The Facebook IPO Debacle

It has been interesting to watch the Facebook IPO debacle. The privately held company sold about 10% of the shares to the public at a price of around $38 a share. The total deal valued the company at about $100 billion on the day of the IPO.


Since then, the price of a share has slumped pretty dramatically. In the week since the IPO, the value of the shares have plunged 25% from the opening day high. The individual investors who fought for the chance to buy some of the allocated shares now look like chumps.

This was predictable, and there were plenty of warning signs.

Generally speaking, there are two reasons why you sell a piece of a company:

• You need the money to expand the company. This expansion will make the remaining shares in your possession more valuable.

• You are cashing out, in whole or in part.

Let’s look at using the money to expand the company first.

To illustrate, let us suppose that you have invented a new product, say a holographic projector for use with home computers. You have built your prototype, taken it to venture capitalists. They like the prototype, and funded the development of the final production ready design. Now you want to go into production. You have to build a factory, acquire raw materials, and build up an inventory of finished projectors. You also have to mount a mass media campaign to introduce your product to the public.

All this takes a lot more money than what the venture capitalists are willing to put up. So you sell shares to the public to raise the necessary funds to expand into full production. In full operation, your remaining slice of the company becomes worth more than what it was before you sold part of it. That is how a traditional IPO functions.

Then there is how Facebook did it.

For Facebook, the venture capitalists and other early stage investors have fully funded the company’s very fast growth to date. Indeed, much of the company’s growth to date has been paid for out of continuing operations. The early investors do not need any additional capital to expand the business, and that is not how they were going to use the money from the IPO. Instead, they are paying themselves back for all the money invested on the front end.

When it became clear that there was going to be tremendous demand for Facebook shares, the offering price was increased. Tellingly, the number of shares tendered also was increased. Now you have to ask yourself: Why would someone sell their piece of a business if they thought it was going to increase in value? The answer is they wouldn’t. But you would sell more shares if you thought the price being taken was more than the business would be worth in the future.

For the early investors, the IPO was the best of both worlds: they got the money back that they put into Facebook on the front end, and they still own lots of shares. Any future recovery in the stock price lifts the value of their residual positions. In the meantime, the investors who bought shares in the IPO have taken a 25% hit to their wallets.

One classic investing tip is to invest in what you know. With hundreds of millions of users, lots of people know and love to use Facebook. But it is important to remember that just because you know and love something, that doesn’t make it a good investment.

I sure didn’t think so. That’s why I didn’t buy any stock in the IPO.