012, at 6:39 PM, AvantiFilm wrote:

    FaceBook was started by the young ZUK lying, cheating, & stealing from his "friends"; it is built from wrong-mindedness and takes advantage of the 666 flaw in every personality. (Something he learned in those psychology classes at school). FB is riding the zeitgeist of the internet and like all tides it will recede as fast as it has advanced when the masses of MAU's discover it is an Exploitation Utility, used to drain personal wealth & integrity!

    FB is a great stock to short: Every status update, photo, boast and tweet – is chosen to present to the world the type of person we want everyone to think that we are. There is something wrong with this. However, it’s now common for people to pose to be something that they really aren’t.

    I think social media is to blame for the lack of authenticity that is running rampant online, on Wall Street and in the Media!

  • Report this Comment On May 24, 2012, at 7:56 PM, WhyNot222 wrote:

    FB came out at $38 and closed the day a little above $38...sounds like they priced it exactly where it needed to be to get every penny possible.

    If the media hadn't touted it as a failure, maybe it wouldn't have sold off the way it did in the following days.

    I had no intention of buying any and didn't, but what will tell the story is the price per share a year from now...I have no sympathy for those who are bellyaching because they didn't make a killing in 48 hours.

  • Report this Comment On May 24, 2012, at 9:08 PM, ceallachqn wrote:

    I think some folks jumped on board with Facebook because it is Facebook. They had expectations: that the stock would soar and they would become instantly ahead of the game. People generally look for someone to blame when their expectations are not met. The thing is, Facebook is no different than any other stock and has to be looked at with the same discretion applied to other stock picks. I personally think that IPOs can be tricky and didn't buy Facebook because it was so hyped up (one reason). I also agree with other commentors who have mentioned the media's role in creating a notion of Facebook "failure". A person simply can't be a lemming with stocks.

  • Report this Comment On May 24, 2012, at 9:47 PM, jc09058 wrote:

    A great article that did a bang up job of describing the IPO mechanics. The dirty little IPO secret is the trick here and it has been a while since an IPO came back and bit the insiders. Kind of glad to see it still happens sometimes.

    As it stands, I don't really see that Facebook can make their business plan work in the long run. As soon as a replacement social site comes along, Facebook will be replaced like MySpace was and all of that data mining Facebook did will become dated and obsolete.

    This one got played up way too much and with the initial pricing being bounced around too much, I figure people were getting greedy and it was time to be a little fearful.

  • Report this Comment On May 25, 2012, at 12:12 AM, Notfooled1 wrote:

    Travis Hoium, if you believe that the Facebook IPO was a successful IPO, you really are a fool.

  • Report this Comment On May 25, 2012, at 12:35 AM, depsee wrote:

    In my opinion this was a classic "SUCKER" play. There was a incredible amount of hype before the IPO. But you didn't see the CEO (ZUK) or anyone talking about how this is a great deal, how they have all these great plans to grow the company. How the $38.00 dollar price may be very expensive now, in a year or two we expect our plans to vastly increase earnings and the stock price to double or better. How we expect to start paying a dividend.

    No. What you did hear was how much money insiders were going to make, and apparently they were planning on dumping stock ASAP. It went as far as one individual in the company saying he was canning his U.S. citizenship and becoming a citizen of Singapore because of tax reasons. Well, you don't pay taxes on stocks until you sell, so that indicates he planned on selling a butt-load of stock real soon. Apparently as a insider he saw $38.00 as a great sell price. So much so as to abandon his home country. Also just before the IPO, GM quit buying adds on face book because it wasn't working. A bad sign.

    This has "Pump and Dump" written all over it. Insiders and the Wall Street gang figured they could hype this to the point that the price would shoot up out of the gate, they all sell and make a killing, and enough little people make a few bucks and its in play a while. Given enough time, when the stock tanks, that's the market. The ultimate "Suckers" are those left holding the stock.

    Interestingly right after the IPO, Zuk had this top secret marriage. It was to a Oriental lady. In light of the other company insider seeking haven in Singapore, could Zuks bride be a attempt to shelter his IPO profits from U.S. courts?

  • Report this Comment On May 25, 2012, at 1:07 AM, Draytonbird wrote:

    "Be fearful when others are greedy" - Buffett

  • Report this Comment On May 25, 2012, at 1:48 AM, Chontichajim wrote:

    Finally someone writes the obvious, that this IPO was a great success for FB. I have been on IPO alerts for some time though only purchased 2. Prices change based on people expressing an interest. The price may go up or down some percentage or the offering pulled altogether if the demand is way to high or way to low at the starting price. Zuk saw the high demand and increased the price as high as he could without delaying the IPO. FB then got as much money out of the deal as possible by increasing shares available along with the price.

    IPOs which have a large jump immediately after issuance is a sign management can not value their own company. NASDAQ couldn't handle the volume, but that is not a FB failure. I have no interest in owning FB, but I would credit their management with raising as much capital as possible.

  • Report this Comment On May 25, 2012, at 6:16 AM, AlfalfaWolf wrote:

    Sorry, not buying it. FB OR the idea that an IPO is a tool to serve the company first and foremost. Frankly I'm surprised at how many comments here agree with that notion. An IPO is no different from any sale transaction. A mutually fair transaction has to take place in order for any business relationship to be sustainable. Sustainability may not be the calculated concern of any single individual looking to retire tomorrow, but without it there is no marketplace. And therein lies the rub: you can retire filthy rich tomorrow if that's what drives you, but if it's at the expense of other folks then the system needs to autocorrect, as it has been since the first IPO - painfully slow as it has been. The irony here is that corrections don't take place until the unbalance affects the top tiers.

    Hedge funds, institutional investors, and Morgan Stanley may indeed be no better than an overvalued company in many ways, at the end of the day. But all else being equal, there are still real lives tied to those funds. They can only hope that their hard-earned buck will return an honest dime when all is said and done, by a company that offered them their word that what they're selling is as close to being 100% accurate as it can possibly get.

    I have no dog in this race, mind you. I don't really care if current regulatory framework still turns a blind eye towards unbalanced transactions (well, the capitalist in me doesn't give a damn). All I am saying is that, if it doesn't make sense in your personal life, it doesn't make sense, period.

  • Report this Comment On May 25, 2012, at 11:49 AM, truman1987 wrote:

    Nice article. Perfectly described.

    The only problem with pricing it too high is that when the Heavies get burned the government starts investigations.

    If FB went to 60 on IPO day as the Littles bought out the Heavies and then collapsed to 30, there would be no investigation.

    Sounds successful to me. The Company got a better price, the Heavies got whacked, and the Littles got a fair shake for once.

  • Report this Comment On May 25, 2012, at 12:07 PM, TMFFlushDraw wrote:

    You can't cover all bases in one article and this article was intended to cover the mechanics, the institutional side, and Facebook's point of view.

    The article below points out how the IPO was a disaster for naive individual investors, also true. Some very good points.

    http://www.fool.com/investing/general/2012/05/25/the-tragedy...

    Travis Hoium

  • Report this Comment On May 25, 2012, at 3:43 PM, bgk23 wrote:

    Love your prospective, and you're absolutely right! I was thinking, another young CFO in over his head (like Groupon), but with your article, I've changed my perspective (at least on the Facebook CFO). That said, can't say much for his integrity.

  • Report this Comment On May 25, 2012, at 4:06 PM, truman1987 wrote:

    In the real estate market if your broker sold your house at 10% under market value to one of his buddies and that guy hyped it up and sold it the next day at 20% over market value, it would called fraud. In the financial world that is called a successful IPO.

  • Report this Comment On May 27, 2012, at 3:06 PM, asansotta wrote:

    The Facebook Debacle – More Undisclosed Insider Secrets

    Facebook's mobile woes just got bigger

    BREAKING NEWS: Facebook’s Mobile Woes Just Got Bigger

    Leader Technologies is awarded the patent on social networking apps after a 10-year USPTO evaluation

    READ MORE....WWW.DONNAKLINENOW.COM

  • Report this Comment On May 28, 2012, at 11:34 PM, TMFAleph1 wrote:

    <<Of course, it is now too big to fail...>>

    Facebook is *not* too big to fail. If Facebook disappears tomorrow, it won't send the economy into a tailspin.

  • Report this Comment On May 28, 2012, at 11:38 PM, TMFAleph1 wrote:

    If Facebook disappears tomorrow, it won't send the economy into a tailspin

    ...if anything, U.S. GDP would probably increase if this time sink were to disappear.

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